Thoughts on Investing for Income

The last few years have been difficult for the income investor. Prudence meant investing in short and intermediate bonds as the Federal Reserved raised rates. It was assumed that investments in longer maturities, including preferred stocks, held more than normal risk, thus resulting in potential reduction of principal and ultimately, income for many investors. The flat yield curve has to some extent allowed for increased income for investors focusing on very short term securities such as US T-bills and CD's. We are now seeing forecasts that suggest that shorter-term rates may well be either stabilizing or perhaps heading down. In a recent report UBS indicated their belief that the US economy will experience a "growth deceleration.....and a rate cut [by] December 2006." Bank of America's website forecasts a rise in the "Fed Fund rate to 5% and remain there for the balance of the year." These represent just a few of the examples reflecting a potential decline or flattening in interest rates.

With that in mind we believe portfolios should have a widely diversified bond/income component. In addition to the typical investments, we are structuring portfolios using Exchange Trade Funds, discounted closed-end fixed-income funds (corporate, preferred, senior bank debt, foreign and municipal) and REIT's. These investments are currently yielding between 6.5% and 9.0% for taxable debt and 5.5% to 6.0% for municipal fixed income. We believe such an approach will result in solid returns in this flat yield curve environment and higher returns in an environment of declining interest rates. It will also improve income stability going forward.

Strategy Update: We recently reduced again our exposure to commodities in the Dynamic Commodity Strategy. Reason? Too much frenzy there for our liking - a time to lean into the wind.

Market Musings

It was reported by some observers that today's 195 point liftoff in the market was due to the release of FOMC minutes that indicated only one or two more tightenings would be necessary. Didn't everybody know that already?

We think bond yields have overshot on the upside with 10-year treasury note yields up 70 basis points from mid-January lows to 5%. The Fed Funds rate has increased nearly 400 basis points from cycle lows. Prices of the intermediate to longer-term treasury market usually rally after the end of tightening cycles. Several developments indicate we are within striking distance of the top in intermediate-term rates. The first is the recent acceleration in the decline of the US Dollar. The cycle peak of the US Dollar Index occurred in mid-November of 2005 with a secondary peak in mid February/early March of this year. This week's rout takes it down to January lows with momentum likely to carry through to new lows. We think this is significant particularly since 10-year US treasury rates were already 100 basis points over a blended euro sovereign yield and showing signs of rolling over (source: UBS). Foreign inflows of capital, by definition, offset domestic savings. This would indicate higher savings, probably due to less home equity extraction.

Second, confidence and consumer spending growth appear to be highly influenced by swings in gasoline prices. The recent jump in crude oil prices to $71.50 per barrel will pinch consumer spending on other items. We would also site the recent collapse of the housing market index (HMI) nearly a year after the peak in June of 2005.

Strategy Update: our bond strategy managers have lengthened duration in anticipation of a peak in rates. Bond strategies are classic contrarian investments. Discounts to NAV on closed-end funds widen (as they have recently) and fund managers shorten to the point of having prospects for minimal gains on a break in rates. We bought a bond mutual fund in 1984 when treasuries were yielding 14% in anticipation of big gains when rates dropped. Rates dropped and NAV barely budged. When the quarterly report came in the mail later it showed that this "intermediate" bond fund had an average maturity of 18 months! We believe the early part of any rate drop is where the easy money is made and you need to make a contrarian bet to be there. Usually, the discounts to NAV on closed end funds will tell you the right time as the lemmings exit.

Late cycle thoughts

Our friend at UBS, economist Maury Harris, commented in a recent edition of Global Economic & Strategy Research that:

"the upbeat nature of the latest consumer sentiment and regional manufacturing surveys for March was consistent with good Q1(06) growth in the neighborhood of our 4.4% forecast. However, the economy has yet to absorb the likely imminent blow from the projected end of the residential real estate boom. Meanwhile, recently muted price inflation reports suggest that still strong demand apparently has not been racing much ahead of supply. That should make the Fed more willing to stop tightening soon after viewing still likely upcoming softer economic data."

We agree. The stress on consumers is piling up: a doubling of the minimum payment on credit cards, upward resets on interest rates for adjustable rate mortgages, relatively slow wage growth and flat/declining home values, among other things. This puts an upward probability on seeing some unusual economic reports as we enter the summer months. Anecdotally, while out walking recently we overheard a mobile phone call from someone to their mortgage broker: "this monthly increase in my mortgage payment is killing me - please give me a call back with some ideas on creative financing into a fixed payment!" Not only should this call have been made 18 months ago but the thinking is a little backwards on which mortgage is the creative one.

Strategy update: We raised 5-7% cash (versus a 0-20% permitted range) in the Equity Opportunity and Small Cap Value equity models, primarily from several retailing stocks that have done very well. This makes sense in an intermediate-term overbought market. In addition, today's semi-reversal day performance (to the downside) is worth noting. Our Dynamic Beta Strategy, which targets an overall beta, is about 25% committed for a beta of .35-.40.