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VOL. 37 | NO. 23 | Friday, June 07, 2013

Playing it safe can be risky business

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Ever since the Federal Reserve began its zero interest rate policies, investors have searched for higher yielding assets.

This makes sense. If you need income to run your household or make your pension distributions, you must locate investments that provide yield. If Treasury bonds will not, what will?

Domestic and local stocks, real estate investment trusts, master limited partnerships, preferred stocks, emerging market debt, high yield debt and investment grade corporates have all provided investors greater yields since the Fed flattened Treasuries.

Today’s ultra-low risk-free rate environment forces yield hungry investors into alternative yield-producing securities.

Unfortunately, as investors crowd into these investments they have driven prices up to historically high levels.

The Rising Rate Preview

On May 2, the 10-year US Treasury Bond yielded 1.62 percent, ending the month at 2.20 percent. That’s a substantial move in a short period of time.

Interestingly, for all of the anxiety surrounding how stocks would react to a rising rate environment, stock benchmarks (the S&P 500 rose 2.9 percent) actually appreciated alongside rates.

Treasuries, high-yield bonds, investment grade corporates and emerging market bonds all shed more than 2 percent. High dividend equities and preferred stocks also lost money while REITs saw the largest declines, down over 6.06 percent. Typically, in any asset allocation plan, equities are perceived as “risk” assets and bonds are perceived as “safe” assets.

Should a rising rate environment persist, investors may find risk in safety and safety in risk.

The Inside Game

We know that the recent rise in rates damaged bond returns and enhanced stock returns overall, but stock investors shouldn’t necessarily take comfort in that.

Within the stock market, there were clear winners and losers over the time period. Rising rates actually benefit banks as the spread between borrowing and lending rates widens in their favor, leading to a 6 percent return in financials.

More cyclical sectors like materials and industrials outperformed, as well.

But traditional high-yielding sectors like utilities, consumer staples and telecom actually lost money over the time period.

These sectors traded in sympathy with their fixed-income cousins as the rising rate environment exposed their current bond like characteristics.

Putting it all Together

Looking backwards, any investments with yields exceeding treasuries have performed fantastically. High-dividend paying stocks have mesmerized investors in the low-yield climate.

However, looking forward, if we enter into a persistent environment of rising rates, “traditional” yielders will once again begin competing with the “alternative” yielders like REITS and utilities.

Those investors who oversubscribed to these investments for their high-yields and perceived safety may get surprised.

Furthermore, if rates in the U.S. rise more quickly than rates abroad, the U.S. dollar will also strengthen, threatening gold returns. Over the time period analyzed above, gold fell more than 6 percent.

Bottom Line: For those of you who might have been curious about the investment impact of rising interest rates you now have your answer.

In a rising rate environment, “safety” becomes risky.

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.

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