David Evanson and Oliver Pursche
Minyanville.com, Summer, 2013
As market uncertainty rises, investors will likely be hit with pitches about the irrefutable benefits of REITs and floating rate bonds. But donzzt be fooled.
As market uncertainty over rising interest rates increases, investors are likely to get bombarded with sales pitches about the wonderful and irrefutable benefits of Real Estate Investment Trusts (REITs) and floating rate bonds. REITs do have some merits to them, but I would only put a small portion of my investible assets into them, and only into liquid, publicly-traded REITs.
The hard pitch will likely come with floating rate bonds, and will sound something like this: It’s a bond like any other! It will return your principal upon maturity, but will increase its interest payment if rates rise above xx%.
It’s a suckerzzs game folks, so be careful.
First, in many cases, the assets backing floating rate bonds tend to be of far lesser quality than the collateral backing traditional bonds. Second, the total return of these instruments has been very close and highly correlated to those of junk bonds – which historically are more volatile than the stock market as a whole. Last, many floating rate bonds require a significant rise in interest rates before the coupon payment increases. Looking for proof? The US Treasury is planning to issue floating rate bonds in the first quarter of 2014 because they know investors who have been rattled by talk of higher interest rates will flock to them. Given the high deficit levels, I don’t see much of a chance of the Treasury Department and the Federal Reserve allowing a significant enough rise in interest rates to sharply increase their borrowing costs. Yes, the market will drive yield a bit higher, but I don’t believe it will be enough to offset the risk of these instruments.
So what should investors do? Well, as always it depends on their risk appetite. Very conservative investors who believe interest rates will rise should put their money in a money market fund. Not because it’s safe, but rather because money market rates will also rise as interest rates rise.
Investors with a more moderate risk tolerance should stick with high-quality dividend-paying stocks. They should look for companies with strong balance sheets and declining dividend payout ratios. Exxon Mobile (NYSE:XOM), Altria Group (NYSE:MO), and Microsoft (NASDAQ:MSFT) are great examples.
Growth-oriented investors should take a close look at low-volatility small-cap stocks. Although these companies can be more volatile than the overall market, many pay a reasonable dividend, have a low correlation to the S&P (INDEXSP:.INX), and are a great supplement to a large-cap portfolio. My firm has put together a portfolio of high-quality small-cap stocks, and one of our favorite names includes WD-40 (WDFC), which just announced second-quarter earnings that handsomely beat estimates and raised its full year outlook. We also like Tootsie Roll Industries (NYSE:TR), which is benefiting from significant international expansion of its business.
The bottom line: Follow Warren Buffett’s advice and invest in what you know. Don’t fall for great sales pitches — after all, that’s what got people in trouble with the tech bubble, the mortgage crisis, and just about every other investment disaster I can think of.