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Thursday, January 30, 2014 - 14:30

Interest Rates Are... Falling? 3 Ways To Profit

Thursday, January 30, 2014 - 2:30pm

When it comes to picking investments, stock guys like me have it easy.

Let's say we're looking for a stock. Well, we like spaghetti. We know that other people like spaghetti. We know that the Whatsamattayou Pasta Co. is the largest manufacturer of dried pasta in the country. The company makes money, and the stock looks undervalued. We buy.

Bond guys have it much tougher. They have to be way better than stock guys at math and economics and reading the tea leaves. That's why I really respect the work they do. No wonder the colorful political pundit James Carville once said he'd like to be reincarnated as the bond market -- that way, he could "scare the hell out of everybody."

So, when I decided to write about the bond market, I had to approach it from a stock guy's perspective.

As I've mentioned, I'm not a "wiggle reader," as I like to call chartists. However, the charts on the 10-year Treasury yield have grabbed my attention big time:

This one-year chart is pretty self-explanatory: Rates are trending lower. And there's money to be made.

Bond prices have an inverse relationship to bond yields: Prices go down as yields rise. So it's also no surprise that the one-year price chart for the 10-year Treasury looks like the yield chart standing on its head.

Treasury prices slid roughly 8% in 2013. While 8% isn't the end of the world, keep in mind that Treasurys are an asset class that have been rallying for nearly two decades. Naturally, investors are a bit freaked out by the erosion in principal value. However, where there are freaked-out investors, there's opportunity.

Bonds appear to be due for a bounce -- the chart and the macro conditions both indicate so. As money rotates out of speculative emerging markets -- as is currently happening -- investors typically gravitate toward safer, more stable markets. And the United States and Treasurys are widely perceived as the most stable investment on the planet.

As investors buy Treasurys, rates will head lower with firmer prices, and interest rate-sensitive stocks will benefit. Here are three plays to consider:

PowerShares Preferred Portfolio ETF (AMEX: PGX): I profiled this ETF just a couple of months ago, and it's still one of my favorites to use in building a portfolio. PGX holds a basket of preferred stocks that mimics the BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities Index. Shares currently trade around $13.80, down 8.5% from their 52-week high, and yield 6.8%. One of PGX's strengths is that 63% of the basket carries an investment-grade rating. All of the top 10 holdings in the portfolio were issued by large banks and diversified financial institutions, which usually benefit directly from stronger bond prices and lower yields.

AllianceBernstein Holdings (NYSE: AB): Asset management companies always benefit from positive financial market. Currently, fund managers are enjoying healthy equity fund inflows after a rough patch since 2008. However, as volatility finally entered the bond market, positive equity flows have been somewhat offset by bond fund outflows. A firmer bond market should stem the negative flow from bond funds.

One of the more attractively valued publicly traded asset managers, this MLP (master limited partnership) trades near $22 and yields a generous 7.3%. AllianceBernstein has a strong, research-driven equity business that should benefit from increased participation by individual investors. AB is trading at a 20% discount to its 52-week high.

Southern Co. (NYSE: SO): Like most utility stocks, SO spent most of last year sitting on the bench, giving up 17% from its 52-week high. The conditions affecting the giant, regulated power producer were mostly macro in nature. Utility companies usually rely heavily on debt financing, so rising interest rates make investors nervous about the ability of those companies to continue their liberal dividend payouts as their financing becomes more expensive and their operating margins are squeezed. Southern Co. is the biggest of the big and well run, to boot. Shares trade near $41 and yield 4.9%. Last year, the company generated over $5 billion in operating cash flow. That consistent strength, combined with interest rates easing, should take some pressure off of the share price.

Risks to Consider: Despite what looks like a near-term rally in bonds, volatility is likely to hang around for some time to come. Fits and starts will affect the price movement of these three securities. The above-average dividend yields and discount prices should provide some insulation and compensation for the risk assumed.

Action to Take --> On average, this basket of stocks trades at a 15% discount to their 52-week highs and has a blended yield of 6.2%. In addition to the attractive yield, prices of these could rise 15% to 20% based on the yield on the 10-year Treasury falling 10%. This would mean bond yields would fall from their current level of 2.8% to around 2.5%.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of SO in one or more of its “real money” portfolios.

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