News Analysis date published New: 
Monday, August 6, 2012 - 14:00
New Date created: 
Tuesday, August 7, 2012 - 14:30
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Monday, August 6, 2012 - 14:00

Forget Treasuries, Score a 3.7% Yield with More Safety

Monday, August 6, 2012 - 2:00pm

Treasuries are still viewed as the safest assets in the world, but a closer look at the numbers reveals a very different story. In the past 10 years, the federal debt has almost tripled, climbing by more than $10 trillion to $16.5 trillion. The federal government borrows 36 cents out of every $1 it spends, pushing total daily borrowings to an astounding $3.6 billion. Looking forward, the trend is only expected to accelerate, with reports from the Congressional Budget Office (CBO) projecting that just unfunded liabilities for programs like Medicare and Social Security could total more than $43 trillion.

Meanwhile, what has been happening to the federal government's cost of borrowing? Interest rates have rarely been lower, with 10-year notes yielding a meager 1.5%. This has pushed real rates into negative territory with annual inflation trending just above 2%. Take a look at the incredible trend in falling yields below.

But this trajectory of falling yields is unsustainable, placing Treasury holders at great risk of serious capital losses when the disconnect corrects itself. It's precisely why now is the perfect time to shift into the most underappreciated fixed-income assets in the market: Investment-grade corporate bonds.

Unlike the federal government, the private sector has been on a roll since the recession of 2008. Keep in mind that the problems with the economy have been almost exclusively related to weakness in the financial sector. This forced companies that were already strong to get even stronger in order to survive the effects of little consumer spending and restricted access to credit. The end result has had a profound effect on the financial profile and performance of the private sector.

The first place we can see this is in earnings. After three years of incredible earnings growth coming out of the recession, the S&P 500 Index is on the verge of reclaiming peak earnings from 2007 -- projected to produce full-year earnings of $103 this year. Earnings are the single most important factor dictating the strength or weakness of a company, so this rebound back to peak earnings in the S&P is a big signal that the private sector is firing on all cylinders and benefiting from strong sales and operational efficiencies.

Speaking of operational strength, the private sector is also boasting record margins after years of gutting costs and expenses. There is some sentiment on the Street suggesting this is a bad thing, because of the traditionally cyclical nature of margins. But longer term, margin strength enables companies to send a greater portion of revenue growth to the bottom line, which is undoubtedly a good thing.

This string of operational strength and earnings growth has enabled the private sector to pump up its financial profile greatly, with the S&P 500 reporting a cash balance of $1.2 trillion at the end of the first quarter this year. This is meaningful for two reasons. First, because it insulates these companies from any further economic volatility or weakness in sales and earnings. Second, because in the long-term, it could enable these companies to make huge investments in future growth when they gain the confidence to deploy that cash back into the market.

But even though the private sector is incredibly strong right now, there is always risk in owning fixed-incomes assets of any one individual company. And that's why my favorite way to invest in investment-grade corporate bonds is with an exchange-traded fund (ETF) that corresponds to the price and yield performance of the Barclays U.S. Credit Bond Index, the iShares Barclays Credit Bond (NYSE: CFT). With 1,868 bond holdings, this ETF does a great job of reducing company-specific risk.

The iShares Barclays Credit Bond is heavily concentrated toward the S&P 500, with 72.5% of its current holdings being U.S. companies. It also has tons of liquidity, with average daily volume of 144,559. And with an expense ratio of just 0.20%, this ETF is a pinch below its category average of 0.21%.

But the best thing about the iShares Barclays Credit Bond is its yield, currently standing at 3.7%, more than twice what the 10-year note is yielding, with the additional security of robust earnings, strong margin profiles and plenty of cash on the balance sheet.

Risks to Consider: The iShares Barclays Credit Bond has exposure to the weaker financial sector, with Goldman Sachs (NYSE: GS), Citigroup (NYSE: C) and Bank of America (NYSE: BAK) all in its top 25 holdings. Although the concentration of financials is very low, these would be higher risk holdings in the event of more disruptions in the euro zone.

Action to Take --> The private sector has rarely been stronger than it is right now, with earnings, margins and cash balances all at a record high. But in spite of this strong fundamental profile, the iShares Barclays Credit Bond still pays a hefty 3.67% yield that is more than twice the yield of a 10-year note.

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