The Fed is About to Smile on Income Investors

You’ve likely been wondering what’s going on with the market.

The S&P 500 is up about +12% since the start of September, yet unemployment is still high, the U.S. deficit is still enormous and the overall economic picture is still hazy. What’s behind it all?

I think most of the answer lies in QE2.

No, not the Queen Elizabeth 2 ocean liner. QE2 is what the business media is calling the pending second wave of quantitative easing by the U.S. Federal Reserve.

To stimulate the economy, the U.S. Federal Reserve has set short-term interest rates at all-time lows. But the economy is still sluggish and unemployment remains stubbornly high. To further stimulate the economy, the Fed has stated that it is likely to try a little-used tool called quantitative easing.

Quantitative easing is used to hold or push down long-term interest rates. To do this, the central bank buys long-term Treasury bonds, keeping their prices higher — and yields lower.

The hope is that by making Treasuries less attractive, banks (which have been borrowing for next to nothing and buying safe Treasuries) will be more apt to lend to businesses and consumers.

Quantitative easing is experimental, and whether it will really help the broader economy is unknown. Even Ben Bernanke says that “we have less experience in judging the economic effects of this policy instrument.” But one thing is almost certain: The Fed’s expected move is good for almost all income investments — and great for others.

So for which securities would the easing be great?

I’ve found two: foreign income investments and lenders. If the Fed announces a quantitative easing program at its next meeting, these are spots I want to be.

Foreign Income Investments: There is no free lunch when it comes to Federal Reserve intervention. When the central bank buys Treasury bonds, it is likely that it will turn on the printing press to pay for them. In the tried and true law of supply and demand, the new money supply is likely to weigh on the relative value of the U.S. dollar. And to some extent, just the rumor of QE2 has put some pressure on the greenback. The euro has gained more than +8% against the dollar since the start of September.

But what is bad for the U.S. dollar is good for other foreign currencies. A weaker dollar means companies earning revenue in a foreign currency will be making more when computed in U.S. dollars. It also means dividends paid in foreign currencies will be worth more U.S. dollars.

Lenders: When short- and long-term rates are held in check, lenders tend to do well. They can borrow money cheaply and lend it out at higher rates. Historically, that has been good for banks. But for now, the big banks are embroiled in controversy, stemming from their less-than-stellar foreclosure processes. [Read: “The Best-Managed Bank in America”]

But there is another type of lender that should do very well in an environment of lower interest rates.

Business development companies (BDCs) act as venture capital firms, lending money to small companies that can’t easily get financing elsewhere. I already have two BDCs in my real-money portfolio for The Daily Paycheck. Both have been good performers with above-average yields. Main Street Capital Corporation (NYSE: MAIN), for example, has returned an outstanding +25% with a current yield of 9.3%.

[For more on BDCs, you’ll like my colleague Carla Pasternak’s recent article on the topic.]

Banks are still firming up their balance sheets and are reluctant to loan. In its third-quarter financial report, JPMorgan Chase (NYSE: JPM) announced a mere +1% increase in its outstanding commercial loan portfolio. So with less competition in the mix, BDCs may have access to even more lucrative lending deals.

The market rally during the past month and a half has reduced the number of above-average yield opportunities. But BDCs, required by law to distribute 90% of their taxable income to shareholders, are still offering rich yields.

Action to Take –> The market expects the Federal Reserve to announce its program of quantitative easing at its next meeting, scheduled for November 3rd. We’ve already seen the value of the dollar and the price of Treasuries bounce around in anticipation.

But regardless of the market’s reaction once the announcement is made, the longer-term effects of easing should make this a friendlier environment for BDCs and foreign investments specifically — and all fixed income securities in general.