Do you own these dangerous “bond replacements”?

Certain “safe-haven” stocks are more dangerous than you realize…

In yesterday’s Daily, I told you that the rising interest rates would blow a hole in bondholders’ portfolios.

Interest rates had been declining for the past 35 years, reaching all-time lows in 2016. Ultra-low rates distorted the prices of “safe” interest and dividend-paying securities—making them overvalued.

But that trend is now reversing… If rates start to rise, bond prices will plummet. Certain stock sectors will, too.

Let me explain…

We are coming off an unprecedented seven years of near-0% interest rates. Miniscule bond yields forced investors to use certain stocks as bond proxies… More money flowed into these “bond replacements” than it normally would.

Take utility stocks, for example. These companies have little growth potential. Investors own them for one reason: the dividends.

Investors consider these stocks safe. People need electricity, even in recessions. Cash will continue coming in the door for utilities… even during the worst of times. So, utility companies are generally viewed as recession-proof.

Since these companies have little growth, the stock price and dividend payments remain relatively stable. Therefore, they act a lot like bonds.

But Utility Stocks Have Gotten Expensive

The Utilities Select Sector SPDR ETF (XLU) acts as a proxy for utilities stocks.

Over the last 15 years, XLU’s average price-to-earnings ratio has been 15. (The P/E ratio measures how much investors are willing to pay for $1 of profit.)

Today, it’s at 17… That means utilities are still 13% more expensive than average.

And with rates rising, XLU is falling… right alongside bonds.

Just check out the chart below. As you can see, the 10-year interest rate is up 33% since July. And XLU has dropped 8% over that same period.

Why Utility Stocks Will Take a Beating If Interest Rates Rise

Stocks are riskier than bonds, so investors demand a higher yield from stocks. The difference between the two yields is called “the spread.”

Historically, the 10-year Treasury yielded more than utility stocks (except in  recessions). When utilities yielded more than Treasuries, it was a good buying opportunity.

But since interest rates have stayed so low for so long, the market became distorted. And income-starved investors have plunged into dividend-paying stocks like utilities.

Since the end of the last recession in 2009, the average spread in the market has been about an extra 1.5% from utilities to cover the risk of owning a stock over a U.S. bond.

Six months ago, when the 10-year note yielded 1.8%, a utility would have to pay a 3.3% dividend to cover the 1.5% spread.

The 10-year note has risen to 2.5%… And utilities currently yield 3.6%. So, the spread has shrunk to 1.1%.

To meet the 1.5% spread the market has been demanding, utility stocks would need to increase their yields from 3.6% to 4%.

That implies a 10% price drop in utilities (as with bonds, utility stock prices fall as interest rates rise). If rates continue rising, utility stock prices will fall even further.

Bottom Line: Utility stocks—and other “bond replacements” like consumer staples and health care companies—are likely to tumble if interest rates continue rising.

Regards,

Nick Rokke, CFA
Analyst, The Palm Beach Daily

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CHART WATCH

Stocks and bonds aren’t the only asset classes affected by higher interest rates. Real estate faces challenges, too.

Nearly half of all U.S. homes are financed. So as rates tick up, mortgage payments will get more expensive.

Generally, homebuyers base their purchases on how much they can spend per month on a mortgage. So, higher interest rates will likely lead to buyers either paying less for a home… or not buying at all.

We can already see a slowdown in pending U.S. home sales. They’re down about 7% over the past six months (see chart below).

Since rates started rising in mid-2016, pending sales have declined. This does not bode well for home prices in general.

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Money Flees War on Cash… Finds Safety in Bitcoin


BIG T’S 3-MINUTE MARKET MINDER


World governments continue their onslaught against cash… and that’s just making bitcoin more valuable.

Bitcoin breached $1,000 per coin on New Year’s Day… a three-year high. Palm Beach Letter editor Teeka “Big T” Tiwari expects it to jump even higher.

In today’s must-see 3-Minute Market Minder (transcript included), Big T says the catalyst behind bitcoin’s recent run is government crackdowns on cash. The latest example is China, where capital controls have sent money fleeing into bitcoin.

After you watch Big T’s latest video, check out this presentation on another one of his favorite cryptocurrencies.




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MARKET BRIEFS

Senegal Launches E-Currency: The West African nation of Senegal will begin issuing its own digital currency this year. According to a report in Quartz, the move is an effort by emerging markets to bypass traditional banking systems. It’s the latest sign that central banks are creating their own digital currencies to compete with popular decentralized cryptocurrencies like bitcoin.

Record Debt Mark Hit: Global debt sales hit a record $6.6 trillion in 2016, led by corporations rushing to load up on cheap borrowing costs, the guys over at Zero Hedge report. That’s an ominous sign… The previous annual record for in-debt sales ($2 trillion) was set in 2006—less than two years before the Great Recession started.

Italian Bank Bubble: The Italian government just threw a lifeline to the world’s oldest bank, Banca Monte dei Paschi di Siena. Initially, the taxpayer-funded bailout was tabbed at 5 billion euros ($5.23 billion). But Wolf Street reports that the bailout skyrocketed to 8.8 billion euros ($9.21 billion) after new bad loans were found on the books. That’s a whopping 78% increase.

Stockholders have already been crushed—down 99.85%. Now bondholders will likely take a haircut, too. Our friends over at Casey Research have been following this crisis for months. They say time is running out to fix Italian banks.

We’re trying a new format for The Palm Beach Daily. Tell us what you think. Please give us your feedback right here.

IN CASE YOU MISSED IT…

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During the class, Chris will pull back the curtain and reveal his next big idea on how he’s identifying stocks with the potential to return 10-to-1, 50-to-1, and even 100-to-1 or more for every $1,000 you invest. Register here to make sure you don’t miss a thing…

Money

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