Friday, January 31, 2014

An Alternative to Trading Bonds.

Trading bonds substitutes.

During the financial crisis, clearly bonds represented an exceptional opportunity.  Not surprisingly, during the liquidity crisis, people were liquidating bonds at prices well below normal.  However, if one purchased bonds during the financial crisis, by about 2011 a well-constructed bond portfolio had appreciated so much in value that there was little incentive not to take the capital gain.  Interest rates were so low that holding bonds was a waste of one's capital.  The likely outcome was a loss of purchasing power over the remaining life of the bond.   Furthermore, with the Fed manipulating the entire yield curve, it was impossible to assess the risk of continuing to hold the bonds. 

Consequently, for the last few years, utilities, Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) were viable alternatives.  However, just as bonds experienced substantial appreciation coming out of the financial crisis, REIT and MLP valuations have risen significantly since 2011.

MLPs presented an unusual opportunity when the President decided to postpone the decision on the Keystone pipeline for political reasons.  By acting counter to the economic pressure, the Administration guaranteed that the economic pressure would surface in the form of higher returns to alternative energy transportation options.  Alternative pipelines or pipelines that could benefit from the absence of Keystone were guaranteed to experience an increase in demand.  That greatly reduced the risk associated with selected other pipelines.  Those pipelines could be purchased as a bond substitute with very little downside risk and dividends substantially above the interest rate on bonds.  

In the MLP space, pipelines provide a potential substitute for bonds.  There near-monopoly on transportation along their routes insulates them from competitive pressures over a fairly long term.  It takes a long time to build a new pipeline, as Keystone illustrates.  Further, the decision on Keystone created a unique opportunity to select MLP pipelines.  It is not MLP structure that makes pipeline MLPs a potential bond substitute; it is the combination of their specific business and the MLP structure.  Consequently, mutual funds that are composed of all types of MLPs whether pipelines or not, are a poor substitute for bonds.  Individual MLPs would seem to be a more reasonable bond substitute because you can restrict it to pipelines and you know they yield.

Some of those pipelines would have served as a successful temporary bond substitute.  For example, Enbridge Energy Partners (EEP) provided a nice dividend, and that was about it.  However, as occurred with bonds coming out of the financial crisis, other pipelines would have appreciated to the point where there were substantial capital gains.  For example, between the end of 2011 and May 2013, the gain in Plains All American Pipeline (PPA) was almost 100% without including dividends.  By mid-2013 the logic of holding either was greatly diminished to the point where they no longer justified the additional tax complexity associated with MLPs.  Generally, the yield on MLPs had fallen.  Those that retained the high-yield did so because they became more risky.

For many years REITs were what the name implies: Real Estate Investment Trusts.  Thus, during the financial crisis and coming out of the financial crisis, REIT mutual funds represented a way to diversify into real estate.  The popularity of that shift, however, attracted firms that stretched the definition of real estate to the breaking point.  Consequently, by 2011, one had to pick individual REITs in order to ensure that the investment was really a real estate investment.  The security of real estate holdings is one of the reasons that REITs served as a potential bond substitute.  The other reason is the cash flow.

Among REITs, as long as it is real estate, no specific industry stands out as a natural substitute for bonds.  Most real estate can be replaced much faster than a pipeline.  Consequently, all real estate industries are more competitive than pipelines.  So, market considerations in the industry of an individual REIT are more important.  

One type of REIT that has some characteristics which make it a good candidate for a bond substitute is a REIT that specializes in “triple net” properties.  (Triple net properties generally have long-term leases where many variable expenses are shifted from the real estate owner to the occupant).  If the REIT has broad geographic exposure and a diversified base of renters, it takes on additional bond-like characteristics.  One does need to be careful about the amount of leverage on the REIT’s balance sheet.  That is particularly true of new REITs, but it is less of an issue with the larger REITs that have existed for a number of years.

The least specialized triple net REITs are concentrated in retail.   I have a large number of tenants.  The tenants may be entirely different retail segments, and they often have very broad geographic coverage. National Retail Properties, Inc. (NNN) provided a pretty good substitute for bonds from 2011 to 2012.  However, early in 2013 its valuation got way out of line as the stock appreciated in value.  A very popular triple net lease REIT is Retail Income Corp. (O).  Its monthly dividend structure appeals to many investors.  However, the appeal of that monthly dividend structure has resulted in higher valuation for Retail Income Corporation than National Retail Properties.  Its price followed a trend similar to National Retail Properties.  Of the two, National Retail Properties seemed to provide a better bond substitute.  But in both cases, by early in 2013, the valuation spikes justified exiting the positions.  If their prices fall off a bit more, National Retail Properties could be a very good bond substitute.

Another appealing area within the REIT space is healthcare REITs.  The demand for healthcare is reasonably stable.  Consequently, occupancy rates, an important metric in real estate, are fairly stable.  The risk in healthcare REITs is the stability of payment streams that result from government payments for health services (Medicare and Medicaid reimbursement rates).  However, it is possible to select healthcare REITs that are not extensively exposed directly to the whims of politicians regarding prices.  Basically, a REIT that owns the property and is dependent upon rents is more stable than one that both owns and operates the properties.  National Health Investors, Inc. (NHI) is one such REIT.  It has the added advantage that many of its hospitals and other facilities operate under a triple net lease.

A purchase of National Health Investors at any point during 2011 would allow one to currently exit with a capital gain, as well as the dividend stream.  That is true despite a price spike in May of 2013, and the subsequent decline.  But the combination of the run-up in the price of National Health Investors and then the price spike provided ample opportunity to adjust one's holdings in such a way as to end the year with holdings in this bond substitute at almost no cost.  LTC Properties (LTC) was formally known as Long-Term Care Properties and is another healthcare REIT.  Like Retail Income Properties, LTC pays a monthly dividend.  It displayed a price time path similar to National Health Investors.   Of the two, National Health Investors is the better bond substitute. 

An unfortunate side effect of monthly dividends is that the REITs attract investors whose only concern is the cash flow.  Consequently, REITs that pay monthly dividends tend to have higher valuations, and, other things being equal, they tend to be more risky.  Thus, while both National Health Investors and LTC Properties have been acceptable bond substitutes until their price spiked, National Health Investors was the only REIT that was worth retaining as a bond substitute after the price spike.  Its a ration seems more reasonable.

Other REIT sectors such as commercial space also provided a bond substitute.  However, unlike those cited above, commercial space REITs often have more limited geographic focus.  During the period from 2011 into 2013, a number of commercial space REITs were good bond substitutes.  However, because of their geographic focus, that ability to substitute is more ephemeral.  It depends upon too many factors: the quality of the REIT management, the performance of the local economies, and conditions in the local commercial real estate market.  Thus, it is not surprising that they are temporary holdings. 

Both the REITs and the MLPs as bond substitutes do not require expert timing although timing was more important with the REITs.  REITs seem to have been more influenced by the chase for yield.  However, the price spikes that preceded their decline provided the investor with a warning.  Their price decline was almost a mirror image of the spike.  However, for both the MLPs and REITs, an investor who is still holding those assets has not lost principal.  Not losing principal is an important requirement for a bond substitute.

As mentioned in “Rebalancing in a Manipulated Interest-Rate Environment,” utilities are the traditional equity substitute for bonds.  Thus, not surprisingly, there were opportunities to substitute utility stocks for bonds during the period from 2011 through 2013.  

When looking utilities, it is worth remembering that Verizon (VZ), which is sometimes considered a utility, was included in the widows’ and orphans’ portfolio.  One might ask whether Verizon belongs in the utility sector at all.  The question is legitimate given the importance of its unregulated businesses.  The point, however, is that Verizon retains enough regulated landline business to make it unnecessary to consider telecom utilities for a bond substitute. 

Electric utilities, which are often thought of as the prototypical utility, are so much of a regulatory crapshoot and had so many industry-specific risks, that they were not a good bonds substitute.  Although with the hard to find the data to prove it, electric utilities seem to suffer the most from regulatory whims.

Two gas utilities provided an excellent opportunity to substitute equity positions for bond holdings.  Both have the advantage that they operate in a number of subsectors of the gas industry.  AGL Resources Inc. (GAS) has been an excellent bond substitute for number of years.  It is to the point where it is almost a core holding, but only to the extent that one might hold bonds on a regular basis. 

The other, National Fuel Gas Company (NFG), was far less of a pure bond substitute.  It would have been totally inappropriate previous to 2012.  However, at the beginning of 2012, National Fuel Gas seemed to be priced based totally on its non-utility operations.  Consequently, one could acquire the company and get gas utility exposure almost for free.  That type of sum-of-parts analysis is usually not required to identify a utility is a bond substitute.  However, in the case of National Fuel Gas, it was essential since National Fuel Gas did not pay a high enough dividend to justify considering it as a bond substitute based on its dividend alone.  National Fuel Gas may continue to be an excellent investment opportunity, but by the end of the year it could no longer be justified as a bond substitute.  It could be sold and the proceeds used to purchase a more traditional bond substitute or held as cash.

The final area where it may be possible to find bond substitutes among the utilities is water utilities.  American Water Works Company Inc. (AWK), and Aqua America Inc. (WTR) are the two largest.  Water consumption is obviously extremely stable and insensitive to the economy.  One might conclude from that stability that water utilities would be a natural substitute for bonds.  However, both companies suffer from lower dividend rates than one would want in a bond substitute.  Despite that, Aqua America looks like an attractive bond substitute going into 2014.  The lack of sensitivity to the market and the economy is true of both the company’s business and its stock price.  Thus, it is a reasonable place to park money absent some more compelling bond substitute.

Interestingly enough, after having made that decision and purchased additional shares of Aqua America, an article in BARON’S on January 25, 2014, “Dow Slides 3.5% in a Global Retreat From Risk,” referenced the stock as attractive.  One might expect to find a reference to water utilities in an article talking about a stock market decline.  The rationale for holding Aqua America is that it is almost totally impervious to stock market fluctuations and economic cycles.  Fortunately, the stock did not jump after the reference in that article.  So, the stock is still an attractive investment.  A reasonable plan for 2014 is to add to the holdings of Aqua America as long as the price remains stable.

In summary, going into 2014, positions in National Health Investors, AGL, and Aqua America currently serve as bond substitutes.  However, it is reasonable to assume that during the year other stocks will have to fill the role bonds usually play. 

One other passing note, because of the repression of the interest rates, the period 2010 through 2013 and going into 2014 is one of the few times where holding more cash than normal made sense.  The cash needs to be available as opportunities arise to purchase bond substitutes.  The rationale behind the approach of holding cash and using bond substitutes that embody slightly higher risk was discussed in a posting on September 30, 2011 entitled “The Fed Cannot Force Investors toShift to a Different Risk-Return Profile.”




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