Issue 7 • March 9, 2011

Fixed income investors take note; it may be high time for you to review your strategy ...“as bonds’ golden age comes to an end.”¹

That’s what a recent article in the Financial Times proclaims. The story points out how the unique “circumstances that produced that golden age for bond returns — falling inflation, surplus savings and the rest — will not be repeated...”²

Indeed, with developed government debt levels soaring, investors today are more worried than ever about the specter of runaway inflation rearing its ugly head once again.

In our opinion, if you can be certain of anything in today’s turbulent financial markets, it’s that rates are eventually going to move higher from near-record low levels. It is only a question of timing.

And when yields go higher, bond prices go lower. As a result, if you’re holding a portfolio full of long-dated bond maturities during a rising rate climate, you face a potential loss of capital.

What can you do about it?

At Banyan Partners, we’re anticipating a higher interest rate climate ahead. And even though the potential for 1970s-style inflation may be overstated, we are taking proactive steps to help position our clients’ fixed income portfolios for rising rates well ahead of time.

We discussed some of the specific moves we’re making in a recent investment strategy webinar (go here to view the replay for a limited time). Here’s just one key take away from this event.

Rather than holding long-term bonds in your portfolio, which are particularly vulnerable to rising interest rates, one of the ways we generate income is through alternative income investments ... including “bond surrogate” portfolios.

I’ll give you more details on these in just a minute, but first let’s take a closer look at the historic backdrop for bond market returns to give us a better idea about what to expect in the years ahead.

Why Long Term Bonds Face Stiff Headwinds

Since 1926, the return on intermediate-maturity Treasury bonds has averaged 5.3 percent annually. Most of this return ... over 90 percent ... has historically come from coupon payments — or the annual yield received.³

Today’s coupon yield for newly issued 10-year Treasury notes is only about 4 percent; however, quite a bit less than the average annual return of 5.3 percent.

That means today’s bond market investors must count on a lot of price appreciation potential to produce just average returns going forward.

How likely is that?

We don’t think it’s likely ... for a very important reason. The grand bond bull market that started in 1981 is no longer running strong.

The late, great bond bull market began from a favorable starting point for investors. Treasury bond yields peaked at 16.4 percent in August 1981 — ah, the good old days.⁴

From such lofty levels, there was almost no place for yields to go but DOWN and for bond prices to go UP. Sure enough, bonds returned an average of nearly 9 percent annually over the nearly 30 years that followed the 1981 interest rate peak.⁵

A significant tailwind pushing bond returns higher during that period was steadily falling inflation and interest rates.

But today, this tailwind has turned into a hostile headwind for the bond market. With Treasury yields at such low levels today, the upside appears a lot more limited.

Let’s go even further back in time, to the last secular bear market (or down trend) for bond prices, from 1941 to 1981 as interest rates and inflation were on the rise. Investors in Treasury bonds (intermediate maturity) earned a yearly return of just 3.3 percent during this period as bond prices declined about 1 percent per year, which ate into income gains of 4.4 percent annually!⁶

This long bond bear market more than half a century ago is perhaps a better model for what could happen in the years ahead.

What’s our solution?

Seeking Shelter from Rising Rates: 3 Options to Consider

First, for both taxable and tax-free bonds, we have proactively shortened our average maturities to less than 5 years. The average maturity of the bonds you’re holding is a key measure that tells you how long it will take to get repaid your principal (assuming no default).

In a rising interest rate climate, we think it’s smart to keep your average maturities shorter. You’ll get your money repaid sooner, and can reinvest principal at potentially higher yields. Even today, a diversified portfolio of fixed-income holdings (government, corporate, etc.) with an average maturity of 5 years can still deliver yields of about 4 percent.

That may not sound like much compared to 16 percent Treasury yields in 1981 ... BUT it’s still a lot better than a current 5-year bank CD when compared to a taxable bond portfolio!

Second, as the US economy appears to be growing stronger, we’re finding good opportunities in higher yielding corporate bonds of high-quality US companies. At Banyan, we’re already doing the balance sheet work to analyze individual stocks for our clients. So it makes perfect sense to take our research a step further ... if we already like the company’s common stock, then the next logical step is to take a closer look at its credit, too.

Appliance maker Whirlpool (NYSE:WHR) is a perfect example. We believe the company’s common stock is a solid long-term investment owing to its international sales growth. So we took a closer look at Whirlpool bonds that offered double-digit interest rates from a more senior security.

Third, while bonds can play an important role in diversifying your overall portfolio, there are other ways for income-seeking investors to earn attractive yields aside from owning 20- or 30-year bonds.

At Banyan, we’ve been putting together what we refer to as bond surrogate portfolios, which include dividend-paying common stocks and select master limited partnership (MLP) securities yielding 5 to 7 percent or even more.

Here’s one example we talked about in our recent investment strategy video: Sea Drill (NYSE: SDRL) is an oil and gas service company that provides contract well drilling services and offshore oil rigs. The company pays a handsome 7.2 percent indicated dividend ... and has grown its dividend 135 percent over the past three years!⁷

Another case in point is Kinder Morgan Energy Partners (NYSE: KMP) a master limited partnership that operates energy pipelines and terminals. KMP is in the business of moving and storing gasoline, crude oil and natural gas and pays an attractive indicated annual dividend of 6 percent, consistently boosting its payout over the last five years.⁸

A word of caution when it comes to MLPs: You must be careful about investing in these securities for your IRA. If you generate too much income from these securities ... it could trigger an IRS rule regarding Unrelated Business Taxable Income ... which could make your tax-deferred account suddenly taxable.⁹

For more details about the tax implications of MLPs, you should speak to your tax professional. To learn more about how we are using these and other bond surrogate securities for Banyan client portfolios, you can still watch our recent strategy webinar here, or contact a Banyan financial advisor at: 800-814-3045.

Bottom line: There’s more than one way for income-oriented investors to earn decent yields in today’s low-interest rate climate. Be sure to consider ALL your options.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

The investments discussed in this newsletter may not be appropriate for all investors. Investors must make their own decisions based on their specific investment objectives, risk tolerance, and financial circumstances. This report is solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.

¹ Financial Times: Hard and Fast Rules Should be Treated with Caution, 3/7/11
² Ibid.
³ FMRCo (MARE): Bonds: Lower Yields, Lower Expectations, 3/2/10
⁴ Ibid.
⁵ Ibid.
⁶ Ibid.
⁷ Bloomberg market data, 3/7/11
⁸ Ibid.
⁹ American Association of Individual Investors Journal: Do’s and Don’ts of IRA Investing, March 2010