I just saw a analysis of how various asset classes performed during the four-month period after Ben Bernanke suggested that the time for the Fed to cut back on its bond purchasing program was approaching. The markets reacted dramatically–what has been referred to as the ‘taper tantrum.’ The summary chart is shown below:
This chart shows returns on various asset classes over the period from 5/2/2013 to 9/5/2013. The article notes that the yield on 10-year Treasury bonds rose 137 bps (1.37%) over this period. The results are dramatic for a number of reasons. First, of course, the relative gains and losses from various sectors are asset classes are huge. Telecom stock and utility stocks declined by 10.8% over four months. This is truly dramatic. On the other hand, it is the norm for utilities to have a negative response to rising bond yields. In addition, the drop in these asset classes must be considered in light of their meteoric gains in recent years.
Over the past three years, for example, the iShares U.S. Utilities ETF (IDU) has provided an average return 11.9%. Over the past ten years, this is an even more surprising 9.3% per year. This is for data through late November of 2013, so it includes the price drop in the chart above. My analysis comes up with an expected long-term return for IDU of 7.2% per year. What is of more concern for income investors is that the current yield of IDU is 3.1% and the projected volatility is 23.9%, with a -20.8% correlation to 10-year Treasury yield. The yield frontier for a portfolio with 10% volatility and a -20% correlation to 10-year Treasury yield provides a yield of 8.4%. Utility stocks, as a sector, are not included in the optimal income portfolio. In other words, the yield of utilities is far below what it needs to be to make utilities attractive to income investors and, even with the 10.% drop during the ‘taper tantrum’ included, utilities have provide a return in recent years that is far above the fair ‘expected return.’
The 10.8% drop in utilities and telecoms have far more to do with a long-overdue correction in these asset classes than anything else. Utilities and telecoms have seen their prices driven up to levels such that the income that they provide as broad asset classes no longer justifies their risks, as compared to other income asset classes such as MLPs (included in the table above). There are, however, individual firms that remain attractive in both sectors.
MLP’s held up remarkably well during this period, with a decline of only 1%. The Alerian MLP fund (AMLP) has a 29% correlation to 10-year Treasury yield. This suggests that the asset class tends to rise with rising bond yields, but this is far from a one-to-one relationship. A decline of only 1% during the ‘taper tantrum’ is quite reassuring.
One asset class that is not included in the table above is preferred shares (PFF, PSK). Preferred shares took a big hit during the ‘taper tantrum.’ Preferred shares are an intriguing asset class because they continue to provide a substantial amount of income (PFF has a 5.5% yield) with reasonable volatility and, over the past three years, a modest positive correlation to rising Treasury yields.
Source: Yahoo! Finance
Once again, the question is whether this drop is meaningful as a warning about responsiveness to rising rates or rather that the fear or rising rates triggered an overdue correction. The five-year average annual return of PFF, for example, is 15.5%–and that’s including the drop.
Growth vs. Current Income
The story that most strongly emerges from the first chart is that the market did exactly what the Fed would have hoped (albeit with a magnitude and speed that was unexpected). Investors responded to a hint of the possibility of rising bond yields by selling off assets with higher current income in favor of this expected to provide higher income in the future (dividend growth and broader equity indexes). Looking deeper, however, the response was also a needed equilibration after a period in which some income-generating assets have seen their values rise so much as to make their current yields relatively unattractive. The Fed hopes to drive investors from conservative, low-growth asset classes into higher-growth / higher-risk asset classes. In this regard, Bernanke’s comments have been very effective.