Retaining a ‘sweet spot’ in investment portfolios

In August, private payrolls were better than economists
forecasted, US budget deficit unexpectedly fell and S&P 500 companies held
cash reserves at USD $1.8T or 10.2 per cent of total assets, a 30 per cent
increase from 2007 levels.

But minus these positive metrics, investors were faced with
a slew of weak macroeconomic news that certainly has been driving markets this
year. Notwithstanding there are some fundamental bright spots with companies
such as Kraft, Dupont and Johnson and Johnson that are either consistently
beating earnings quarter after quarter, raising guidance going forward or
significantly improving their profit margins. However top down factors seem to
completely overwhelm any bottom line performance and fears are only exacerbated
at the sign of any negative economic news.

One thing is for certain. The ‘sweet spot’ investors
experienced for most of 2009, achieving gains in both the equity and fixed
income markets, appears to be a distant memory. Painstakingly high
unemployment, massive contraction in construction and home sales and
affirmation of a ‘more modest’ recovery from Fed Reserve chairman in his
Jackson Hole, Wyoming statement have riddled investors with fear. It is now
common belief we are on the cusp of a double dip recession or a prolonged
period of very low economic growth at best.

Unless you are laden with longer dated treasury securities
you would have experienced a very low or negative return in your investment
portfolios. Even with two and ten year Treasury securities hitting intraday
record low yields of 0.45 per cent and 2.42 per cent respectively, this has not
stopped an influx of investors into bond funds reaching $120B year to date.
This de-risking of portfolios does not bode well for the economy. Not only does
this represent very little confidence in the current economic and monetary
policies but lends itself to a negative feedback loop as customers delay
purchases of homes and other big ticket items on expectations of even lower
economic growth.

Contrary to our dismal economic landscape, there are some
great opportunities in the market awaiting the brave and courageous few.

Consider structuring a laddered bond portfolio that will
allow you to take advantage of changes in interest rates when they do occur.
This strategy works well both in inflationary/deflationary cycles. While the
intermediate and longer term holdings will contribute better returns during
prolonged period in which prices fall substantially, the shorter dated holdings
will provide the opportunity to reinvest proceeds at higher rates during an
inflationary period.

Incorporating a barbell strategy with some yield enhancements
can also provide reliable income and a high degree of principal security. This
strategy may incorporate a liquidity as well as a yield generator component.
The shorter dated securities can act as the liquidity generator while
securities further out on the curve can result in significantly higher yields.
Preferreds may be a good option in this regard. Preferreds combine elements of
both stocks and bond.

They exhibit bond like characteristics during rising
interest rate environments but have a higher priority in the payout profile
versus common equity. Like stocks they offer the potential for appreciation
while the fixed dividend payments provide regular income similar to that of
coupon payments. The universe of preferreds is however much smaller than stocks
and it does not carry any voting rights. 
Given their attractive yields and risk/return trade off, preferreds can
add much needed diversity reducing the overall risk inherent in a pure
equity/fixed income portfolio.

And perhaps the most attractive complement to any portfolio
during periods of low economic growth is high dividend paying equities in
strong companies with solid fundamentals. For the first time since the start of
the last bull market in 2003, many of the stocks in the S&P 500 now carry higher
dividend versus bond yields. With greater dividend yields investors are given
the opportunity to partake in higher current income yet maintain the potential
upside of the equity markets. As volatility in treasury markets reach a three
month high, the benefits of having this equity exposure in the defensive
sectors may prove the only sweet spot that can last for years.

 

Disclaimer: The views expressed are the opinions of the
writer and whilst believed reliable may differ from the views of Butterfield Bank
(Cayman) Limited.  The Bank accepts no
liability for errors or actions taken on the basis of this information.

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