By Philip van Doorn, MarketWatch
Patrick T. Fallon/Bloomberg
As interest rates head toward zero in the developed world, it’s going to get more difficult to find reasonably safe investments with attractive yields. That means income-seeking investors need to consider broadening their horizons and, in the process, do more research.
The end of the risk-free rate
In finance class, we were taught that when using quantitative analysis to make decisions, we should compare internal rates of return to an “opportunity cost,” or “risk-free rate,” as a basis for deciding whether a project would be worth pursuing. Going back three decades, an 8% risk-free rate was considered reasonable, because one might expect an average return that high just by investing cash in the market, rather than developing a new project or product.
I remember a classmate arguing with one of my finance professors, saying a 3% risk-free rate was much more appropriate because an 8% return in a market investment was unreasonable.
These days, even that 3% assumption seems too high, considering that 10-year German government bonds /zigman2/quotes/211347112/realtime BX:TMBMKDE-10Y +3.09% have negative yields and 10-year U.S. Treasury notes yield about 1.6% /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +3.27% .
The idea of a risk-free rate is that an investor can always lend money and receive something in return. With bank deposit rates so low (since the banks don’t need the money) and government bond yields also so low, or even negative, that assumption has gone out the window. That is a depressing development for investors who have put together nest eggs to make relatively safe investments for income during their golden years.
Research Affiliates just published a report called “Death of the Risk-Free Rate ,” which explains this phenomenon and the inherent risk of a switch to a high-inflation environment. That can happen because central banks have gotten addicted to endless stimulus through historically low (and now negative, in some cases) interest rates, and via massive purchases of government bonds. At some point there will be too much cash in a world that’s already awash with cash, and that means prices for all sorts of good will rise.
The end of central-bank stimulus
The S&P 500 Index /zigman2/quotes/210599714/realtime SPX +1.62% trades for 18.3 times weighted aggregate consensus 2016 earnings estimates, according to FactSet. That compares with 17.7 a year ago, and the index’s current-year price-to-earnings ratio hasn’t been so high since 2003.
We’re still in a long-run bull market for stocks, but a big factor in the rising price-to-earnings ratio over the past year has been a decline in earnings expectations for the index. A bull market is generally driven, at least in part, by rising earnings. But for the second quarter, analysts expect earnings for the S&P 500 to decline 5.3% from a year earlier, with six of the 10 market sectors expected to show a drop, according to S&P Global Market Intelligence.
The high current valuation for U.S. stocks, along with central banks’ seeming exhaustion of economic stimulus tool kits, means investors shouldn’t expect returns over coming years approaching the S&P 500’s average return of 12.8% over the past five years. Even the 10-year average return of 8% might be a tall order.
Research Affiliates’ assertion of the “death of the risk-free rate,” factoring in central banks’ largesse, is that investors “should diversify away from government bonds and U.S. equities into higher-yielding inflation-sensitive asset classes such as commodities, bank loans, high-yield bonds, REITs and emerging-market equities.”
If you are looking for current income, REITs, or real estate investment trusts, may fit the bill as having relatively low risk compared with several other asset classes listed by Research Affiliates. A REIT that invests in commercial properties can combat inflation over the long term by raising rents, while also benefitting from rising real-estate prices.
FBR’s list of dividend stocks
In a strategy report for clients on July 18, FBR & Co. director of research David Hilal said market sentiment “is now one of prolonged low rates and a flattening yield curve.” He warned that investors on a quest for yield need to avoid companies with potential credit problems.
The firm’s analysts put together a list of 16 stocks (including five REITs) that Hilal said “offer an attractive yield and potential share appreciation.” The analysts argue that the yields are safe and there are reasons to be optimistic that the share prices will rise.
Here’s FBR’s list, in alphabetical order of “16 stocks to own” for a prolonged low-rate environment:
|Black Stone Minerals LP||/zigman2/quotes/207555482/composite BSM||Oil and Gas Production||6.91%|
|Blackstone Mortgage Trust Inc. Class A||/zigman2/quotes/209229036/composite BXMT||Real Estate Investment Trusts||8.88%|
|ClubCorp Holdings Inc.||Movies/ Entertainment||3.57%|
|Great Ajax Corp.||/zigman2/quotes/203948221/composite AJX||Real Estate Investment Trusts||7.22%|
|Hersha Hospitality Trust Class A||/zigman2/quotes/201346460/composite HT||Real Estate Investment Trusts||6.02%|
|James River Group Holdings Ltd.||/zigman2/quotes/202205552/composite JRVR||Property/ Casualty Insurance||2.35%|
|Just Energy Group Inc.||/zigman2/quotes/205585785/composite JE||Electric Utilities||6.32%|
|LCNB Corp.||/zigman2/quotes/206182006/composite LCNB||Regional Banks||3.72%|
|Monroe Capital Corp.||/zigman2/quotes/200285859/composite MRCC||Investment Trusts/ Mutual Funds||8.90%|
|National CineMedia Inc.||/zigman2/quotes/210013369/composite NCMI||Advertising/ Marketing Services||5.52%|
|New Residential Investment Corp.||/zigman2/quotes/203592214/composite NRZ||Investment Managers||14.05%|
|Preferred Apartment Communities Inc.||/zigman2/quotes/207795485/composite APTS||Real Estate Investment Trusts||5.42%|
|SeaWorld Entertainment Inc.||/zigman2/quotes/210357674/composite SEAS||Movies/ Entertainment||5.71%|
|Six Flags Entertainment Corp.||/zigman2/quotes/208050417/composite SIX||Movies/ Entertainment||3.93%|
|Starwood Property Trust Inc.||/zigman2/quotes/202642684/composite STWD||Real Estate Investment Trusts||9.10%|
|SunCoke Energy Partners LP||/zigman2/quotes/205808240/lastsale SXCP||Coal||15.65%|
|Sources: FBR Research and FactSet|
The list not only includes companies whose dividends are considered “safe” by FBR’s analysts, but also stocks that the analysts believe are well-positioned because of particular industry disruptions. SunCoke Energy Partners LP /zigman2/quotes/205808240/lastsale SXCP -1.04% , with a dividend yield of 15.65%, is an obvious example. The company produces coke for use in steel production and also provides services at coal terminals.
There are plenty of stocks on the list with attractive dividend yields. If you are considering any of them for an investment, it’s important that you discuss them in detail with your broker or financial adviser. Request research reports, review company filings and consider a company’s business strategy and whether you believe it can be successful over coming decades.