Which Income ETFs are Handling the ‘Taper Time’ Pressure?

August 16th at 2:49pm by Gary Gordon

On Thursday, 8/15/2013, the 10-year yield broke through the psychological barrier of 2.75%. Since May, the intermediate-term 10-year Treasury has catapulted from a year-to-date low near 1.6% to a year-to-date high of 2.8%.

Clearly, the U.S. Federal Reserve is having trouble persuading investors that — absent its $85-billion-per-month bond binge — they have the tools to suppress longer-term interest rates.

Perhaps ironically, if the Fed announces any tapering of its quantitative easing (QE) program in September, many project that it will be a modest move from $85 billion to $75 billion.

Think about that for a moment. Bernanke’s central bank may or may not slow the purchasing of U.S. treasuries as well as mortgage-backed securities. What’s more, should they do so, it will be an exceptionally modest reduction.

Yet the 10-year yield has rocketed 75% higher (120 basis points) from 1.6% to 2.8% — in advance of the Fed and in spite of them.

The media have dubbed the speculative exodus from bonds “front-running” the Federal Reserve. Specifically, investors do not wait around for what they perceive as a foregone conclusion; better to get out before the central bank of the United States exits QE and before the demand for U.S. Treasury bonds dissipates.

The U.S. stock market via the S&P 500 SPDR Trust (SPY) has experienced a few hiccups with the prospect of losing QE stimulus. However, SPY has been far more resilient than the vast majority of rate-sensitive income producers — preferred shares, munis, high yield bonds, longer-term corporates, dividend stocks, REITs, utilities as well as Treasuries. That said, by investigating the reaction of income producers to Thursday’s surge in the 10-year yield, we’re able to gauge which income ETFs might stand up to the kitchen’s heat.

The first item that stands out is the difference between real estate investment trusts via VNQ and pipeline partnerships via MLPI. The structure of partnerships as well as the structure of real estate trusts are similar in that they both exemplify tax-favored entities. REITs don’t have to pay corporate taxes as long as they distribute 90% of their income, while MLPs do not have to pay federal taxes when all earnings go to unit holders. Consequently, distributions to owners of aggregate funds/notes like VNQ and MLPI are higher than many income-producing alternatives. That said, REITs have been drastically hit by the rise in the 10-year yield, as rising mortgages hit at the heart of the real estate recovery. MLPs have been less affected by rates because the toll operators of oil and gas pipeline infrastructure still have growth potential.

The second item that merits discussion are the relative success of foreign developed market bonds. The perception of Europe is that the stimulus is intact, and that tapering is not in the near future. Whereas a number of emerging markets may not be able to stimulate due to inflation or differences in central bank goals, Europe, Japan, Australia, England are still looking to boost respective economies. Bond ETFs like IGOV and PICB are faring better than the U.S. investment grade equivalents.

Last, but hardly least, many folks have received the message on floating rate bonds and senior bank loans. The “hang-in-there” ability of FLTR and BKLN is worth noting, as extremely modest price depreciation may be offset by the enviable cash flow. [Senior Loan ETFs: 'Steady Returns and Higher Yields']

Gary Gordon is president of Pacific Park Financial, Inc.

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