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Income Investing

Income Investors: Focus on Quality, Not the Fed

By obsessing over interest-rate moves, investors may miss other potential perils—in particular, the scary default rate on energy-related junk bonds.

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The bond market has not ruptured since the Federal Reserve raised overnight interest rates by one-quarter of a percentage point. This nonreaction reinforces my conviction that longer-term yields, which are set by investors in the bond market, will stay within a narrow range in 2016. The proposition that we’re on the verge of a period of steadily rising rates that demands radical portfolio surgery is premature at best and crazy at worst.

See Also: Kiplinger's Economic Outlook: Interest Rates

I welcome the central bank’s measured action and its suggestion that it will exercise patience in determining the timing of any additional rate bumps. That should allow traders and strategists to focus on basic market and economic factors, at home and abroad. In my view, the current state of those fundamentals suggests that it’s safe to keep longer-term, high-quality bonds and dividend-paying stocks—except those tied to the energy sector.

Why? Start with the mistaken assumption that banks are eager to poach gazillions from the securities markets by sweetening savings yields. Standard & Poor’s, after examining dozens of banks’ regulatory disclosures, recently concluded that few institutions can or will raise deposit rates, though many are already charging more for loans. Bankers don’t have much reason to offer bribes to start a stampede into certificates of deposit and interest-bearing accounts. They’d much prefer to boost profits from lending.

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As for an impending rise in yields for money market mutual funds, don’t expect much. The yield on three-month T-bills hopped from 0.01% in October to 0.16% in early January. That should provide fodder for higher yields for money market funds. But not so fast. The fund industry, which has had to swallow billions in management fees over the past half-dozen years to keep their money funds from delivering negative returns, may not be eager to lift yields in lock step with increases in T-bill rates.

Meanwhile, over in the bond market, the benchmark 10-year Treasury has done little since the Fed acted, with its yield meandering between 2.15% and 2.3%. And why should it move more? As Fed chair Janet Yellen said after the Fed’s announcement, “We have very low rates, and we have made a very small move.” That’s the truth.

Yes, markets do occasionally ignore benign Fed statements and beat up bond prices anyway. In The Courage to Act, the book recounting his time as Fed boss, Ben Bernanke laments that pervasive distrust of officials’ statements contributed to the 2013 “taper tantrum,” which slashed prices on many bonds and bondlike investments by 10%. Although some bond investors may ignore Yellen and assume that rates will spiral and prices will plunge, as they did in 2013, nobody I’ve spoken with recently expects that to happen (bond prices and yields move in opposite directions).

Other potential risks. At any rate, by obsessing over potential Fed rate hikes, income investors may miss other potential perils—in particular, the scary default rate on energy-related junk bonds. Moreover, the continued strengthening of the dollar means more hardship for U.S. investors in foreign bonds, especially emerging-markets debt. And although real estate investment trusts and utilities could be vulnerable at the mere hint of the next Fed move, focusing on rates could cause you to take your eye off equally important risks, such as poor management and ill-timed acquisitions. REITs and utility stocks should do well in 2016, but it’s not a lock.

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In sum, your best strategy is to focus on quality investments. Favor municipals and corporate bonds rated single-A and up, as well as blue-chip stocks with high dividend yields. Once the world figures out that the Fed doesn’t mean that much business, solid yield-paying stuff will regain its lost mojo.

See Also: 2016 Outlook for Municipal Bonds