The Carnage in Pimco’s Closed End Funds

Bill Gross is by any measure financially sophisticated. Which is why it’s entertaining to watch him reconcile his undoubtedly well-honed skills at investing with his firm’s management of one of the most overpriced closed end funds around. The closed end fund sector is one of the truly inefficient sectors in financial markets. Investors routinely confuse distributions with yield, and presume that a security sporting a 10% yield is offering good value that has just been overlooked by many other investors.

So it is that the Pimco High Income Fund (PHK) recently reached a price of $14, a heady 70% premium to the NAV of its assets. It reached this level because investors are searching for yield everywhere, and because Bill Gross is the portfolio manager. For many investors, Bill Gross at any price is better than the tyranny of low market rates, and who can blame them.

Barron’s ran an article on the weekend noting the absurdly high premium to NAV of this fund. Mr. Gross does eats his own cooking by investing a modest amount of his net worth in the fund. He would know as well as anybody that investing in a portfolio of high yield bonds at 70% above their market value is not a sensible strategy, and yet as PM he can hardly advise that way nor sell his own shares. This week PHK has fallen spectacularly (at least, by the standards of closed end funds) falling around 20% from its level of last week. It still sports a heady 50% premium, and perhaps that will be sustained. It’s not possible to short it, but let’s just say there are quite a few more sensible places to put your money than PHK. Unless you’re the PM there’s not much point in owning it.

The Increasing Risk in Owning Bonds

The Fixed Income market has been a tough place to find much value for far longer than I can remember. And yet, that hasn’t stopped the returns from being nothing short of spectacular. In fact, it’s not hard to find securities that have outperformed equities, and most would agree that it’s been a surprisingly good year for stocks.

Take the iShares Investment Grade Bond ETF (LQD) for instance. Up 10.5% year-to-date, for high grade bonds debt. The current yield to maturity on the portfolio is 2.89%, and a good part of the return for the year has come from price appreciation of the underlying bonds as the Fed’s relentless buying of government and mortgage debt has drawn investors to bid up the prices of other fixed income securities. If LQD returns 10.5 over the next year, 7.6% of that return will have to come from price gains which, given its effective duration of 7.8 means the yield to maturity will need to fall to under 2%.

The JPMorgan Emerging Market Bond Fund (EMB) has generated 14.5% so far this year, only 2% or so less than the S&P500. The yield on this portfolio has drifted down to 4.1%. For EMB to return 14.5% over the next 12 months, the same Math as in LQD means that, with an effective duration of 7.7 the yield to maturity will need to fall to 2.75%.

Even more striking has been the performance in some of the closed end funds that invest in senior loans. We’ve liked the ING Prime Rate Trust (PPR) for quite some time, but evidently we’re not alone for it currently trades at a 4% premium to NAV. PPR has returned a staggering 28% so far this year as investors have piled into bank debt and high yield in general.

There’s never any easy money to be made, but none of these investments appears that compelling today. Earning the current yield would seem to be the best plausible outcome on LQD and EMB. This morning’s Employment report was also reasonably positive, with the Unemployment rate falling below 8% for the first time in over three years. We’ve owned these securities in our Fixed Income Strategy but recently exited. The risk/return just doesn’t appear attractive, though bonds have looked expensive for a long time with barely a pause in the march to ever lower yields.

 

Ten More Years To Recover?

March 2022. That is the point at which, according to eurodollar futures prices, three month Libor will reach the heady yield of 4%. Ten years from now until money market yields are restored to “equilibrium” as defined by the FOMC in their rate forecast issued for their January 24-25 meeting earlier this year (reproduced below). The time to reach equilibrium is not defined in their forecast, so plausibly their forecast could be consistent with market interest rates. But I suspect that if asked whether it’ll take ten years for conditions to return to normal, Ben Bernanke would sound somewhat more optimistic than that. Or put another way, if during one of his testimonies before Congress he suggested that we have another ten years of digging to get out of the economic hole we dug in ’07-’08, many Congressmen might take the view that this is far too long.

So the bond market disagrees with this outlook. Bond investors believe we are ten years away from full recovery, while the government believes or hopes that this is far too pessimistic. Forecasts can differ, but meanwhile I keep returning to the fascinating optics of the Federal Reserve imposing on the market (through Operation Twist and its predecessors) long term interest rates that reflect market forecasts they themselves find too pessimistic. The only way to reconcile the Fed’s actions with its forecast is to acknowledge that its bond purchases are uneconomic – indeed, they are intended to be so. As the logic goes, maintaining stimulative interest rate policies is the best way to assure that ultimate recovery and an improved labor market both transpire.

It’s rare that a central bank provides so much information about its thinking. An easy way to square the circle would be for the FOMC to produce rate forecasts that are consistent with the yields at which they’re buying bonds. It would ensure consistency between their actions and their forecasts, but to their credit the Fed is promoting far greater transparency than they did under Greenspan. Consequently, presuming that the FOMC doesn’t seriously believe it’ll be ten years before a return to equilibrium interest rates, they are investing at yields too low for any commercially driven bond buyer. This is not even a guess; the Fed is telling you so! The Fed doesn’t need to make profitable investments, and they likely expect to hold what they own until maturity. But if you could catch Bernanke at an unguarded moment, perhaps over a glass of wine with no press nearby, he would surely acknowledge this incongruity and justify it based on the Fed’s twin mandate of promoting full employment consistent with stable inflation. The Fed is doing what they’re supposed to. And they are explaining it as plainly as anyone could hope.  Today’s bond buyer needs to be a very definitely not-hold-to-maturity type to make a profitable investment in ten year treasuries at 2.3% (or corporate bonds tethered through credit spreads to this return-free yield). If it turns out badly because the Fed starts raising rates with a view to reaching their longer run objective before 2022, it’s because the investor didn’t become a trader quickly enough.

Jeffrey Lacker, President of the Richmond Fed, thinks rates may need to rise as soon as next year. He is presumably one of the dots in the chart reproduced below, and no doubt one of the more hawkish. How fascinating to be able to ask him what he thinks of current interest rates. In fact, he’s already told you.

Advice from the Federal Reserve – Bonds Still Aren’t Cheap

Although treasury yields have risen around 30 bps over the past couple of weeks, yields have not yet reached what the Federal Reserve itself might call equilibrium. The FOMC rate forecasts that the Fed published earlier this year reveal an intriguing inconsistency between the Fed’s actions and its own market forecasts. Operation Twist and its predecessors are intended to drive down long term borrowing costs, to the benefit of those who can access those markets (qualified homebuyers through mortgages, investment grade corporations and of course the Federal government itself).  This along with concerns about Europe have pushed yields lower.

The Fed published rate forecasts from each FOMC member earlier in the year. Their interest rate forecasts are at odds with the term structure of interest rates, which the Fed of course is heavily influencing. The FOMC expects the long run, equilibrium Fed Funds rate to be around 4%. Although they don’t say when the rate will reach that equilibrium level, it seems reasonable to suppose that their forecast horizon wouldn’t be longer than five years. And yet, the 5 year forward treasury rate in five years (derived from the five and ten year treasury yields) is around 3.5% (it was close to 3% before yields began rising recently). The market forecast for short term rates in five years is 0.5% lower than the FOMC’s forecast.

It’s not a huge difference, but what’s interesting is that the Fed’s Operation Twist, by forcing long term yields down, is at odds with their own rate forecasts. By their own admission they don’t believe long term bonds at current yields are a good investment. Their own actions, based on their own forecasts, are not designed to be profitable for them or for anyone following them.

Corporate bond issuance has been running at record levels so far this year, spurred by corporations wishing to lock in low rates. Retail investors have happily taken the other side. The question is, since the Fed is clearly a non-economic buyer and is forcing yields down to levels that their own rate forecasts show to be unprofitable, should this be made more explicit to the retail investors that are buying at current levels? If the government is consciously seeking to make some investment uneconomic, shouldn’t they just say that in plain English? This isn’t critical of Operation Twist or earlier efforts by the Fed to maintain low long term rates – such moves have so far probably been good.

But when retail investors hiding in fixed income start to see losses on their holdings, they might wish the Fed had told them more clearly the risks they were facing. Long term bonds are still a poor investment.

Why The Fed Believes The Yield Curve is Too Flat

Eurodollar futures provide quite precise data about the market consensus forecast for interest rates. Since they extend out for ten years, they provide a rich set of information constantly updated about where market participants think 3 month Libor will be every three months.

The FOMC recently started making public the interest rate forecasts of its members. They issued a graphical representation of when FOMC members expect to begin tightening and what each member expects the year-end rate to be through 2014. You can find it here listed as “Projection Materials” for their press conference. For some weeks now I’ve felt that there exists a mild discrepancy between the rate forecasts imbedded in the eurodollar futures curve and the FOMC’s forecasts. For instance, only 6 of 17 FOMC members expect the Fed to begin tightening by 2013, whereas 11 (i.e. a majority) expect so by 2014. So the majority think they’ll be raising rates no later than 2014. Similarly, the median rate forecast of FOMC members at the end of 2013 is 0.25%, but a year later it’s 0.75%. Moreover, if you compare the average forecast rather than the median, rates are expected to move from 0.56% to 1.12% (there are a couple of outliers on the high side). So on balance, it looks as if the FOMC expects short term rates to rise around 0.5% during 2014.

Meanwhile, the spread between the September 2013 and September 2014 eurodollar futures yields is 0.36%. The market is priced for less of a tightening than the FOMC is forecasting.

Now eurodollar futures and the yield curve in general are analyzed probably more closely by more smart people than any other variable in financial markets. In addition, not all FOMC members vote, and it’s not clear what each members’ forecast is (although you can make some reasonable assumptions based on public comments by individual members). Current market pricing is not an oversight, it correctly reflects market expectations. And yet, were you able to sit in on a discussion of the FOMC, or better yet debate interest rate forecasts with them, they would likely tell you that the yield curve out to three years is not pricing in enough of a tightening of short term rates. Of course, the FOMC’s forecast could be wrong; after all, they really don’t know more than anyone else about what the economy will be doing in 2014. One interpretation of market pricing is precisely this – FOMC members are overly optimistic about GDP growth and the economy will still be facing headwinds 2-3 years out.

This may be so, and yet the knowledge that the FOMC thinks the yield curve is too flat would have been considered valuable inside information not so very long ago. Today, it’s public information. And they are of course in a position to make their forecasts come true.

The view that the yield curve is too flat can be most easily expressed through a long eurodollar futures calendar spread (long September 2013 and short September 2014), betting on a wider spread or steeper yield curve between those two points. Not everyone chooses to trade futures, but the rate forecasts revealed explicitly in the eurodollar futures curve are part of the term structure of bonds as well. Although the eurodollar futures market makes plain the precise path of interest rates the market expects, bond yields of different maturities are priced to be largely consistent with the same information. So an investor today who selects five year bonds over shorter maturity two years in exchange for the modest yield pick-up available is effectively rejecting the FOMC’s interest rate forecast as too optimistic on the economy. The FOMC is telling you they think you’re making a mistake.

Disclosure: Author is Long the September 2013/2014 eurodollar calendar spread.

6% Yields In Senior Loans With A Cheap Market Hedge

We continue to like using a short Euro position in combination with risky assets. In our Fixed Income Strategy we’re invested in senior loans through closed end funds such as BlackRock Defined Opportunity Credit Trust (BHL) and ING Prime Rate (PPR). They’re both at a modest discount to NAV of around 5%, and yield over 6%. Their portfolios of leveraged loans to non-investment grade borrowers will no doubt go down if equities sell off, but holding this position in combination with a short Euro (we’re long EUO) protects against the tail risk associated with Euro sovereign debt problems or Middle East conflict (such as an Israeli attack on Iran). The US has a 3% GDP differential over the Eurozone so over time this should favor the US$ anyway. Short Euro is akin to owning put options on the market – you just need to own something in addition that will generate a return.

There were a couple of interesting articles about energy over the past 24 hours. The WSJ noted that natural gas is eating into demand for coal. Over the past three years natural gas has gone from producing 21.4% of U.S. electricity to 24.4% (coal has dropped from 48.2% to 42.8%). It’s a slow process and don’t expect near month natural gas to trade at $4 anytime soon. But it does illustrate market forces at work. In another article, Bloomberg notes that the U.S. is on its way to achieving energy independence . By way of illustration, they report that Methanex, the world’s biggest producer of methanol, is dismantling a factory in Chile and moving it to Louisiana to take advantage of cheap natural gas. We continue to own Comstock Resources (CRK), which reported earnings yesterday and expects production to be 20% oil by the end of 2012. They have minimal debt, low operating costs and while today’s low natural gas prices don’t help the company does control its own destiny and trades at a healthy discount to book value (even after taking a reserve writedown in 4Q11).

Finally, Bill Gross wrote an interesting piece on the problem with low interest rates in yesterday’s FT. He suggests that QE2 and Operation Twist are keeping long term rates so low that banks don’t see much upside in lending there. This slows down the recapitalization of the banking system that a steeper yield curve would provide. Whether he’s right that this is slowing growth or not, he’s certainly right that long term rates provide little incentive to lend. Long term high grade and government bonds are a safe way to lose purchasing power. An obscure but interesting trade can be found in the eurodollar futures curve. The spread between Sept 2013 and Sept 2014 is 35 or so basis points. The market is pricing for an increase in three month Libor of only 35 bps between 2013 (when a majority of FOMC members expect short term rates to be unchanged) and 2014 (when a majority expects them to be rising). This spread is unlikely to narrow much beyond 25-30 under those circumstances, and an upside surprise in GDP growth (perhaps led by housing?) could cause a substantial steepening in this part of the curve, straddling as it does the point at which the Fed has indicated it will start raising rates. We think it’s an interesting trade, there’s probably no need to rush into it though.

Disclosure: Author is Long PPR, BHL, CRK, EUO

Operation Twist Claims a Victim

Morningstar reported through the Wall Street Journal that PIMCO’s $244BN Total Return Fund (PTRRX) suffered the first outflow on its history last year. $5BN left the fund in 2011 including $1.4BN in December as investors soured on PIMCO’s mis-timed trades in U.S. government bonds. Bill Gross hasn’t achieved what he has by accident, and no doubt many more good years lie ahead. But the Federal Reserve’s distortion of interest rates, through Quantitative Easing (QE) Versions 1 and 2 and more recently Operation Twist illustrate the problem. Bond yields today do not reflect the private market’s appetite to lend money; they are being held down by the Fed’s buying. Consequently, ten year treasuries offering a yield of less than 2% are guaranteed to slowly erode the real value of the money invested in them even in a tax-deferred or tax-exempt account. For a taxable investor the erosion takes place more quickly.

Last Summer PIMCO publicly spurned U.S. debt as offering an insufficient return, and after lagging the indices badly while a Fed-induced rally took hold they reversed course. PIMCO no longer hates government bonds and a look a the holdings of PTRRX on Morningstar reveals several positions in long term government bonds. 2.3% is invested in the 3.5/8 of 2/2021; 1.5% in the 2.1/8% of 8/2021, and so on. 27% is in government debt – and yet, since the hold to maturity real return will most assuredly be negative, the justification for these holdings is that they will zig when other things zag. In a flight to quality, “risk off” trade (in which the market engages fairly often) holdings of treasuries can be relied on to retain their value or even appreciate. The negative return is in exchange for reduced volatility, and extracting real value from such holdings therefore requires that they be sold by a nimble PM at precisely the time of crisis. This is increasingly what active bond managers are faced with – they need to be good at market timing to justify some of their holdings.

PIMCO may well be good at that too, last year notwithstanding. As the government stealthily imposes loss of purchasing power on savers, successful bond managers will be those who are nimble enough to keep time to the music.

Quarterly Outlook

That the world’s a risky place has not escaped the recent attention of investors. The potential demise of the European single currency and perhaps with it European banks and the European project itself looms large over every investment decision, and has for many months. Economic slowdown in China, the uncertain consequences of the Arab Spring and more recently Iran’s nuclear ambitions all add to the global uncertainty. Within the U.S. a highly partisan Congress has led to legislative gridlock and no certainty about long term fiscal policy. It makes you wonder how investors get out of bed in the morning. And when they do, they are confronted with a choice of risky assets (such as equities) which may lose value immediately, or less risky assets (such as bonds) which will lose real value with certainty. That investors are choosing the certainty of lost purchasing power over the available alternatives reflects the seemingly poor choices on offer. Thus is the equity risk premium, the difference between the earnings yield (inverse of the P/E ratio) on the S&P500 and the ten year U.S. treasury yield, at its widest since 1974, a year that closed with the Dow Jones Industrial Average having dropped 45% from its peak only eighteen months earlier, and inflation at 12.3%.

Start with bonds. Today’s ten year treasury yield of around 2% assures even the tax-exempt hold-to-maturity investor of a loss in purchasing power if inflation over ten years exceeds 2%. The taxable investor of course will fare even worse. Even a portfolio of blue chip corporate bonds yielding around 4% will struggle to overcome the twin headwinds of taxes and inflation. But bonds have a big thing going for them, which is momentum. For those who draw comfort from investing with a tailwind, bonds are a warm and cozy place. The Dow Jones Corporate Bond Index has returned 10% per annum for the past three years including 8.5% in the most recent one.  Who’s to say that this won’t continue? And of course it may, although such forecasts will struggle mightily to overcome the Math; for bonds to return more than their current yield, their yields need to fall causing prices to rise. Corporate bond yields could drop from 4% to 3%, although such would presumably require a similar drop in treasury yields, to 1%. The world in which 1% ten year treasuries draws buyers is unlikely to be a friendly one for corporate credit, and at such a time credit spreads might be substantially wider, depressing the prices of corporate bonds. So, much as bonds investors might draw comfort from looking backwards, their best plausible outcome is that they’ll earn the current yield and suffer a steady depreciation in the real value of their assets.

In fact, relative pricing between stocks and bonds is such that $20 invested in the S&P500 yielding 2% will, assuming 4% dividend growth (and the 50 year average is 5%) generate the same increase in after-tax wealth as $100 in ten year treasuries. This assumes the $80 not invested in stocks earns 0% by sitting in cash, although holding cash provides the option to do something with it that might well earn a return later on. The Math works for corporate bonds as well (just change the $20 in stocks to $40).

So bonds have been good, but past performance is highly unlikely to be repeated. In fact, we believe there’s a strong case to be made for all investors to reduce their asset allocation to fixed income. Government policy is to maintain ruinously low interest rates while debtors rebuild their balance sheets. The Federal government is effecting a transfer of real wealth from investors to borrowers. This policy is likely to continue for quite a long time, not least because it’s popular (with those voters who contemplate such things). There are many more debtors than creditors, and regardless of how independent you think the Federal Reserve is, monetary policy is unambiguously populist, designed for the masses. The appropriate response is to allow the government’s voracious appetite free rein. If Chairman Bernanke likes bonds that much he can have the lot.

As a result, identifying alternatives sources of investment income is a task that consumes much energy on a daily basis at SL Advisors.

The stock market offers a risk to suit every taste. For those who like to wake without first worrying whether their holdings are solvent, many reasonably priced large cap companies with low levels of debt and a history of steady earnings growth are available. Kraft (KFT), Microsoft (MSFT) and Berkshire Hathaway (BRK-A) are all examples in our Deep Value Equity Strategy, along with less well-known names such as Corrections Corp (CXW) and Republic Services Group (RSG). Domestic energy exposure adds volatility and return potential through Devon Energy (DVN) and Comstock Resources (CRK). The former bond investor can allocate his new funds to a combination of stocks and cash (depending on risk appetite), or to other income generating strategies.

There are even examples of stocks whose dividend yield exceeds that on their own bonds – not because their fortunes have suffered and a high dividend yield reflects expectations of a cut, but because price-insensitive bond investors have driven bond yields low in their flight from equities. Johnson and Johnson (JNJ) is one such example. Our Dividend Capture Strategy consists of a diversified portfolio of such names combined with a hedge to eliminate most of the daily market moves. The result is a portfolio exposed to dividend paying stocks and dividend growth that is hedged against excessive moves in stocks.

Master Limited Partnerships (MLPs) are another attractive asset class for taxable investors tolerant of K-1s. I won’t repeat here the well-worn arguments that are familiar to regular readers, except to note that the sector’s unique structure renders it worth having in many income-seeking portfolios. MLPs offer tax-deferred distribution yields of 5-6% combined with growth expectations of 4-6% (suggesting a total return potential of 9-12% with no change in earnings multiples).

Disclosure: Author is Long KFT, MSFT, BRK-B, CXW, RSG, DVN, CRK, JNJ

MLPs Offer Steady Income and Exposure to Shale Gas Development

The New York Times today has a piece on Richard Kinder, founder of Kinder Morgan (KMP) the largest publicly traded partnership in the U.S. KMP recently agreed to acquire El Paso Corporation to create an entity controlling 80,000 miles of pipeline crisscrossing the U.S. KMP is a Master Limited Partnership (MLP), which is to say that owners of LP units (as their shares are known) own a proportional stake in the underlying assets rather than shares in a corporation. The big advantage of this structure is that there is no 35% corporate income tax, so the profits flow straight through to the unitholders without the double taxation that occurs when corporations use after tax profits to pay dividends that are themselves taxable. MLPs and KMP in particular also represent an investment in the growth of natural gas as a source of America’s energy production. Cheap shale gas is increasingly being used to produce residential electricity. From 2005-2010 consumption for this purpose grew from 5.9TCFE (Trillion Cubic Feet Equivalent) to 7.4TCFE, more than 70% of the increase in total natural consumption to 24TCFE last year (according to the EIA). A shifting mix of energy sources requires new infrastructure to transport, store and refine it, which is what KMP recognizes. JPMorgan initiated coverage on the sector in October and expects $130BN in infrastructure spending over the next 10 years.

KMP pays a $4.64 distribution, giving a current yield of 5.9%. They’ve grown this distribution at a compound annual rate of 14%. This is high for an MLP, but 6% annual distributions with likely growth of 4-6% over the next 2-3 years is a reasonable assumption, offering the potential for 10-12% total return (assuming multiples are unchanged). Distributions are also largely tax-deferred, since much of the cash received by unitholders is classified on their K-1 as a return of capital, rather than income. Ah yes, you have to deal with a K-1 instead of a 1099. They’re not for everybody, and unless you use a tax accountant and can afford to invest at least $250K in a diversified portfolio of individual names this sector is probably not for you. But for high net worth investors interested in a 6% tax deferred distribution yield with likely 4-6% growth and tolerant of K-1s, this is a sector that belongs in most portfolios. In fact, I think MLPs are a great substitute for high yield bonds. They exhibit similar levels of price volatility (in a weak equity market they can fall farther than you’d like) but offer better return prospects. While unitholders do own equity interests, the overall risk/return characteristics are more bond-like than equity-like.

MLPs are putting in another solid year, with the Alerian MLP Index returning 7.7% for the year through November. That’s ahead of both high-grade bonds (the Dow Jones Corporate Bond Index is +6%) and the S&P 500 (+1.1%) over the same period.

Government policy is to transfer real wealth from savers to borrowers. Policy rates and bond yields are being maintained at levels so low that, after taxes and inflation savers are virtually guaranteed to lose purchasing power. Bonds have their place in a portfolio, and no doubt there are plenty of issues facing markets right now starting with the Eurozone. But given the guaranteed poor long-term outlook for bonds, we think investors should be reducing their overall fixed income weighting in favor of alternative sources of income (such as MLPs) and dividend paying stocks. Retail investors have been steadily increasing their holdings of corporate debt. For example, the  iShares iBoxx Investment Grade Corporate Bond Fund (LQD) has seen steady growth in outstandings all year. Corporate bonds have been strong performers for the past couple of years, but with yields on high grade bonds currently around 4%, you can only make 4% and after 2.5% inflation there’s about enough to pay taxes and that’s it. The Federal Reserve is causing this distortion in the fixed income markets. They can keep it up for a long time. Today’s fixed income investors are competing with the world’s deepest pocket – it’s probably time to look elsewhere.

 

Disclosure: Author is Long KMP

Bond Math

You don’t need a degree in Psychology to know that investors are nervous. Pick up any newspaper, or just take your own pulse. Macro issues dominate almost every investing decision, and it’s therefore not surprising that the safety of bonds remains attractive. No doubt fixed income has had a great run. The Dow Jones Corporate Bond Index, a benchmark of long duration investment grade debt, has returned 7.9% p.a. since the beginning of the millennium. The S&P500 has managed 0.5% p.a. over the same period. Investing by looking backwards can be reassuring – generally if something has happened before, it can happen again. Bonds look better than stocks in the rear-view mirror and they can appear pretty compelling looking forward too. If the Euro collapses then for stocks, so goes the conventional wisdom, down is a long way. And so it might be. But here’s the Math. High grade bonds (as defined by the relevant iShares ETF, LQD) yield 4.4%. That is what the hold-to-maturity investor in long-term corporate debt can hope for. Factor in a 40% tax rate on interest payments with 2.5% inflation and it will be hard to maintain purchasing power. Stocks were roughly 2.5 times as volatile as bonds over the last decade – selling those bonds and putting 40% of the proceeds in large cap, dividend paying stocks that yield 3.5% (with the rest, for now, in cash) maintains the same overall portfolio volatility and only requires 3.8% dividend growth to beat bonds (compared with a fifty year growth rate of 5%). The 60% in cash provides a useful option to invest at a later date when prospects are clearer – and who knows, maybe one day interest rates with an integer could return to the money markets. Ben Bernanke is steadily raising the stakes for those bond investors who wish to invest alongside him. The Fed’s QE2 program has created a large and non-commercial buyer for debt that is not motivated by profit. Indeed, the Fed’s objective is to create an environment in which bond investors wish they owned something else. Real returns on investment grade and government debt are likely to remain negative for an extended period of time. The Fed has the ability to ensure this state of affairs persists indefinitely should they so desire. “I promise you negative real returns for many years” may not be a catchy soundbite, but if Chairman Bernanke said those words they would not require any change in monetary policy. While it’s usually good to follow the smart money, in this case it may be academic smarts rather than street smarts that are on display. The most significant long-term challenge facing investors must surely be identifying alternatives to traditional fixed income.