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Vanguard Extend Duration Treasury ETF: Long Duration Could Be Great In December

Summary The Vanguard Extend Duration Treasury ETF gives investors exposure to the very long end of the yield curve. The yield is material but the price swings on long duration treasuries easily dominate the yield in determining annual returns. I won’t be surprised if the Fed hikes short term rates in December, but I don’t think they can continue to push up short term rates after that. If investors buy into the Federal Reserve’s picture, there could be some great sales on long duration treasuries. The Vanguard Extend Duration Treasury ETF (NYSEARCA: EDV ) is a solid option for exposure to treasuries. The ETF has an expense ratio of only .12%. As I’ve been searching for appealing bond funds, I’ve found some of my favorites are from Vanguard. Given my distaste for high expense ratios, it should be no surprise that the Vanguard products would be appealing. After looking through the portfolio, I think the holdings are fairly reasonable for an investor wanting to regularly keep part of their portfolio in a bond fund. Quick Introduction The Vanguard Extend Duration Treasury ETF is showing a yield to maturity of 3.0% and an average effective duration of 24.6 years. This isn’t an investment that investors should take lightly when it comes to interest rate risk. In my opinion the big reason to use such long duration securities is to reduce total portfolio volatility due to the negative correlation with the market or to make a play on long term yields falling and creating substantial capital gains. Maturities I grabbed another chart to show the effective maturity on the securities: That shouldn’t be surprising given that the effective duration of the fund was running almost 25 years. December The reason I’m looking to keep an eye on the very long duration securities in December is because of the Federal Reserve’s constant pressure to try to increase rates. If they actually get the short term rates higher there may be a shift up across the entire yield curve. The greatest price volatility would come from the long duration bonds. To avoid sensitivity to credit risk, I may opt to use treasuries rather than corporate securities. The Rate Issue The Federal Reserve has been talking for years about raising rates and they finally got some ammunition in November when the “jobs report” came out and indicated that unemployment levels were lower than expected and lower than the previous measurement. The Federal Reserve has an opening and they could use this opportunity to push interest rates higher. I think there is a fairly significant chance of that happening. The latest probability numbers from the CME Group, which uses the “Fed Funds Futures” to track implied probability, is shown below: (click to enlarge) We’re expecting around a 70% chance of short term rates getting a slight boost. I don’t believe that the Federal Reserve can continue to raise rates in the manner that they would like to, but I do think that an increase in short term rates finally happening could create a serious hit in the value of long term treasuries as investors start to buy into the idea that the United States will be creating higher interest rates on treasuries while most of the developed world is showing significantly lower rates. I wouldn’t be surprised if the Federal Reserve raises rates in December and sends bond prices falling. If that happens, I would consider it more likely that they would be forced to go back down on rates in 2016 rather than being able to raise them again later in the year. If short term rates went back down, I think it would be an admission of the difficulties of raising rates in this environment and the 30 year yields would fall. A falling 30 year yield would push prices on EDV materially higher. Conclusion This is a great treasury ETF with a low expense ratio and it should be on the “watch list” for investors going into December. If the Federal Reserve manages to raise rates and the 30 year yields rise (prices fall) materially, then I think it will become a fairly attractive option. I’ll be looking at long duration treasuries in December as a possible way to reduce my portfolio volatility and capture some significant gains if rates fall back down. Over the last year, EDV has had a negative correlation with the S&P 500. This wasn’t a slightly negative correlation either, this was -.41. This serves as potentially a useful hedge against my equity positions while giving me the potential to benefit from falling yields and rising prices if the Federal Reserve is unable to follow through on their plans to raise rates. My view on price movements is a significant chance of prices going lower into December followed by attractive buying opportunities to create capital gains in 2016.

Are Utility Stocks In A Bubble?

Summary Utility stocks have benefited significantly from extremely low interest rates over the last 5+ years. Yield-starved investors have chased the sector, and utilities’ high debt loads have benefited from lower financing costs. The utilities sector plunged over 3% on Friday with expectations rising for the first Federal Funds rate hike in nearly 10 years. We look at the sector’s current yield relative to history and how it performed during the last period of tightening. Utility stocks pay some of the safest dividends around and typically sport much higher dividend yields than the market, reflecting their low growth prospects and making them a favorite source of income for retirees living off dividends . Many dividend investors wonder if favorite utility stocks like Duke Energy (NYSE: DUK ), National Grid (NYSE: NGG ), NextEra (NYSE: NEE ), Dominion Resources (NYSE: D ), and Southern (NYSE: SO ) are in a bubble today after benefiting from extremely low interest rates for more than six years. Utilities were clobbered on Friday after strong employment data strengthened the likelihood that the Fed would raise interest rates next month for the first time since mid-2006. The fear is that many investors flooded into higher yielding stocks like utilities because they could not earn enough safe income from the very low yields bonds offer today (see below). Once bond yields begin to rise as the Fed gradually raises its target interest rate, these investors might sell their stocks to purchase bonds. Source: Simply Safe Dividends , Federal Reserve Bank of St. Louis As seen below, we have been living in unprecedented times over the last seven years, with the Fed’s target interest rate remaining just above zero percent. It has never been this low for this long before, so there is plenty of uncertainty regarding how an eventual interest rate increase, as early as December, will impact markets and yield-sensitive sectors like utilities. Have these safe haven sectors been artificially inflated by the Fed’s easy money policy? Will they pop when interest rates begin to rise? Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis Many dividend investors are clearly worried. On Friday, November 6th, a strong US payroll report came out. The Fed watches employment figures and inflation to determine its stance on interest rates, and the strong jobs report signaled that a rate hike in December was now almost a certainty. This would be the first rate increase since 2006. Immediately, many dividend aristocrats and utilities sold off hard. The XLU utility ETF finished the day down more than 3.5% despite the S&P 500 finishing about flat. Clearly the knee-jerk interest rate trade is to sell higher yielding, slower growing companies like utilities in favor of interest rate beneficiaries like banks (the Financials sector was the strongest performer on Friday) and more cyclical growth companies that would benefit the most from an improving economy. Before diving into utilities in particular, let’s take a step back and look at the S&P 500’s dividend yield relative to its history and the Federal Funds Target Rate. As seen below, the S&P 500’s dividend yield sits just below 2% today compared to the Federal Funds Target Rate of 0.25%. If we were living in a dividend stock bubble that could be popped by rising interest rates over the next few years, we would expect the market’s dividend yield over the past several years to be extremely low relative to history. Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis However, this is clearly not the case. The last time interest rates were exceptionally low was during 2003 when they sat at 1% for several quarters before tightening significantly to 5.25%. During 2003, the market’s dividend yield hovered around 1.5%, 25% lower than today’s dividend yield. We can also see the market’s extreme euphoria during the tech bubble when the S&P 500’s dividend yield dipped to 0.98%, half of today’s yield. Perhaps most interesting is the period from 2004 through mid-2006 when the Fed tightened interest rates from 1% to 5.25%. The market’s dividend yield increased around 20%, from 1.5% to 1.8%, but both of these yields are still lower than the market’s yield today. While certain parts of the market are likely more vulnerable than others during a period marked by rising rates, the entire class of dividend paying stocks does not appear bubbly relative to the last 20+ years of market data that we can observe, especially relative to current interest rates. What about the utilities sector? The Conservative Retirees dividend portfolio we oversee has meaningful exposure to utilities and REITs. As you can imagine, Friday wasn’t a great day. While we don’t lose any sleep over our holdings’ abilities to continue paying and growing their dividend payments, we remain mindful of the portfolio’s overall total return potential (income and price return) and continuously look to minimize our downside risk. If utilities and REITs are in a bubble, we should seek returns elsewhere until conditions normalize as a result of rising interest rates. The chart below compares the annual total return of the S&P 500 (blue bars) and the Utilities sector (red bars). The Federal Funds Target Rate (green line) is also displayed to highlight periods of rising and falling rates. Many investors are quick to assume that higher yielding dividend stocks like utilities will be major underperformers over the next five years as interest rates gradually rise. Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis However, we can see that during the last period of rising rates, from 2004 to 2006 when rates increased from 1% to 5.25%, the utilities sector actually outperformed the S&P 500 in each of those years! Despite four straight years of outperformance relative to the market during 2004-2007, utility stocks still significantly outperformed during the 2008 market crash. 2014 was a huge year for the utilities sector, which returned about 30% and easily outpaced the market. Many investors have predicted higher interest rates in each of the past few years, but the Fed has continued delaying, helping utility stocks outperform. However, December 2015 could finally vindicate those expecting higher rates. Not surprisingly, the chart above also shows that utility stocks have return -8.1% YTD, significantly trailing the market’s 3.7% return and reflecting investors’ expectations for a rate hike next month. With rates looking set to move higher, will utility stocks need to meaningfully drop in value to keep their dividend yields relatively attractive for investors? While we can’t predict the future, we can compare the dividend yield of utility stocks today to their yield throughout history. The chart below does just that while overlaying the Federal Funds Target Rate (red line). Utility stocks, as represented by the XLU ETF, closed Friday with a dividend yield of 3.7%. This yield is higher than the 3.4% yield utility stocks had in 2003 when interest rates were 1%, and it’s also higher than the 3.4% yield utility stocks topped out at in 2006 when rates peaked out at 5.25%. Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis The utility sector’s dividend yield has been in a downward trend since 2009, but its current yield appears quite reasonable relative to the last decade and historical interest rates. Once again, we don’t see signs of a bubble here despite Friday’s price shock. Finally, we compared the Utility sector’s dividend yield to the S&P 500’s dividend yield over the last decade. The chart below shows the difference between the two yields. A figure of 2% would mean that the Utility sector’s dividend yield was 200 basis points higher than the S&P 500’s yield (e.g. 5% yield compared to a 3% yield). A lower yield gap suggests that utility stocks could be expensive relative to the market. While the yield premium has come down meaningfully since peaking out at 2.4% in early 2011, its current reading is about in line with where it traded prior to the rate increases that occurred from 2004 through mid-2006. Interestingly, the yield premium fell during this time as utility stocks outperformed the market. Unless cyclical growth stocks really take off and leave utility stocks behind, it’s hard to imagine the yield premium returning to 2.4%. Source: Simply Safe Dividends How Interest Rates Actually Impact Utility Stocks Beyond historical dividend yields and interest rates, remaining focused on companies’ fundamentals is the key to long-term investing success. For this reason, it is important to understand why interest rates are very important to utilities’ actual businesses (not just fickle investor sentiment). First, utilities maintain extremely large debt loads. Constructing and maintaining power plants and infrastructure to deliver electricity and gas are extremely costly activities. The stable cash flows generated by utilities alleviate some of their credit risk, but the regulatory environment in each operating region plays a big role in a utility company’s health. Some companies are able to gain regulatory approval to increase the rates charged to customers to finance the large construction projects and higher borrowing costs they undertake, while others must absorb more of these costs themselves if customers cannot afford higher rates, lowering earnings. Many utilities have benefited from lower interest rates over the last 5+ years, allowing them to cheaply improve their infrastructure and refinance high interest rate debt to improve cash flow generation. Improved cash flow and the lower cost of debt has also enabled some utilities to acquire businesses in non-regulated industries to gain exposure to faster-growing businesses over the past few years, perhaps reducing the sensitivity of their businesses to interest rates. While rising rates make other yield investments relatively more attractive and could gradually increase utilities’ borrowing costs, it is important to remember why interest rates generally rise in the first place. The Fed will only raise rates if it believes the US economy is strengthening and inflationary pressures are gaining steam. In such an environment, consumers are doing well and are more able to afford higher energy prices. For utilities operating in regions with favorable regulation, this means they have a greater ability to pass on their higher borrowing costs resulting onto consumers through higher energy bills, protecting and growing earnings. As we previously showed, during the last tightening period from 2004 through 2006, utility stocks actually outperformed the market in each year! It’s far from a certainty that rising rates over the next few years will be worse for utilities than the rest of the stock market. So, Are Utility Stocks in a Bubble? While the plunge in higher yielding, slower growing companies such as utilities was painful on Friday, it is important to keep the big picture in perspective and remain resistant to swings in market sentiment. Given the world’s fragile state, the Fed seems likely to very gradually raise interest rates, assuming it does indeed start to act in December. Whether rates rise or fall, owning a portfolio of reasonably priced companies that earn solid returns on capital and grow their cash flow (and dividends) over long periods of time will always be a winning strategy. That is what we try to do with our Top 20 Dividend Stocks portfolio , which includes several REITs and utilities. From a historical point of view, dividend stocks do not appear to be in a bubble, but they could decline in the initial months surrounding an interest rate increase like they have in the past . Utilities’ dividend yields also appear reasonable, and these stocks actually outperformed the market during the last period of rising rates from 2004 through 2006. While anything can happen and we are coming off of an unprecedented period of low interest rates, we do not see a bubble today and believe that most utility stocks will continue providing stable income and reasonable downside protection for many portfolios, even if they continue experiencing near-term price volatility.

All About Nothing: Stock ETFs Celebrate Zero Percent Rate Policy

If someone had told me in the 80s that 3-month T-bills would someday yield 0%, I might have doubled over in hysterics. Nevertheless, this is the world that has been created by a Federal Reserve that has waffled on leaving the zero-bound on its overnight lending rate, even after seven years. While one may be tempted to say that financial markets are losing respect for the Federal Reserve, it seems more likely that the financial markets are gaining confidence that interest rates could be kept near 0% for longer. About a year ago, I was meeting a client at a restaurant in Marina Del Rey, California. The traffic had been mild by Los Angeles County standards, so I arrived in the area early. I stopped in a local coffee shop and sat down in a booth. Lo and behold, in the booth next to me, Jerry Seinfeld had been interviewing Jim Carrey for a “webisode” of the popular online show, Comedians In Cars Getting Coffee. The reason that I bring this up? I began my financial services pursuits in the the second half of the 1980s, when songs and shows about “nothing” seemed to have their biggest impact. For instance, in November of 1987, British rock artist Billy Idol scored a top Billboard hit with a live remake of “Mony Mony.” The original writer of the song acknowledged that he got the title from Mutual Life Insurance of New York’s acronym (MONY), though the acronym in the song lacked any actual meaning. Similarly, Larry David and Jerry Seinfeld set out in the late 80s to create a show about nothing. “Seinfeld” later became one of the most iconic sitcoms in television history. Interestingly enough, investors on Monday (10/5) bought $21 billion in three-month Treasury bills at a yield of 0%, the lowest yield at a three-month Treasury auction ever recorded. The lowest yield ever! And there was healthy demand for the 0% return because the bid-to-cover ratio was the highest since late June. Strong demand for “nothing.” If someone had told me in the 80s that 3-month T-bills would someday yield 0%, I might have doubled over in hysterics. I was used to seeing anywhere between 5% and 7%. Who would be interested in 0%? Nevertheless, this is the world that has been created by a Federal Reserve that has waffled on leaving the zero-bound on its overnight lending rate, even after seven years. What’s more, the voracious appetite for nothing beyond the preservation of capital suggests that few believe the Fed will raise rates at all in 2015. Some contend the longer that chairperson Yellen and her Fed colleagues abstain from hiking borrowing costs, the less that financial markets will show confidence in the institution. That may not be accurate… at least not yet. For example, Friday’s jobs report (10/2) served up an abysmal 142,000 jobs, flat hourly earnings, downward revisions to the job numbers for prior months, and a monstrous drop in labor force participation. Every expectation was a “miss.” Stocks initially sold off, but they quickly surged higher by more than one percent on the anticipation that the data virtually assures ongoing Fed inaction. What about Monday (10/5)? The one saving grace of the U.S. economy has been the “well-being” of the services sector. Yet both data points on the services sector dropped more than expected from the previous month. The Institute of Supply Management’s (ISM) non-manufacturing index for September registered 56.9, down from 59. Markit Economics’ services purchasing managers’ index report fell to 55.1 from 55.6. Equally troubling? Business activity and incoming new work rose at significantly slower rates. Still, stocks in the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) catapulted higher, rejoicing at yet another disappointing batch of data. The exchange-traded fund closed above a short-term, 50-day moving average. It has also bounced off of support at 160 and is testing resistance five percentage points higher around 168. So while one may be tempted to say that financial markets are losing respect for the Federal Reserve, it seems more likely that the financial markets are gaining confidence that interest rates could be kept near 0% for longer. After all, the Federal Reserve’s song, dance and pony show is all about the continuation of zero-percent rate policy. (Some even think that we may even see negative rates before we see a hike.) Indeed, as long as global and domestic economic concerns persist, and the Fed maintains its squeamishness about leaving the zero-bound, financial markets have the potential to rejoice. Which sectors jumped the highest off of the intra-day bottom from Friday (10/3)? Here is a quick rundown: The Big Bounce Off Of Friday’s Intra-Day Lows 2-Day Turnaround SPDR Select Sector Energy (NYSEARCA: XLE ) 8.7% SPDR Select Sector Basic Materials (NYSEARCA: XLB ) 6.8% iShares Telecom ETF (NYSEARCA: IYZ ) 6.1% SPDR Select Sector Industrials (NYSEARCA: XLI ) 5.8% SPDR Select Sector Financials (NYSEARCA: XLF ) 5.4% SPDR Select Sector Technology (NYSEARCA: XLK ) 5.0% SPDR Select Sector Consumer Discretionary (NYSEARCA: XLY ) 4.7% SPDR Select Sector Consumer Staples (NYSEARCA: XLP ) 4.3% SPDR Select Sector Health Care (NYSEARCA: XLV ) 4.2% SPDR Select Sector Utilities (NYSEARCA: XLU ) 2.8% ETFs that have been beaten down the most from the global economic slowdown – XLE, XLB, XLI – rocketed the most. Since neither the global economy nor the domestic economy has demonstrated an enhanced potential to expand, it stands to reason that the super-sized price gains reflect the anticipation of more stimulus. (Or for fans of Saturday Night Live and Christopher Walken, “We need more cowbell.”) If the Fed is going to stand pat at the zero-bound, they’ll need to tell the investment community that they’re planning to remain there until the end of Q2, 2016. If they’re going to raise borrowing costs, they’ll need to describe the precise nature of the hiking campaign. Will it be one-eighth of a point every meeting until the end of the second quarter next year? Will it be one-quarter of a point every other meeting until the end of Q2? An inability by the Fed to make up its collective mind alongside murky claims of data dependency would continue to embolden short-sellers and safety-seekers. Conversely, if Janet Yellen and other voting members of the Fed’s Open Market Committee (FOMC) determine that the data call for additional stimulus in the form of “QE4,” only an “open-ended” stimulus will pack the kind of wallop to send risk assets into the stratosphere. It was the open-ended nature of QE3 that pushed stocks to all-time records; QE1 and QE2 lost firepower with the investment community’s knowledge that the stimulus had a definitive end date. At this stage of the correction, traders will likely sell the S&P 500 near the 2000 level and buy it near the 1900 level, at least until the Federal Reserve delineates an unambiguous course. The S&P 500 VIX Volatility (VIX) may have fallen below 20, though I presume that volatile price movement for stocks will remain the norm. For Gary’s latest podcast, click here . Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.