Posts Tagged ‘income’

In an article published at Bloomberg.com on March 18, 2010, it was noted that bonds issued by financial services firms like JP Morgan and Credit Suisse in particular came with rates that were substantially higher than rates in the general market. What this means for mutual funds and growth funds in particular is that there is plenty of opportunity in the financial services sector. Let’s take a closer look.

The Bloomberg article in questions makes it quite clear that the debt sold by banks, brokers and insurers returned 0.81% compared to the broader market’s return of 0.48%. This is a premium of more than 80% over what the broader market dictates. Consider this for a minute as we explore another interesting comment that was made in the article in question.

Brian Machan, a money manager at Aviva was quoted as saying that very few people are “underweight” in financials. This means that mutual funds are heavily buying up this debt. They are doing it because it looks attractive. The reason it might look attractive is that the yield is expected to drop, thereby increasing the value of those bonds on the open market.

The flip-side is that the financial services firms issuing this debt find rates attractive. This means they expect rates to increase in the future, allowing them to finance debt at today’s currently low rates. All indications support a rising interest rate environment; if ever there was a time to issue corporate debt now be that time (to the benefit of the borrower, that is).

Now, getting back to the premium paid by these financial services firms. Consider why they might need to raise this type of capital. It is cheap. Plus it helps finance a whole lot of plans. These banks have something up their sleeve and it is just around the corner by the look of things.

As far as growth funds are concerned, the mutual funds that are bullish on financial services such as the Ivy Small Cap fund we wrote about already or the Dryden fund we bragged about earlier, send a strong message to the investment community: financial services stocks are expected to outperform. This sure seems to be supported by the level of debt they are confidently raising right about now.

Other growth funds that invest heavily in financial services stocks include the FBR Small Cap Financial fund which has a history of LOW risk and above average returns. Morningstar rates it as a 5-star fund! Like the Ivy Small Cap fund that we touted as our Top Small Cap Pick for 2010, the FBR fund has a large interest in Iberiabank and East West Bancorp, regional banks that stand to substantially benefit from a positive shift in the economy.

Regardless of what type of mutual fund you choose, ensure that your growth funds have at least some exposure to the financial services sector. Whether they are smaller, regional financial companies like those held in the IVY or FBR mutual funds or larger banks like JP Morgan and Credit Suisse, the indications are quite clear that these firms expect to reap the profits and rewards of an economic turnaround that is just waiting to happen.

One of the reasons we like the Ivy Small Cap Value fund so much that we named it as one of our top mutual fund picks for 2010 is that it invests heavily in the right kind of financial services firms. The kind that have great value, even if they are consider small cap stocks or mid-cap stocks. We feel that as an investment strategy, these types of securities will allow the Ivy fund to not only outperform in pure growth areas but with its generous dividend it will also generate some decent income.

One of our reasons for liking the Ivy fund is that its underlying securities stand to benefit handsomely from a housing recovery, something we have already started to see according to a recent post over at Reuters about Homebuilder Confidence.

So why Ivy Small Cap Value and not something like the Fidelity Real Estate Income fund? After all, some of these real estate funds produce fairly substantial gains and income — Fidelity’s sure is one of them with a nice 4.8% yield and high returns compared to its peers, along with its “low” risk rating. But comparing Fidelity’s fund to Ivy’s is not a proper comparison. You cannot compare the two.

You cannot compare a real estate income fund to a small cap value fund.

For starters, funds like Fidelity’s are part of the income class. They invest in income-producing securities with roughly 50% of their total holdings in bonds. Of the 20% they hold in  stock, guess what 91% consists of? (Hint, we talk about about them a lot and suggest the difference between “good” and “bad” financial services firms to hold. Somewhat surprisingly, they seem to be holding the “bad” ones).

In comparison, the Ivy fund is equity driven. They have a purpose, with roughly 40% of their portfolio invested in the type of securities that will benefit from the same recovery from which a pure real estate fund (equity based) should.

So while the Fidelity Real Estate Income fund exists to produce income, Ivy Small Cap Value exists to generate long-term gains with income being a nice bonus. For people who are bullish on real estate, Ivy still makes better sense as an equity play because it stands to profit from the recovery. For the Fidelity fund to remain attractive, rates would have to continue dropping, which is still possible given how fixed mortgage rates continue to drop).

Ivy, however, does not need a housing recovery to remain a top-performing small cap stock fund. Why? Because the majority of its securities are already profitable. Remember, there is a difference between good and bad financial stocks; Ivy knows the difference because they hold the good ones. And those firms will only see their revenues increase when housing makes its come-back.This of course is one of the benefits to holding small cap stocks in a portfolio in the first place.

Would we recommend the Fidelity fund as an income play? Not now (besides, we prefer the Janus High Yield Fund as our preferred income fund for the year. Does that mean the Fidelity Real Estate Income fund is a bad one? Definitely not; it just does not make much sense as an investment strategy right now. And we feel our statement is fully backed up by the yield curve.

Our site has seen a lot of traffic coming in to see what our 2010 Top Pick has been… and why. Although more and more investment sites are starting to see the true potential in high yield investments, there is still a lot of negativity when it comes to these types of mutual funds particularly for this year (2010). A lot of the uncertainty might have to do with just how well these bond funds have performed over the past year (2009), some returning just as much as the S&P 500 (and some returning even more). While there is a fair amount of risk associated with the types of funds, we are at a point in history that may never repeat itself for the balance of our lives.

…we are at a point in history that may never repeat itself for the balance of our lives.

At the Mutual Fund Site, we believe there are two things working in the favor of investors who look at high yield investments for 2010 (and our High Yield Investments: Top Pick for 2010 in particular). We will outline the advantages briefly:

1. As markets improve, so will yields on these high yield investments. While this statement runs contrary to the academic studies of the past, consider this: The credit crisis of 2007 – 2009 pushed rates on all types of non-government borrowing sky high. Government rates of course fell through the floor due to demand, and this high demand for government bonds and low money supply for corporate bonds created a wide spread between corporate and government rates.

As the economy improves, rates typically increase in order to keep the economy from overheating. This time is different because corporate rates are already high, meaning they will either stay the same or drop marginally. We see a few common reasons for this. The first being that with there being less perceived default risk, more money supply will head into the corporate side. As supply rises, rates will start to drop (or in the case of rising rates, stay the same). This will have the effect of narrowing those spreads between corporate and government rates. As well, default risk will tangibly reduce because as the economy recovers those companies that were seen as “suspect” will become healthy again while those that were expected to fail will have already failed and be gone.

2. High income, high market value. Probably the most persuasive reason to hold high yield investments today is that the rates story (outlined above) will provide bond holders (again, visit our Top Pick story) will benefit from higher income. And if turns out that those rates start to drop rather than staying the same, then the other part of this equation is that the bonds in question will start to appreciate in value (remember, as rates drop, prices rise). This presents high yield investors with a double-bonus system of enjoying higher income derived from those original, inflated rates and the added bonus of higher market prices that the markets will pay for such high-rate bonds.

Remember, the primary motive to invest in bonds is the income (hence the “income class”). Unless the economy makes a miraculous recovery and starts providing returns that are far in excess of expectations, then those rates will not skyrocket. They will, at the very least, remain level, making high yield investments a great place to invest for 2010. And if your income class knowledge is sub-par (or you want to properly invest in this class) the only way to play this game well is through mutual funds or ETF’s.

It will probably come as a surprise to many investors that Bond funds offer as many practical options as many of the equity funds on the market. As far as bond funds are concerned, you can have core bond funds that are high quality, low risk and you can high yield bond funds that offer mid quality and medium/high risk.

For many people, bond funds offer a great alternative to term-deposits. Not only do bond funds offer liquidity as well as higher rates of returns (than comparable term deposits), but they are an asset class all their own that allows investors to tactically shore up their asset allocation model.

For a limited few, bond funds present a tremendous opportunity. Since bonds do offer growth potential, there are tax advantages to owning bonds over other income-paying investments. In its most basic format, bonds bought at a discount and held to maturity allow for capital gains rather than straight income. In some (okay, most) jurisdictions, capital gains offer benefits at taxation time.  (However, if taxation is a primary concern when it comes to your investment strategy, you should consult your tax accountant to determine the best income source).

Since bond funds offer investors the opportunity to properly diversify their holdings, it has a considerable importance when it comes to your asset allocation model. The problem is that most investors have a tough time understanding the intricacies of bond funds. For example, bond prices will fluctuate based on many of the same factors that affect equity prices like currency, geopolitical, commodity as well as corporate risks.

The difference is that most bond funds will respond differently to those influences. As such, investors whose knowledge falls short on bonds need to align themselves with an advisor who does have something of a decent knowledge base when it comes to this asset class.