Embrace the Carry

Sometimes, someone says it better than you can...so the best thing is to quote that person.

I am often asked the question: why do you invest in bonds/preferreds (and select high-yielding stocks) in an environment of rising interest rates?

Well, excepting the fact that the 10-year Treasury yield is now 17 basis points lower than it was in early July, I do comprehend the possibility of rising rates and thus can't dodge the question.

But I can get someone else to answer it for me, in this case legendary bond investor Bill Gross. Gross' most recent monthly investor letter has drawn much attention for his bold proclamation that he, and his firm PIMCO would win the "bond wars."

While conceding that bond investors may have to accept lower returns (mainly because there is very little room for rates to decline on an absolute basis), Gross correctly points out the key tactical maneuver necessary for bond investors to beat benchmarks: embrace the carry.

As Gross points out carry is another term for yield, but as he also points out, it is more specifically a measure of risk undertaken by the investor. He mentioned four other types of carry -- maturity, curve, currency, volatility -- but my firm's (and my column's) focus is on credit, specifically finding instances where the market is overstating credit risk for a specific company.

Gross didn't really touch on the main competition to bonds, of course stocks. This chart from www.multpl.com shows why I am not bullish on stocks (and Gross doesn't seem to be either). The REAL return on stocks, i.e., the dividend yield, has fallen below the 2% benchmark, and thus, after a brief inversion, represents a significant discount to the yield offered by the 10-year Treasury note. That combined with a run-up in "P" that has been combined with, at the margin, a decline in "E" (earnings expectations for the S&P 500) and that's why I'm not bullish on stocks....224 more words left in this article. To read them, just click below and try Real Money FREE for 14 days.

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