Rational Investing: Treasury obligations challenge portfolio planning

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Clark Davis is a 34-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money-management company.|ret||ret||tab|

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The caution flag has been raised for the bond markets.|ret||ret||tab|

Our concern is reflected in our position relative to long-term U.S. Treasury obligations. What we have done is what we recommend for the serious investor who allocates portions of his portfolio among various asset classes. Shorten the maturities among Treasury obligations by laddering the issues no farther out than 10 years.|ret||ret||tab|

Any issues maturing beyond 10 years should be sold. Add high-yield corporate bonds to the level consistent with your risk tolerance if you don't currently own them. If you are not accustomed to operating in the high yield (junk) bond area, get help from your investment professional.|ret||ret||tab|

Look at both open-end and closed-end mutual funds as a means of holding a diversified high-yield position in the portfolio, but be prepared to sell them when interest rates begin trending upward. (Note the keyword "trending" and do not act prematurely on the basis of a week or so of short-term blips in rates.) |ret||ret||tab|

A caveat! |ret||ret||tab|

We are closer to the bottom on interest rates than we are to the top. As the economy gathers momentum, interest rates will rise. We are not there yet, as disinflation pressures continue, but monitoring interest rates is necessary to capitalize on this allocation. |ret||ret||tab|

Let's think a bit more about interest rates being close to the bottom. Here are five signs to watch for:|ret||ret||tab|

Mortgage rates are at all-time lows. (Have you refinanced yet?)|ret||ret||tab|

Money market funds are barely generating enough income to cover their management fees and expenses, raising the possibility that management fees may have to be waived in order to avoid negative returns. |ret||ret||tab|

Low Treasury rates mean foreign investors are more likely to sell their holdings in government obligations and move the proceeds to investments outside the United States, creating both lower prices (and higher yields) and weakening the dollar. The Federal Reserve will tolerate this for a period, but not to the point that dollar weakness damages the borrowing power of the government or the stability of the bond markets.|ret||ret||tab|

This one is anecdotal. Wall Street firms will always bring to market whatever they can sell the easiest. It's the theory of taking the path of least resistance. That was the case with limited partnerships in the 1970s, biotechs and closed-end country funds in the 1980s, and (as so many are painfully aware) dot coms in the 1990s. Watch the advertisements in the financial section of your newspaper for new mutual funds, both open-end and closed-end, that focus on high yield. Some will emphasize preferred stocks, some will focus on convertible preferreds and bonds, and others will concentrate on straight high yield (which they will never refer to as junk or less than investment grade). |ret||ret||tab|

When everyone is interested in buying the same thing, the bloom is about to fade from the rose. Remember that if everyone were right, everyone would be rich.|ret||ret||tab|

The best indication of the bottom of interest rates would be the U.S. Treasury reinstating the 30-year bond, a maturity it ceased issuing several years ago, preferring to fund its liabilities with shorter maturities. That was a good call, as declining interest rates have benefited the government by lowering the cost of new borrowing.|ret||ret||tab|

Now, just as homeowners are refinancing both intermediate-term and long-term at record low rates, doesn't it make sense for the federal government to do the same. If you see the return of the 30-year bond, it will signal that the Treasury wants to lock up current rates for a longer period because it believes rates are heading higher. If this happens it would be the prime indicator that interest rate declines are over.|ret||ret||tab|

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Dividend-paying stocks?|ret||ret||tab|

When I wrote about a compromise between what the president asked for and Congress proposed, I speculated that a cut in dividends would likely be phased in over a period of years. Well, I was partially right. While it is too early to tell what the final version will look like, the compromise appears to be one in which a partial phase-in will take place this year, but then we ultimately get a total reinstatement after three years. |ret||ret||tab|

So how does one plan an investment portfolio for an on-again-off-again tax? Even more difficult, how does a corporation plan? Sort of like driving from here to California knowing that somewhere along the way the interstate will end.|ret||ret||tab|

I continue recommending stocks that have a history of regularly increasing their dividends. Ask your financial consultant about them, and when you review the list compare their current yields to the yields on certificates of deposit and short-term treasuries. |ret||ret||tab|

Then ask yourself which you would rather own over the next three to five years, a fixed-rate low yield or an increasing yield with a tax advantage.|ret||ret||tab|

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