'On the brink of default'... What Puerto Rico's default could mean for municipal bonds... Doc Eifrig on rising interest rates and muni bonds... One of the best income opportunities available today... Reader question: World Dominators and trailing stops...
After years of debt struggles, Puerto Rico appears about to default...
As we last discussed in the June 30 Digest, the U.S. commonwealth owes more than $72 billion to creditors. It's managed to "get by" the past couple of years with cost-cutting measures and additional borrowing. But the situation became critical this summer when Governor Alejandro Garcia Padilla publically called Puerto Rico's debts "unpayable."
Puerto Rico was able to make one $169 million debt payment on Friday. But it failed to make a separate $58 million payment on Public Finance Corp. ("PFC") bonds over the weekend. And according to an article in the Financial Times, the failure has triggered an official "default"...
The missed payment will push Puerto Rico formally into default after the close of business on Monday, said credit rating agency analysts. The PFC bonds are the first to fall into arrears, and a government "working group" is racing to come up with a plan to restructure the territory's debts and overhaul its economy...
The PFC bonds hold fewer protections than "general obligation" bonds issued by the Puerto Rican government. The U.S. commonwealth is likely to prioritize which bond payments it makes over the remainder of the year, said traders and portfolio managers.
Peter Hayes, head of municipal bonds at BlackRock, the world's largest fund manager, said the missed payment would be an "awakening" for investors who were holding Puerto Rican debt to generate income. "It gives you an indication of how [Puerto Rico] is going to proceed going forward," he said. "They will have some interruption to debt payments, potentially a moratorium of debt service. It is indicative of their solvency situation."
Our colleague Dr. David "Doc" Eifrig has been following the news closely.
And while the default is bad news for Puerto Rican citizens and the island's creditors, Doc says it's not a concern for most municipal bond investors. As he told us when Puerto Rico's debt problems were making headlines in June...
While Puerto Rican bonds are trading around 70 cents on the dollar, the larger municipal-bond market is unscathed. Crises that happen in slow motion are easily contained. Most municipal-bond mutual funds have already gotten out of Puerto Rico. Your muni funds should be doing just fine, but you can check their exposure at the fund's website to be sure. And you can see a list of highly exposed funds right here.
Of course, Puerto Rico isn't the only worry on bond investors' minds today...
Many folks are also worried about rising interest rates. As Doc noted recently to his Income Intelligence subscribers...
Investors think that the Federal Reserve will raise its benchmark interest rate, called the federal-funds rate. The consensus is that the September meeting will be the turning point.
A higher federal-funds rate will make other investments look less attractive in comparison.
Remember, rates and prices move in opposite directions. If a bond pays 3% and rates rise to 5%, the price of the bond declines because investors can easily find higher-yielding investments than the original 3% bond. So right now, municipal-bond prices are falling in anticipation of higher rates in the future.
But as Doc explained, the real world isn't usually so simple. Even if the Fed does raise rates next month, he says interest rates are likely to remain low a lot longer than most folks believe. And more importantly, Doc says muni bonds in particular have likely already "priced in" higher rates. More from Doc...
It all comes down to the yield of muni bonds versus U.S. Treasury securities...
Over the past five years, investment-grade municipal bonds maturing in 10 years have typically yielded about five to 10 basis points (0.05%-0.1%) more than 10-year U.S. Treasury securities. The peak of this spread was 40 basis points (0.4%) higher, though that wide of a spread is rare, only occurring about 1% of the time.
Right now, Treasury securities yield about 2.35%. We put the peak of how high Treasury yields are likely to go in the near future at about 3%.
That means the best yield we can reasonably expect on investment-grade munis would be about 3.4%. Today, muni bonds yield about 2.4%. That means we're within 100 basis points (1%) of the perfect yield-buying opportunity. To us, rising rates look like they are already built into the price of muni bonds.
Doc believes municipal bonds are still a "buy" today... and has recommended his readers "double down" on his favorite municipal bond fund.
But if you're looking for more income today, Doc sees an even more exciting opportunity...
It's a way to safely and conservatively generate 15% or more in annual income on a retirement account.
Used properly, this strategy can help you make hundreds – even thousands – of dollars in extra income every month... And believe it or not, Doc has logged an incredible 99% success rate with this strategy.
Right now, Doc is sharing a live-recorded demonstration of how his strategy works. To watch the video (and learn how to claim a free year of Doc's trading service Retirement Trader), click here.
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In the mailbag, a subscriber asks an important question about trailing stops. Send your questions and comments to feedback@stansberryresearch.com.
"I've read time and again about sticking to trailing stop losses and such from you and other authors. My question is with stocks that are held in companies that are world dominators with great balance sheets, solid dividends, and that will essentially always be around: Coca Cola, Chevron, constellation brands, McDonalds, Hershey etc. With that being said, do you still recommend following trailing stops, or is it better to always hold a position and gather more shares when prices are falling, as they are now? At some point we're going to have to deal with a currency/debt crisis that is in our country's future. Buy and hold forever, or be mindful of how much pain to take before selling?" – Paid-up subscriber Austin DeSico
Brill comment: As always, we can't give individual investment advice, but we have some thoughts...
We generally recommend using trailing stop losses – along with proper asset allocation and position sizing – for one important reason: To help limit your risk and protect you from suffering a catastrophic loss... the kind that can ruin your year, your marriage, and even your retirement.
While the idea of buying and holding dividend-paying World Dominators forever is appealing, most individual investors are unable to do it successfully. When the shares of even great companies are crashing – think back to 2008-2009 – many folks will panic and sell at exactly the wrong time. And even if you have the stomach for it, it's important to remember that as individual investors, we have imperfect information about the companies we invest in... and sometimes even the world's best companies make mistakes or become obsolete.
Still, that doesn't mean they are our only option for managing risk...
As an alternative for some high-quality dividend stocks, a few of our analysts have suggested using a simple or "hard" – rather than trailing – stop loss and adjusting the stop for dividends received.
As a simple example, suppose you buy company at $100 per share and it pays a fixed dividend of $5. Rather than set a 25% trailing stop, you could set a simple stop at $75 per share. Your maximum risk is 25% of your $100 "cost basis," or $25 per share.
Imagine that the stock rises over the next few years to as high as $150 before pulling back to near $100 per share. If you were using a 25% trailing stop, you would book a profit... but would be stopped out at $112.50, for a 12.5% gain. But with a simple stop, you'd remain in the trade.
Then, as you receive dividend payments, you would reduce your "cost basis" by that much, which lowers your stop price.
In this example, after one year your capital at risk is $95 per share ($100 minus the $5 dividend)... and your stop trigger falls to $70 a share (which would keep your maximum loss at $25 per share, or 25% of your original investment). After two years, your cost basis is $90... and you would only sell if the stock hit $65 a share.
And after 20 years, you've recovered 100% of your original capital at risk, meaning essentially you could never stop out and you're holding the stock for the income it generates.
If tracking this sounds like a hassle… you should take a moment to learn about the position-tracking software developed by our corporate affiliate TradeStops, which simplifies the process.
This example uses a constant dividend of $5. Assuming even modest dividend growth, these numbers get much better. With 5% dividend growth, you would recover your original investment in less than 12 years and would be collecting annual dividends of more than 8.5%. With 10% dividend growth, you would reach that milestone in less than 10 years and would be receiving annual dividends of nearly 12%.
Regards,
Justin Brill
Baltimore, Maryland
August 3, 2015
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