Income Security Recommendations
BondsOnline Advisor – October 2007
By Stephen Taub
The BondsOnline Advisor strives to present you with income investment insights from analysts throughout the United States. Bonds, preferred stocks, real estate investment trusts, or master limited partnerships can be a part of a successful income portfolio – and BondsOnline and PreferredsOnline provide the “Income Investor Tools” to keep you informed.
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Global Strategy/Credit Suisse Securities
Credit Swiss company is bullish on the stock market in light of the Fed’s recent rate cut.
Since 1984, its research found that 100% of the time after the first Fed cut, equities are higher one month later. What’s more, the only time equities failed to be higher one year later was in 2001 when there was what the bank calls “a valuation, economic and corporate leverage problem.”
As a result, CS said it is sticking with its long standing fair value of 1,600 on the S&P 500. “Our main medium term worry is that the market has to absorb weaker US economic data at a time when equity sector risk appetite has rebounded,” it added.
It also stressed that investors should not short equities tactically, given the near record shorts by hedge funds on the S&P 500 and extremely high insider buying.
Where to invest? CS asserted that 80% of the time, capital goods outperform in the first three months after the first Fed rate cut. It’s also the only sector to outperform 80% or more of the time.
On the other hand, CS explained that in order to buy cyclicals, bond yields must be rising as opposed to short rates falling. “In general, we have a valuation issue with many cyclical areas,” it added.
However, there is one cyclical area where it is seeking exposure--those with an emerging market angle, such as technology, mining and luxury goods. “These sectors also look attractive on our valuation screens,” CS added.
Strategy/Citigroup Global Markets
Citi recently set new targets for year-end 2008. The investment bank is looking for the S&P 500 Index to surge to 1725 at midyear, but finish 2008 lower, at 1675.
Citi explained that this is consistent with its concerns that corporate margin and political issues could help pull down equity prices in the second half of the year. “The near-term potential for gains still seems high, especially given Fed action that should add to liquidity,” it added.
It singled out the financials and consumer discretionary sectors as areas where it expects strength, a result of very low investor expectations and traditional positive reaction to rate cuts.
The second half of 2008, however, will probably be more challenging due to a number of factors. Its biggest concerns include the Presidential elections, trade policy, possible tax increases, a post-Olympics Chinese economy, and, more recently, trepidation about margin trends.
Citi stressed that its research suggests that margins could see “a meaningful dip” by the second half 2008. This could pressure equity markets, said Citi, since there is a traditional relationship between the S&P 500’s performance and margin trends.
By year-end 2007, it is looking for the index to hit 1600. However, it warned that stock prices could come in a tad shy of that number as volatility is likely to be sustained through year-end and beyond.
Strategy/Citigroup Global Markets
Citi’s SMID group, however, is not as upbeat about the prospects for small and midcap stocks.
It recently lowered its year-end 2007 target prices for the Russell 2000 from 888 to 840 and the S&P 400 mid-caps from 955 to 880.
In addition, it lowered its mid-year 2008 target prices for the Russell 2000 from 925 to 900 and the S&P 400 mid-caps from 1,020 to 945.
Its new year-end 2008 price projections are 865 for the Russell 2000 and 910 for the S&P 400 mid-caps.
What does all this mean? Citi’s new targets anticipate gains of only about 3% for small /mid-caps in 2008 versus its 2007 targets, with gains coming in late 2007 and the first half of 2008 followed by second-half weakness.
Citi explained that insider buying, Fed easing, buybacks, and lowered third-quarter 2007 earnings per share growth expectations seem likely to support small/mid-caps near-term. “Our small-cap sentiment model is also constructive on a 12-month view,” it added. “But volatility and risk aversion suggest SMID gains will likely be muted and lag large-caps.”
It elaborated that small-caps tend to underperform large-caps when any one of the following four factors is in place: rising volatility, widening high-yield credit spreads, rising consumer loan delinquencies, and slowing corporate profits. “We believe each one of these conditions is emerging and will be important to lowering risk tolerance,” it added.
In addition, it expects higher volatility to persist. “Small-caps simply have not held up as well as large-caps in such environments,” it stressed.
Citi also asserted that the diminished role of the LBO takeout story removes a source of share price appreciation in small/mid-caps until 2007.
It is also concerned that two problems could resurface in 2008. Profit margins may meaningfully dip next year. In addition, the recent deterioration in financial conditions may take some time to seep in, it added.
REITs/Bear Stearns
Bear raised its rating on MFA Mortgage Investments to “outperform” and raised the price target on AMB Property, for which it already has an “outperform” rating.
It also raised its sector weighting to Market Weight from Underweight “to reflect the lower risk profile of the companies still in operation.”
MFA mostly invests, on a leveraged basis, in a portfolio of hybrid and adjustable-rate mortgage-backed securities issued or guaranteed by Ginnie Mae or Fannie Mae, and, to a lesser extent, hybrid and adjustable-rate mortgage-backed securities rated in one of the two highest rating categories by at least one nationally recognized rating agency.
Bear Stearns recently raised its rating to “outperform” and its 2007 and 2008 estimates to reflect improved earnings and growth prospects, which the investment bank believes were helped by the Fed's rate cuts.
Bear asserted that AMB is on track to generate solid double-digit FFO (funds from operations) per share growth in 2008 and beyond, driven by improvement in each of its business lines: core portfolio performance, development, and private capital. The global industrial REIT develops, acquires, owns and operates facilities in 44 markets in 13 countries throughout North America, Europe and Asia, with a portfolio totaling 136.7 million square feet. Its customers are in air and ocean cargo, freight forwarding, third-party logistics, retail and consumer products.
For complete coverage, including target prices, please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.
REITs/Lehman
One day after the Fed cut rates by 50 basis points, Lehman turned more favorably towards REITs. “The Fed's decisive actions, at the upper end of expectations, should alleviate pressure on the housing and credit markets and bolster the consumer,” it asserted. “A stronger economy should help support healthier tenant space demand.”
The investment bank singled out nine REITs for which it has overweight recommendations. Three of them are retail landlords, which Lehman asserted should be beneficiaries of a consumer that continues to spend. The three recommended retail REITs are Macerich (MAC), Simon Property Group (SPG) and Developers Realty (DDR).
Lehman also pointed out that a weaker US dollar boosts the short-term position of AMB Property (AMB) and Prologis (PLD), though it stressed it continues to have concerns about their earnings contribution from development for sale.
For complete coverage, including target prices, please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.
REITs/Deutsche Bank
Deutsche Bank was less excited about how much the Fed’s rate cut will impact REITs. “Generally, we think the Fed rate cut improves sentiment toward dividend paying stocks and the economy overall but that's about it,” it explained.
Deutsche said that REITs are financed with long-term fixed rate debt, so there is virtually no earnings impact. And it doesn’t think the rate cut helps property prices much.
“We don't think aggressive mezzanine loans will re-emerge anytime soon,” the investment bank added. “So the highly levered buyer is not likely to return to the property market and push prices up.”
For complete coverage, including target prices, please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.
MLPs/Lehman
Lehman recently initiated coverage of SemGroup, which went public in July. The partnership owns and operates a network of crude oil assets located in the heart of America’s onshore producing zone – Oklahoma, Texas and Kansas. It provides midstream services: gathering, transporting, terminalling and storing crude oil.
Lehman said its price target is based on a 12-month cash distribution run rate of $1.51 and a target yield of 4.75%. It currently trades at a steep premium to the crude oil/refined product pipeline MLP peer group, but only a slight premium to "growth" MLP, the investment bank points out.
Credit Suisse recently raised its 2007 and 2008 earnings estimates for Kinder Morgan Energy Partners LP after the pipeline transportation and energy storage company had announced it had acquired five steel products handling and storage facilities from Marine Terminals, Inc. for $100 million.
Argus recently increased its earnings estimates for TEPPCO. The brokerage said it is maintaining its near-term “Hold” rating and long-term” Buy” rating on the shares. “We still believe the company has favorable growth prospects for the long term due to its strong diversity of energy assets,” Argus recently told clients. “In addition, TPP's distribution yield of about 6.4% is attractive compared to the 10-year Treasury's yield of 5.2%.”
MLPs/ Stifel
Stifel Nicolaus resumed coverage of Inergy with a “Buy” rating. On September 5, Inergy agreed to buy the membership interest of Arlington Storage Co., LLC, the majority owner and operator of a natural gas storage facility in Stueben County, NY. Arlingtion also owns the development rights to a storage project in Stueben County.
Stifel also noted that Inergy has budgeted for nearly $290 million of midstream organic growth projects, which is expected to deliver annual EBITDA of $42.6 MM over the next several years. “We believe that Inergy is well positioned to benefit from the consolidation of the roughly 60% fragmented retail propane distribution market,” the brokerage recently told its clients.
Closed-End funds/Stifel Nicolaus
Stifel recently downgraded a long-time favorite, Nuveen Tax-Advantaged Total Return Strategy Fund (JTA), to “Hold” from “Buy,” based on valuation, when the fund was trading at a 1.95% discount to NAV. The discount has since widened a bit to nearly 3%. “Since June of 2006, JTA has traded at a narrow discount or a slight premium,” the brokerage pointed out. “Should the fund revert to lower levels, it could cause us to reconsider our ‘Hold’ rating.”
It is still confident the fund will continue to pay attractive levels of distribution and maintain superior management. “We remain positive on the fund long-term, however feel there is better value elsewhere for investors seeking exposure to dividend paying equity funds,” Stifel stressed.
For complete coverage, including target prices, please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.
Preferred Stocks/UBS
The investment bank recently pointed out that non-US QDI (qualified dividend income) preferreds currently provide considerable value when held in fully-taxable accounts. Remember, until Dec. 31, 2010, the dividends are taxed at the reduced 15% dividend tax rate.
And, although a legislative proposal could, if enacted, deny the favorable tax treatment to certain non-US QDI preferreds, UBS is not concerned, because it believes these preferreds are not currently pricing in their tax benefit. “We would not expect prices to decline should this legislation go through,” it added.
Keep in mind that until September, non-US preferreds that pay qualified dividend income tended to move in line with fully-taxable trust preferreds since both groups mostly comprise investment grade companies in the bank, brokerage, and insurance sectors. However, in September non-US QDI preferreds underperformed US trust preferreds due to a heavy concentration of QDI preferreds that were issued in the new issue market, putting pressure on secondary prices, UBS explained.
As a result of the underperformance, the current yields on many non-US QDI preferreds are trading at higher levels than similarly-rated fully-taxable securities, “allowing investors to receive the tax benefit for free,” UBS added. “Thus, these securities currently provide considerable value when held in fully-taxable accounts as the dividends are eligible for the reduced 15% dividend tax rate.”
Municipal Bonds/Citigroup Global Markets
Citi recently asserted that municipals are no longer the “compelling buy” they were back in mid-August.
This situation has already reversed to what it calls a more "normal" investment environment, as muni yields are down as much as 50 basis points from their recent highs.
“The decline in muni yields has two main drivers: the removal of the temporary pressures that caused munis to become so cheap and a decline in yields in sectors (including Treasuries and munis) that were not directly affected by the liquidity problems in the short-term market,” the investment bank recently told clients.
Even so, Citi recommended that investors stick with the asset class. It asserted that demand for municipals is likely to remain strong and broad-based. “So, while munis are by no means as compelling as they were for a brief period in late August/early September, they remain attractively priced,” it added.
It expects supply to remain moderate and demand to be strong and broad-based from both individual and institutional investors.
As a result, it recommended putting cash to work and extending maturity to take advantage of the positive slope of the municipal yield curve.
More specifically, it recommended maturities in the 8-15 year range. However, it also pointed out that it would be comfortable holding some bonds longer than that since the yield curve’s slope is steeper than it was prior to the mid -July-August “crisis.”
Citi suggested that portfolios with heavy cash components or very short average maturities should put additional cash to work or lengthen the average maturity of the portfolio by purchasing some longer-maturity bonds.
In general, it urged investors to constantly monitor their income to determine whether it is likely to be subject to the AMT. “If it is, avoid or sell any bonds that are subject to the AMT,” it added.
