Income Security Recommendations

BondsOnline Advisor – September 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.

Strategy/Lehman

Lehman recently told clients it believes the worst in the markets is behind us.

Its London-based strategist group noted that retail investors recently fled the market amid all of the turmoil in the sub-prime and credit markets. But, it argued that history suggests this will once again prove to be a mistake.

It noted, for example, that we recently witnessed the eleventh occasion in which global retail investors have sold more than an average of $2.75 billion in a four-week period. In eight of the previous 10 periods, markets were higher 100 days later, with a median gain for all periods of 7.7%.

“This selling has been consistent across global regions and investment styles,” Lehman added. “With valuations and net issuance low, while earnings momentum remains relatively strong, we believe recent Fed actions over recent weeks likely mark the bottom of this most recent correction.”

Strategy/Citigroup Global Markets

Citi recently noted that while the credit markets have been roiled in turmoil and risk aversion has returned in a significant way, the equity market had not returned to “irrational exuberance.”

In fact, it asserted that stocks still look pretty good looking out one year. “If one calculates the present value of flat trailing 12-month earnings into the future, one finds that current market levels support S&P 500 appreciation in the coming 12 months, with powerful historical accuracy,” Citi noted.

Where to concentrate? The investment bank asserted that its large-cap bias remains intact. “Given higher market volatility, rising corporate credit growth, better valuation, and solid balance sheets, we remain clearly skewed toward large-cap stocks, especially since we doubt that a new major wave of risk-taking is in the offing,” it added.

One area it is overweight is technology. It pointed to its semiconductor indicator, which showed that chip equipment orders declined 17% year over year in July. This is a sort of counter-intuitive indicator. Citi noted that when equipment orders slide and capacity growth slows as a result, semi stocks typically pull up other tech names with them.

Even so, Citi is somewhat worried about the market's recent selloff. It asserted that it is becoming increasingly difficult to suggest that the current stock market pullback is similar to past sell-offs in May/June 2006 and February/March 2007. “This time, the decline has been greater and the duration longer,” it added. “The protestations of bulls seem repetitive and less insightful, with few new pieces of information to counter the issues of fading liquidity and the various problems in credit conditions affecting consumers, investors, and lenders. In the previous retrenchments, central bankers were not needed to come in and support their target rates.”

REITs/Citigroup

Citi recently warned REIT investors not to get too excited about the Federal Reserve's recent cut in the discount rate and its anticipated reduction in the Federal Funds rate.

It noted that REITs underperformed the S&P 500 following the past three initial Fed rate cuts, on average, in the subsequent 1-, 3-, 6-, and 12-month periods. The only time they did not underperform was in 2001, when REITs were trading at discounted valuations versus historical levels, it added.

In fact, Citi asserted that the environment in which the Fed recently reduced interest rates more resembled 1998, when the Fed took similar action. Back then, REIT valuations also were stretched, amid a liquidity crunch, and in the midst of a REIT correction.

Indeed, back then REITs underperformed the S&P in the 1 and 3 months following the rate cut.

Citi also noted that in 2001, low valuations provided room for REIT stocks to move up. Indeed, REITs “significantly” outperformed the S&P in 2001 as REIT valuations were low and fared well following the rate cut, according to the investment bank.

Getting more specifically, Citi noted that retail and healthcare REITs are the greatest beneficiaries of rate cuts while apartment and industrial REITs are the worst performers following a rate cut.

On the other hand, Citi said it would avoid industrial REITs, so the ratings on two stocks were recently lowered to “sell.”

REITs/Lehman

Ever since REITs decisively broke their long, 7-year trend of outperformance in February, the stocks have been especially volatile. The investment bank recently lowered its price targets on a number of REITs. However, in some cases it raised the prices. Lehman rates four REITs as “overweight.”

“General investors might still wish to wait,” Lehman counseled. “We believe dedicated investors should seek more defensive companies.” It explained that its definition of defensive characteristics includes solid balance sheets with low leverage, safe dividends, quality assets, proven management, no or limited overseas activities and for the longer term, development skills.

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.

Large-Cap Banks/Lehman

Lehman recently noted that large cap banks as a group are currently trading at 12.4 times forward earnings per share, near their lowest level since mid-1996 and well below their five-year average of 13.8 times and its 10-year average of 15.1 times. Several trade at single-digit P/Es, including Wachovia Corp., Bank of America, JPMorgan Chase and Citigroup.

What’s more, the group’s average dividend yield is 3.8%¸ its highest level since 1995. And, five banks have dividend yields greater than the 10-year treasury yield, including National City, First Horizon National, Bank of America, U.S. Bancorp and Wachovia Corp. Bank of America, Wachovia, Wells Fargo and M&T Bank all announced an 11%–16% dividend hike after they reported second quarter results.

The reasons for these developments: Recent subprime mortgage market pressures spilled over into other markets including leverage financing, CDOs and other fixed income/structured products, including commercial paper, the bank explains in a recent report to clients. These conditions resulted in reduced liquidity, a reluctance by many institutions to lend, extraordinary volatility across all markets, difficult conditions in the credit markets, a general widening of credit spreads, rating agency downgrades, a lack of price transparency, margin calls, the reduced value of certain asset classes such as mortgage (as well as houses), and risk aversion, it added.

Lehman asserted that a number of bank stocks have been over-penalized by the markets, given recent concerns, such as JPMorgan Chase, Citigroup, Bank of New York Mellon, and State Street. Among the more traditional banks, it prefers Wells Fargo and Wachovia, “two stocks we believe are being overly penalized, given mortgage-related concerns,” it added. Lehman also singled out U.S. Bancorp and PNC Financial as defensive plays.

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/Credit Suisse

The investment bank is recommending that investors jump back into certain MLPs. It recently told clients that the recent weakness in the MLP market provides an opportunity to pick up quality names that do not have the growth opportunities factored into their current price. “The pullback was precipitated by the lowering of the average spread over the Ten Year Treasury rate to 25 bps, which triggered some selling,” it explained. “In a thinly traded market, the MLPs traded down further than the risk warranted in our opinion.”

For complete coverage of these six stocks, including target prices, please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.

Closed End Funds/Stifel Nicolaus

The closed-end specialist recently asserted that irrational selling has created an opportunistic entry point for closed-end funds. “This irrational selling is not a new phenomenon to closed-end fund investing,” it explained. It pointed out that historically, it has been sparked by tax-loss selling, new issue supply and/or retail investor fear. “The current market is a combination of all 3, in our view,” it added.

It insisted once markets stabilize and retail investors regain their confidence, many deeply discounted funds will revert to more normalized levels. “Additionally, should NAVs perform well, narrowing discounts may catapult investor returns well beyond NAV performance,” it added.

So, it recommends opportunistic, aggressive investors begin to selectively purchase those funds with quality underlying assets trading at mid-to-high teen discounts. For income-oriented investors, it recommends continuing to reduce exposure to funds with the most speculative levels of below investment grade debt, as well as funds trading near or above their current NAV.

On the other hand, should credit conditions continue to deteriorate, it recommends select leveraged closed-end municipal bond funds, figuring investors will be seeking refuge from equity and speculative grade debt markets. “Furthermore, should the FOMC decide to reduce the Fed Funds rate, the borrowing costs of the leverage would decrease, thus increasing the benefits of utilizing leverage in a closed-end structure,” it added. “A reduction in borrowing costs would improve the earning situation of the funds, potentially leading to future dividend increases.”

Stifel recommends six municipal funds, asserting they illustrate ideal investment opportunities based on valuation, credit quality and earning condition. Please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive Yield & Income Newsletter as part of their subscription.

Fixed-Income/Citigroup Global Strategy

Citi said it remains defensive given its view that the liquidity crisis has not fully unfolded. It pointed to what it describes as the bond market’s underlying bifurcation, characterized by a strong flight to quality that has benefited risk-free—government—debt and all but dried up risk appetite for spread products such as corporate bonds.

However, it warned investors not to overreact or do anything drastic. ”Long- term investors should not be unloading positions into this market turmoil and would be well advised to focus on high-quality, liquid instruments until financial conditions appear closer to normalizing,” it advised.

That said, there are specific opportunities it recommends for long-term-investors. For example, it likes certificates of deposit (CDs) for investors seeking a “short-term income-oriented solution” in diversified bond portfolios. “We believe that current yields above 5% are compelling relative to quality fixed-income alternatives of comparable duration,” it added.

For investors with what it described as having “stronger constitutions,” it continues to recommend high-quality U.S. bank and broker dealer issues in the 5-year to 10-year range. “Indeed, since balance sheets are very strong relative to market concerns, we don’t believe the credit crunch or subprime issues will cause material damage to the banks,” Citi explained.

It also recommended another what it described as a “misunderstood story.” It is referring to Fannie Mae and Freddie senior agency debt, which it prefers in the 5-year to 10-year maturity range. “Both issuers continue to elicit fears on the housing slowdown despite less than 5% exposure to subprime in their retained portfolios,” Citi explained in a recent report. “But their balance sheets are in much better shape than just a few years ago, when they were forced to restate earnings, adopt new governance procedures, and exercise more conservative fiscal discipline. Ultimately, they’re very well positioned to withstand the housing downturn.”

The investment bank also recommended preferred stock offerings at 7.5% or more “for yield enhancement in diversified portfolios.” It warned that preferreds are more sensitive to changes in long-term rates. But, it added that if investors believe, as it does, that long-term rates are capped by improved inflation prospects and slowing demand, and with the historical upper band of preferred yields in the 8% area, the risk/reward at 7.5% YTW (yield to worst) appears compelling.

Citi also recently instituted a strong Buy in the tax-exempt municipals sector. “Municipal yields as a percentage of taxable yields have skyrocketed as long-term insured muni paper now yields 5%-plus, a compelling value proposition for individual investors,” it explained.