Alternatives To Fixed Income

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As a Fixed Income value investor it’s not easy to find really good investments at reasonable prices anymore. You can find specific opportunities in Europe or in countries such as Argentina or Venezuela, but the truth is that life is not so easy when US high quality credits are close to the zero bound - US 10 year Government bonds offer a 1.9% yield. The US bond market became so expensive that it’s even hard to get reasonable price to risk opportunities in the High Yield arena.

As matter of fact, ETFs that I have recommended for years for its large number of assets such as the iShares High Yield Corporate Bond ETF (NYSEMKT: HYG), which has a portfolio of over 700 different bonds, are today seemingly overpriced. In the case of HYG the problem is not only the low 6.4% distribution yield offered but also the fact that the average bond price for this ETF trades at above par. As Buffett says, when trading bonds with a considerable probability of default, value is related to a low trading parity rather than high yield to maturity. The reason is simple. When a bond defaults you should focus on getting your capital back. This means that coupon is not very relevant. No matter the coupon, if you paid a price above par, you will most probably lose money under a restructuring scenario. Conversely, if you paid a very low price for the bond, you can still make a good return under a restructuring even if the coupon is low. The risks are not only clear for the case of HYG but also for all other high yield exchange traded funds. For example, SPDR High Yield Bond Fund (NYSEMKT: JNK), the high yield ETF of SPDR, pays a 6.2% average yield to maturity and has an average bond price of $108 with an average duration of 6.93 years. It’s clear to me that at current bond prices you would be taking too much risk for the offered income rate. Alternatives do exist but they are not to be found in the fixed income world. There are some equities that can constitute an opportunity with much higher upside potential and considerably lower downside risk. Surprisingly, they also offer a cash income comparable to any high yield bond fund.

I will name here two of my top picks for 2013. My first 2013 pick is BP (NYSE: BP). The company not only pays a 5.1% cash dividend yield, but also is increasing its dividend at a 12.5% yearly rate. As I have mentioned in previous posts, I consider that substantial gains can be made in this stock when the final solution for the Macondo spill arrives. My bet is that sooner than later a solution will become apparent and BP shareholders will benefit greatly from it. My second 2013 pick is Banco Santander (NYSE: SAN) which is not an Spanish bank but an international bank with very important operations in Spain. SAN is one of the most efficiently managed banks in the world, enjoys a comfortable 10.5% core capital ratio and in 2013 is expected to pay a 10% dividend yield. I would buy SAN and only sell when the environment in Europe starts to ameliorate. As a shareholder, I am sure odds are in your favor.

I learned the hard way that the best thing that you can do when you do not find anything cheap is just sell. I think this is the case in the US Fixed Income arena right now. I recommend selling US high yield and just go for blue chip equities that can pay you a reasonable (or more than reasonable) cash yield.   

martinzaldua has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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