Tightrope Act

Despite the protracted tech collapse, eBay’s shares are up at an annualized clip of 18.29% since June 1999. Even with the stock climbing a third through mid-June, eBay’s business model remains the paradigm of the New Economy. J.P. Morgan’s New York-based tech analyst Imran Khan projects 61% earnings-per-share growth for eBay this year, followed by 33% for 2005. “Better than expected revenue growth and improving margins should lead to multiple expansion,” he concludes.

A play on the developed world’s aging demographics, shares of global medical products maker Stryker have soared at an annualized rate of nearly 29% over the past five years. San Francisco-based Wells Fargo Securities health care analyst Wade King observes that, excluding the period around a 1998 acquisition, “Stryker has reported solid 20% earnings growth for more than 20 years.” Merrill Lynch’s Katherine Martinelli projects this growth rate to continue in 2004 and 2005. With the company being essentially debt-free and sporting a trailing price/earnings ratio of 45, Martinelli speculates that a significant acquisition could further drive earnings.

The Preferred Solution

New York Stock Exchange-traded preferred shares are debt-like securities that many advisors know little about. However, they often consistently yield 100 basis points or more over comparably rated bonds because they are less liquid and have a weaker claim on corporate assets. Many also lack specific maturities.

For example, Kevin Conery, preferred stock strategist at Merrill Lynch, compares an AA-rated Citigroup 10-year bond with a current yield of 5.80% and a Citi series Z preferred share sporting a current yield of 6.97%. Callable in September 2006 and trading slightly under its call price of $25, the preferred’s yield-to-call would be 7.08%. Another lender issuing preferreds is Royal Bank of Scotland. In late June, two callable issues of the bank’s dollar-denominated preferreds, series G and H, were both selling below their call prices and offering current yields of 7.4% and 7.26%, respectively. Even more enticing about these shares is that their dividends get taxed at the new 15% federal rate. However, Wall Street has developed a breed of trust preferreds–including the Citigroup issues–that are backed by bonds and therefore pay interest that is taxed at ordinary rates.

Despite their higher yields, preferreds are not a panacea. Like bonds, their prices move inversely to interest rates. The preferred market experienced a major correction in April, when fear of rising rates generated a total negative return of 4.64% for Merrill’s Master Preferred Index, the single-worst monthly performance since January 1990. May witnessed further erosion in prices, until investors began seeing bargains and demand stabilized.

Banking on Foreign Lenders

Bank shares usually get hit when interest rates increase because the spread between their existing long-term loan rates and the cost of new money is shrinking. However, in a number of major markets interest rates have already cycled up well ahead of the U.S., suggesting that lenders in these countries may have moved past their most vulnerable stage. Looking at trailing five-year market performance through April, bank shares in these countries have sustained their value, in local currency terms, in the face of rising rates while paying dividends of 4% to 5%.

Australia is among the countries with promising high-yield bank plays. The country’s overnight rates are up 100 basis points since mid-2002, to 5.25%. But over the 12 months through mid-April, Australia’s six largest banks saw their stocks increase an average of 25% in local currency terms. Going back to April 2001, annualized price returns averaged 15.69%. Three of the banks–Westpac, ANZ, and NAB–have American depositary receipts that trade in U.S. dollars on the NYSE. Commonwealth Bank of Australia, Macquarie Bank, and St. George Bank trade only locally.

British interest rates, meanwhile, have been among the most stable around, moving within a 50-basis-point band since the end of 2001. However, starting in the fall of 2003, overnight rates have shifted up from 3.5% to 4.5%, with many observers expecting additional monetary tightening. Still, the five major British banks–HSBC, HBOS, RBS, Barclays, and Lloyds TSB–together rose 9.89% (in pounds) over the 12 months through April. Over the past three years, their share prices have increased at an annualized pace of 13.28%. And that does not include their average dividend yield of 4.5% and realized annual local-currency gains of 13.28%. Of the group, HSBC, Barclays, and Lloyds have ADRs.

UBS London-based banking analyst Christopher Ellerton believes that banks’ increasingly risk-averse lending policies, deleveraging of the corporate sector, and the relatively healthy position of emerging markets suggest that the industry doesn’t appear to be especially vulnerable to a credit shock. He sees profitability and capital position strengthening in 2004 and 2005.

High Yields Abroad

In April 2004′s cover story, “Foreign Appeal,” we highlighted the merits of looking overseas for higher-yielding fixed-income plays. The reasoning still holds. Rates in a number of developed markets are significantly higher than ours. And because their central banks have already been tightening monetary policy for a while, interest rates are much closer to peaking in Australia, New Zealand, and Britain than they are in America. That means more yield and less capital risk.

John Kaupisch, foreign bond specialist at St. Louis-based Evergreen Direct Brokerage, is keen on short- and medium-term British and New Zealand government debt. As of mid-June, U.S. one-year Treasuries were yielding 2.14% and three-year bonds 3.4%. British gilts were paying 4.61% and 5.16% for one- and three-year maturities, respectively, while New Zealand’s kiwi-denominated government debt paid out even more, yielding 5.93% for one-year and 5.98% for three-year credits.

Advisors should also look into inflation-protected sovereigns (see table on page 62). While the international market is less liquid than the American one, real yields in more than half the nine countries that offer inflation-protected securities exceed those paid by TIPS. Barclays Capital noted that in June, Australian securities were not only yielding 132 basis points more than U.S. 10-year TIPS, but the country had higher expected inflation–2.5% versus 2.1%–which, if realized, would further enhance Australian inflation-protected debt yields.

The main risk of investing in foreign bonds is currency exposure. As of June, the dollar had paused in its two-year slide. But many foreign exchange analysts believe that this is a short-term phenomenon. They expect that America’s record current account, trade, and budget deficits will force the dollar down further. If this occurs, the dollar value of international assets will rise, further sweetening returns and highlighting the potential of foreign exchange as an asset class.

Will the Buck Bottom?

One near-term dollar bear is Lehman Brothers currency analyst Jim McCormick. He thinks that the greenback might very well sink even in the face of Fed tightening. “Over the past full Fed rate cycle, the dollar has tended to do the opposite of what you would think,” observes McCormick. The dollar declined considerably during the 1994 tightening cycle, then stabilized and began a sharp ascent only after rates had steadied. Despite repeated rate cuts that brought the Fed funds rate to 46-year lows, the dollar only began its present slide after the Fed was virtually done cutting rates. McCormick believes “U.S. yields need to stabilize at much higher levels then they are today if Fed policy is going to play a role in turning the dollar around, especially with a current account deficit heading toward 6% of GDP.”

You can gain foreign currency exposure in various ways. The easiest is buying country-specific exchange-traded funds or dollar-denominated ADRs. It’s also possible to prospect directly on foreign bourses. With a number of global large-cap companies paying dividends from 4% to 5% and foreign sovereign debt offering comparably attractive yields, sitting in such securities provides cash flow and an opportunity to look smart should the dollar weaken further.

More sophisticated players may also want to look into currency options and futures. One way to play these investments is through managed futures programs run by commodity trading advisors. These hedge-like funds are designed largely for qualified investors with large minimum investments. Some CTAs have partnered with major brokerages, like Merrill Lynch and Morgan Stanley. Take Campbell & Company’s Financial Metal and Energy Portfolio, which is largely a financial play with half of its $7 billion assets in currencies and much of the remainder in interest-rate instruments and financial indexes. The portfolio is available through dozens of brokerages, with minimums of $100,000 and less. Its annualized five-year return, net of expenses, through May 2004 was 11.1%, versus -1.53% for the S&P 500. Its standard deviation was 14.29, compared with 16.7 for the broad equity market. But remember that CTAs’ effectiveness is limited when markets are trendless, as they were in the first half of 2004.

Remember, too, that rates may defy the pundits and fail to head substantially higher if it turns out that the economy is growing less vigorously than anticipated. Wall Street, however, is betting that the recovery isn’t faltering and rates have room to rise. In that case, you’ll need to find ways to add a bit of alpha during a time in which most portfolios will be struggling.

Eric Uhlfelder covers international investing for publications including The Financial Times, The Wall Street Journal Europe, and Institutional Investor. He can be reached at [email protected]. His book, Investing in the New Europe (Bloomberg) is available through the IA Bookstore at www.investmentadvisor.com.