How To Invest In The Era of Cheap Money

Jim Jubak MSN Money January 31, 2012

1/30/2012 7:46 PM ET

By Jim Jubak

The Federal Reserve last week promised to keep interest rates near zero for 3 more years. You know that hurts savers, but how is it likely to affect your portfolio?

Last Wednesday, the U.S. Federal Reserve said it would keep interest rates at their current, exceptionally low level until the end of 2014. Forget about the middle of 2013, which seemed extremely far away when the Fed made that "guarantee" in August.

It's 2014. And forget about the beginning or middle of that year. Now the Fed is talking about the end of 2014.

Almost three years from now. Three years with short-term interest rates near 0%.

Let's cut straight to the chase for investors: Who wins and who loses from this extraordinary statement of policy by the U.S. central bank?

The Fed's statement, in essence, extended the current 0% short-term rate from now -- the beginning of 2012 -- to the end of 2014, or three years. As you'd expect, the yields on the two-year Treasury note had already collapsed with the Fed's "guarantee" of 0% interest rates until mid-2013, moving from 0.61% in the beginning of January 2011 to just 0.25% in December 2013. (Lock up your money for two years and earn 0.25%? Amazing.)

The five-year Treasury note had dropped even further in 2011, from 2.02% at the beginning of the year to 0.89% at the beginning for 2012.

Jim Jubak

But the Fed's announcement has already moved it lower -- to a yield of just 0.75% on Jan. 27. The five-year yield could certainly move lower, but the real action now is probably in the seven-year Treasury, which started 2011 at a yield of 2.74%, and began 2012 at 1.41%. The note has dropped since the Fed's Jan. 25 announcement from 1.4% to 1.31% on Jan. 27.

If you remember that Treasury prices move up as yields move down, you can see how profitable the collapse in Treasury yields was for Treasury holders in 2011 and how 2012 could be just as profitable for holders of seven-year Treasury notes.

How the Fed rules interest rates

Banks make their money on lending from the spread between their cost of capital and the interest they can charge on their loans. Much of that spread is because banks raise their money at the short end of the yield by borrowing for 30 or 90 days and then lending out at the long end for seven or 10 or more years. The steeper the yield curve -- the greater the difference between the yield for 90 days and the yield for 10 years -- the more profitable lending is for a bank.

So 2011 wasn't a great year for what is called the net-interest-rate margin at banks. Short-term costs of borrowing funds to lend have been really, really cheap, thanks to the Federal Reserve, with the yield on three-month Treasury bills beginning 2011 at 0.15%. That was a huge 3.21 percentage points below the yield on the 10-year Treasury bond, the benchmark for interest rates on mortgage loans.

Since then, while borrowing costs have remained stable, the yield on the 10-year bond has tumbled to 1.89%. That has cut the spread to 1.74 percentage points from that earlier 3.21 percentage points.

Not all banks feel the effects of this decreasing spread equally. Banks with large investment portfolios with lots of assets maturing -- so they have to replace high-yielding with lower-yielding assets -- will take a bigger hit. That is a problem at Bank of America (BAC, news), it seems, based on the bank's fourth-quarter earnings report.

Banks with big mortgage portfolios with maturities out beyond 10 years will take less of a hit. Banks that raise much of their funds from deposits might have a bit more flexibility in lowering their costs of capital. But all in all, I think it's correct to say that a flatter yield curve, which is what the Federal Reserve has produced with its policies in 2011 and 2012, isn't good for bank margins.

If I were looking for banks that could thrive in this atmosphere, I'd look for banks such as US Bancorp (USB, news), a member of my Jubak's Picks portfolio, that get a relatively higher percentage (compared with their peers) of revenue from fees rather than from lending or investment banking. This environment will also be tough for insurance companies, which will see their investments yield even less in 2012.

Winner: Dividend stocks

The Federal Reserve's low interest-rate policy has been called a war on savers. That seems pretty accurate to me. Currently you can earn a whopping 0.248% (national average) on a three-month certificate of deposit (with a $10,000 minimum). Want to make a decent return -- say, something as magnificent as 1%? Forget a 12-month CD. The yield is just 0.556%. Willing to go out two years? The national average for a two-year CD is just 0.875%. To add insult to injury, the headline inflation rate for 2011 was 3%; the core rate (which excludes increases in the prices of food and fuel) was up 2% for the year. No matter which inflation rate you use, all of those CDs lost value in 2011.

No wonder, then, that dividend stocks paying more than 3% (so an investor at least stays even with inflation) are among the hottest stocks on the market. In a year when the Standard & Poor's 500 Index ($INX) managed a return of just over 2%, a not-especially-stellar drug company like Merck (MRK, news) returned 8.9% -- because it paid a dividend of better than 4%. Verizon Communications (VZ, news), in not a particularly good year for phone companies, managed a 17.6% total return -- because it paid more than 5%. Pipeline master limited partnerships such as Oneok Partners (OKS, news), with a dividend yield of 6%, returned 51% for the year. Another master limited partnership, Magellan Midstream Partners (MMP, news), returned 27%.

I don't see any reason that dividend stocks with yields above 3% won't turn in another stellar performance in 2012. After all, the Federal Reserve just guaranteed that savers won't be able to make 2% even if they buy seven-year Treasury notes. And, looking at the number of financial advisers and gurus that I see praising dividend stocks, I think 2012 could be even better for anything with a pulse and a yield.

Merck, Oneok and Magellan Midstream are all members of my Jubak Dividend Income Portfolio. I'll post a performance report and new picks for that portfolio on Friday, Feb. 3.

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No matter which inflation rate you use, all of those CDs lost value in 2011. 1 0ReportSpamomg627 hours agoWe pay more and invest for less, So whats new. 1 0ReportSpamupperdoper7 hours ago It wont be cheap enough if you pay it all back. As usual only the rich gets cheap money from bailouts just look at the CEO's who awarded themselves millions for getting bailouts. Not everyone has access to that cheap money. 1 0ReportSpamAdd a commentReportPlease help us to maintain a healthy and vibrant community by reporting any illegal or inappropriate behavior. If you believe a message violates theCode of Conductplease use this form to notify the moderators. They will investigate your report and take appropriate action. 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Since then, while borrowing costs have remained stable, the yield on the 10-year bond has tumbled to 1.89%. That has cut the spread to 1.74 percentage points from that earlier 3.21 percentage points.

Merck, Oneok and Magellan Midstream are all members of my Jubak Dividend Income Portfolio. I'll post a performance report and new picks for that portfolio on Friday, Feb. 3.

How To Invest In The Era of Cheap Money

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