2 dividend plays for a risky new world

By Jim Jubak

Time for income investors to switch from worrying about higher interest rates to worrying about borrowers going bust.

Over the last 18 months or so, my income portfolio has successfully skirted the risk of higher interest rates while delivering solid returns to income investors. How solid? Since its October 2005 inception, my Dividend Stocks for Income Investors portfolio has delivered an average annual return of 13.01%. That's slightly below the 15.2% average annual return delivered by the Standard & Poor's 500 Index ($INX), but it came with a lot less risk.

It's sure better than the returns delivered by such well-managed bond market mutual funds as Fidelity Total Bond (FTBFX) and Vanguard Institutional Total Bond Index (VITBX), which are essentially flat for the period. And especially good if you remember that the initial goal when I started this portfolio back in October 2005 was simply to beat the roughly 5% yield on Treasury notes.

The goal is always the same: getting the highest return out of an income portfolio without taking on too much risk. But now it's time to make a switch, because the nature of the risk to guard against has changed.

Now, income investors can stop worrying about the direction of interest rates, but they can't relax. Instead, it's time to focus on credit risk, the worry that corporate borrowers won't be able to pay back what they've borrowed at all.

I'm going to make two sells and two buys in my income portfolio with this column that reflect the change in the nature of the risk facing income investors.

Fed's not the boogeyman

U.S. interest rates aren't anywhere near as big a worry for income investors as they were when I launched the portfolio 18 months ago. Then, if you remember, the financial markets were vacillating. Some days, investors feared the Fed would raise interest rates to slow growth and damp inflation, which would send the price of existing bonds down and generate losses to principal more than large enough to wipe out any gains from interest or dividend payments. On other days, the markets decided the odds were in favor of interest rate cuts because a stagnating economy needed a boost. That sent the prices of existing bonds up and left the stock market to wonder which was better, lower interest rates or stronger earnings growth.

But now the odds that the Federal Reserve will do much of anything in 2007 are just about nil. A depressed housing market -- only a 1- or 2-percentage-point -- only a one or two percentage-point increase in mortgage rates away from a total meltdown -- just about guarantees that the Federal Reserve won't raise short-term interest rates, the only interest rates the central bank controls directly. And inflation that remains stubbornly high by the Fed's standards means a significant easing in interest rates isn't likely either, unless economic growth stalls completely.

So put that worry away for a while and reach for a new worry, one marked "credit risk."

Whenever investors buy a bond, they run the risk that the company won't be able to repay the loan when the bond matures.

Credit risk had been low on investors' list of worries until very recently for a very good reason: Not many companies, even those that were the worst credit risks, have been defaulting. At the end of March, the 12-month trailing global bond default rate for speculative bonds -- I like the name "junk" better -- stood at just 1.17%, according to Standard & Poor's bond rating service. Competitor Fitch Ratings puts the default rate even lower at 0.4% for the trailing 12 months.

The turmoil in the subprime mortgage market has started to change all that. Two years ago, it was possible to pooh-pooh talk of a crisis in the sector. Yes, interest rates were moving up and with them the size of monthly payments due on the large percentage of subprime mortgages with adjustable rates. Subprime borrowers, who had shaky credit histories and often only barely met income requirements, should have been the first to feel the pain, but delinquency and default rates were at historic lows.

The deterioration, when it finally came, was dramatic. In January 2007, 14.3% of subprime mortgages that had been packaged in mortgage-backed securities were at least 60 days late. That was up from just 8.4% in January 2006. And the damage was showing signs of spreading. For Alt-A mortgages, the category between prime and subprime, the 60-day delinquency figure climbed to 2.6% in January 2007 from 1.3% in January 2006.

But it was the size of the losses suffered by investors who had bought packages of subprime loans that really got investors' attention. Wall Street sold about $450 billion in subprime mortgage-backed bonds in 2006. The riskiest tranches, or packages, of those bonds have already lost as much as 37%, according to Merrill Lynch. Total losses on 2006 issues, says Standard & Poor's, could amount to 5.25% to 7.75%, or $23 billion to $35 billion.

Meanwhile, the pattern in the market for corporate junk bonds has enough similarities to make investors nervous. Default rates are currently low. In March, the 12-month trailing global default rate fell to 1.4% from 1.6% at the beginning of 2007, says Moody's. That's the lowest default rate since April 1997.

But this is likely to be the low for the cycle. Moody's is predicting that the global speculative-grade default rate will move up to 2.7% by the end of 2007 and hit 3.5%. That's still a huge leap away from the long-term average default rate of 5.1%, calculated by Moody's. In the last two recessions, Moody's speculative-grade default rate went over 10%.

A pyramid of speculative debt

You don't have to take Moody's word for it. You can just about see the pyramid of speculative debt growing before your eyes minute by minute.

Take the buyout market. The amount of money lent to private-equity funds for acquisitions -- remember these funds use borrowed money to pay part of the purchase price of their deals -- soared to $317 billion in 2006, from $51.5 billion in 2002, according to Reuters Loan Pricing.

Much of that borrowed money is itself borrowed. Wall Street's four biggest securities companies financed $3.3 trillion in assets last year (remember, a loan is an asset) on just $130 billion in shareholder equity. Leveraging equity has long been the name of the game on Wall Street, but in 2006 that leverage ratio hit 25-to-1, according to Sanford C. Bernstein, up from a ratio of 22-to-1 just four years ago.

No wonder that 37% of the speculative-grade bonds sold for leveraged buyouts in 2007 have carried triple-C ratings from Standard & Poor's. Last year, according to Dealogic, such junk bonds made up only 14% of leveraged buyout financing. Think triple-C rated bonds are risky? Here's how S&P defines the rating: "In poor standing. Such issues may be in default or present elements of danger with respect to principal or interest." Only two notches down, bonds in default get a C or C+ rating.

So far though, investors aren't getting paid much for taking on this risk. In April, investors got just 1.8 percentage points for taking on the extra risk involved in buying a triple-C rated bond instead of a B rated bond. The median risk premium in the last 20 years is 4.59 percentage points.

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