Cabot Dividend Investor Issue: January 11, 2023

Bonds Are Back

A terrible year for stocks just ended. This year should be a lot better, but it might get worse before it gets better.

The S&P 500 returned -19.4% and the Nasdaq was down 33% for 2022. That’s the worse calendar year for the market since the financial crisis in 2008. As I mentioned in past issues and updates, I expect the market to turn around sometime in 2023, but probably not until there is more clarity on the inflation/Fed conundrum and the severity of a likely recession.

Sure, it was a tough year for stocks. But these markets happen periodically. This is the sixth bear market in the last four decades. It’s part of stock investing. And history clearly shows that bear markets are great times to invest ahead of the next bull market for long-term investors. The far greater 2022 abomination was the bond market.

It was the worst year ever recorded for bonds by many measures.

The benchmark ten-year Treasury lost more than 15% in 2022, the worst calendar year performance ever recorded since it started being tracked in the 1920s. The 10-year + Treasury Bond Index lost 29.45% for the year, also the worst performance on record.

Since its inception in 1976, the Bloomberg U.S. Aggregate Bond Market Index, a benchmark that includes various types of U.S. investment-grade bonds of varying maturities, only had four down years prior to 2022. The negative yearly returns are as follows.

1994 -2.9%
2013 -2.0%
2021 -1.5%
1999 -0.8%

In 2022, the same Bloomberg Index recorded a negative 13% for the year. It was by far the worst year ever for the index as losses dwarfed anything over the last 46 years.

Those are some nasty losses for an asset that’s supposed to be a safe haven. The issue is interest rates. Bond prices move inversely to interest rates. In 2022, the benchmark 10-year Treasury yield soared amidst the high inflation from 1.5% at the beginning of the year to 3.88% at the end.

But the disastrous year creates an opportunity. Sure, after a 40-year bull market in bonds, they had been low paying and treacherous for many years. But last year seems to have squeezed many years of poor performance into one. Now bonds actually pay decent interest again. And every negative year for bonds ever recorded has been followed by a year of positive returns.

Plus, there is a good chance of recession this year. Bonds love recession as interest rates tend to fall. In fact, recessions are historically when bonds have recorded the best performance.

It is possible that inflation lingers, and interest rates continue to trend higher over the decade, making this not the best time to invest in bonds. But I’m skeptical that interest rates can stay much higher while the government has more than $30 trillion in debt. It’s also possible that this is a rare opportunity to lock in decent rates on quality bonds while they last and add balance and diversification to your portfolio.

In this issue, I highlight a long-term corporate bond fund. It provides access to some of the highest-yielding, investment-grade bonds in the last 15 years while providing a monthly income. The fund is very likely to have a positive total return for the year, and perhaps very positive, at a time when the stock market is highly uncertain.

What to Do now

This issue marks a fundamental change in the way the Cabot Dividend Investor portfolio is managed. From this point forward, the portfolio will be considered an initial investment of $200,000 with allocation recommendations in stocks, fixed income, and cash.

Of course, $200,000 is just the benchmark. You can invest more or less in the same proportions according to your own situation. The new arrangement will hopefully add clarity on how much to invest in each position going forward. It will also add insight regarding when to stay out of the market and when to be more fully invested.

The current asset recommendation is stocks 30%, fixed income 20%, and cash 50%. Those allocations will almost certainly change in the months ahead. In the future, the current allocations will be listed on every issue and update.

As I mentioned above, I believe there is a strong chance that the market turns around and moves out of this bear market sometime later in 2023, but probably not in the early part. Right now, there is too much uncertainty regarding inflation, the Fed, and the severity of an economic downturn.

There could be more uninspired returns and possibly a new low until investors can see past the current inflation/Fed situation and into a recovery. That’s why the current BUY recommendations are in the safer stocks in the utility and midstream energy sectors.

The current BUY-rated stocks include NextEra Energy (NEE), Xcel Energy (XEL), Brookfield Infrastructure Partners (BIP), Enterprise Product Partner (EPD), ONEOK (OKE) and The Williams Companies (WMB). These two fixed-income positions, Invesco Preferred Stock ETF (PGX) and USB Depository Shares (USB-PS) are also rated BUY.

Featured Action: Buy Vanguard Long-Term Corporate Bond Index ETF (VCLT)

VCLT is an exchange-traded fund that seeks to provide high and sustainable current income from a portfolio of primarily high-quality, investment-grade corporate bonds with maturities of 10–25 years. The fund tracks the market value-weighted Bloomberg Barclays U.S. 10-year+ bond index. The large issues have a high degree of liquidity.

Before getting into the particulars of the bond fund, let’s talk about the rationale for choosing the general categories. First, why buy a bond fund? In addition to providing diversification and avoidance of risk associated with one issue, it’s also true that individual bonds aren’t feasible to recommend in this newsletter.

Bonds aren’t stocks and have nowhere near the same liquidity. An individual bond issue may not be available to all subscribers because it depends on brokerage inventories. Buy and sell prices are determined by the bond desks at different brokerages and vary widely, changing the yield and attractiveness based on individual subscriber circumstances. But funds have daily market liquidity like stocks and offer uniform pricing and yields for all.

Second, why buy an ETF instead of a conventional or closed-end mutual fund? Conventional funds tend to have high sales charges and much depends on the management. But I like the basic dynamics of long-term bonds at this point, and I don’t want to risk a fund manager screwing that up. Closed-end funds usually use leverage, which can also skew the positive impact of falling rates on long-term bond prices.

Exchange-traded funds have minimal management and trading. Plus, they’re cheaper. A high annual management fee can eat up a lot of yield, which still isn’t all that high. ETFs typically have low fees, and this fund is cheap for an ETF. VCLT has a minuscule annual fee of just 0.04%, compared to an average of 0.5% for its ETF peers.

Why choose corporate bonds?

The simple answer is that they pay more than treasuries, and investment-grade bonds are less volatile than high-yield bonds. Junk bonds are less sensitive to moves in interest rates but are highly vulnerable to rising credit risk, which happens in a recession. While corporate bonds are lower rated than Treasuries, the high quality and diversification of this fund’s portfolio minimize that additional risk.

Finally, bonds vary in maturity from less than a year to 30 years. Why buy longer-term bonds? The basic reason is that longer bonds are more sensitive to interest rates. Interest rates tend to fall during a recession and slowing economy. The longer-term bond fund should get more appreciation and a higher total return than shorter-range bonds.

The VCLT portfolio currently holds 2,672 different bond issues. The top holdings include debt of Anheuser-Busch (BUD), AT&T (T), Boeing (BA), Bank of America (BAC), and AbbVie (ABBV). This provides a flavor of the type of companies, but the fund is highly diversified with less than 4% of the portfolio in the top ten issues.

The rating breakdown is as follows: AAA (2.4%), AA (8.8%), A (39.3%), BBB (49.2%), and the rest are in Government and non-rated bonds. It’s simply a highly diversified investment-grade portfolio of some of the most recognizable large companies in the country.

The Income

Then there’s the dividend. It pays out every single month. That’s a beautiful thing. VCLT not only provides a safer port in a rough market, but it pays you to do it, and often. Even though the payout comprises bond interest, VCLT pays a monthly dividend. The current yield is technically 4.26%. That’s what it will say on web pages like Yahoo Finance. But that’s the trailing yield, based on the average of dividends over the last 12 months.

The most recent monthly dividend of $0.302 extrapolates to a 4.6% yield if multiplied by 12 and divided by the current price. That’s a more accurate reflection because the payout has been trending consistently higher as maturing bonds are replaced by higher-paying ones. The March dividend was just $0.244. Even that 4.6% yield is likely to trend higher over the course of the next year (based on the current price).

It’s also true that the recent track record for VCLT is very poor. The total return of the fund in 2022 was -24.36%. That’s about as bad a year as a bond ETF ever has. And that’s the point of buying it here. The ETF is highly levered to interest rates, which soared in 2022. After the worst year ever, bonds now pay decent interest and once again provide the diversification and recession defense that they always had in the past.

VCLT is a great addition to an income portfolio at possibly an ideal time. We are likely heading into a year of recession and falling long-term rates, Not only is this fund a safe place to diversify and generate an income, but it could also deliver a total return over the next year that bests the stock market.

Security type: Exchange-Traded Fund (ETF)
Fund Type: Diversified Bonds
Price: $79.74
52-week range: $68.68- $103.60
Yield: 4.3%
Profile: VCLT is a low-expense diversified bond fund comprising long-term, investment-grade corporate bonds.

Positives

• There is a strong chance bonds rebound after one of the worst years in history.
• VCLT provides diversification in a bear market with assets that historically thrive in a recession.
• The fund provides an opportunity to purchase bonds at historically low prices and the highest yields in 15 years ahead of a period where interest rates are likely to fall.

Risks

• Interest rates could continue to trend higher, reducing the price and total return.
• After a 40-year bull market in bonds, the decline may not be over, especially after 2023.

Portfolio Recap

Enterprise Product Partners (EPD – yield 7.9%) – The performance may seem disappointing and uneventful. The price is well off the May high and the same level it was in June of 2021. But EPD returned 18.4% in 2022 while the S&P 500 delivered a -19.4% return. That’s about 38% market outperformance in the year. And it pays a massive distribution that’s safe. Enterprise can endure an environment of both inflation and recession and it started off the year with a bang. I expect the market outperformance to last well into 2023. (This security generates a K1 form at tax time). BUY

Enterprise Product Partners (EPD)
Next ex-div date: January 28, 2023, est.

Medical Properties Trust, Inc. (MPW – yield 9.4%) – MPW had an absolutely abysmal year in 2022, returning -48.6% for the year. But recent action is encouraging. It’s up over 11% so far this month and 25% from the October low. I’m expecting a nice bounce back this year. This hospital REIT remains extremely undervalued, pays a huge dividend, and the company delivered terrific earnings last quarter with profits up 30% over last year. Hopefully, MPW has already made a low and will realize its upside potential in the new year. HOLD

Medical Properties Trust, Inc. (MPW)
Next ex-div date: March 7, 2023, est.

ONEOK Inc. (OKE – yield 5.8%) – This midstream energy stock has also made a strong move in the recent market rally. The price has moved above its recent sideways range and is actually at its highest price since early June. We’ll see if the stock can make a sustained breakout from here in the weeks ahead. But regardless of whether that happens, OKE and other midstream energy companies have the right stuff going into 2023. Revenues are both recession and inflation resistant. The high dividend is safe. And the stock is still reasonably valued. BUY

ONEOK Inc. (OKE)
Next ex-div date: January 28, 2023, est.

Realty Income (O – yield 4.7%) – The legendary income REIT has been going sideways since the middle of November. It’s holding up but can’t seem to get above that 65 per share level. The stock is almost always bouncy. And there is no telling what the next few weeks might bring. But this is a popular and defensive income stock that should hold its own in the event of a recession next year. Investors should find their way to O and the stock should be buoyant over the course of the year. Although it’s a REIT, O tends to move more in sync with the safe defensive stocks. BUY

Realty Income (O)
Next ex-div date: January 30, 2022, est.

The Williams Companies, Inc. (WMB – yield 5.2%) – While WMB held up better than most of its peers during the recent market selling and recorded by far the best 2022 return, it’s been a bit of a dud since the end of October. The market seems to like its defensive characteristics best and it tends to rally with the more defensive plays. That could be a great thing if the market rolls over. It pays a big income and thrives amid inflation and recession. Prospects for this year remain excellent. The company posted strong earnings because of resilient natural gas demand, which should continue even if the economy falters. BUY

Williams Companies, Inc. (WMB)
Next ex-div date: March 8, 2023. Est.

AbbVie (ABBV – yield 3.6%) – This great healthcare company stock delivered a total return of 23.8% for 2022 in a bear market. The stock recently broke out to its highest price since last spring. ABBV has shown great strength in a crummy market. Healthcare is a great place to be as the economy may well be bounding towards a recession. Concern for the Humira patent expiration this year has likely been overblown as AbbVie has 11 other drugs besides Humira that are on track to top $1 billion in net revenue this year. It also continues to sell at an extremely cheap valuation. HOLD

AbbVie Inc. (ABBV)
Next ex-div date: January 12, 2023

Broadcom Inc. (AVGO – yield 3.1%) – While the technology sector hasn’t recovered yet, AVGO seems well on its way. The stock is up over 26% in the last three months. Earnings tend to be less economically dependent than most other tech companies. Broadcom reported 21% revenue growth and a 34% earnings increase over last year in the last quarter and also topped guidance estimates for this quarter. It wasn’t a great year as the stock returned -13.5% for 2022. But the technology sector was down over 30% for the year, and many individual stocks were down far more than that. AVGO should move up fast when the overall tech environment improves. HOLD

Broadcom Inc. (AVGO)
Next ex-div date: March 19, 2023, est.

Brookfield Infrastructure Partners (BIP – yield 4.5%) – BIP sold off with the other defensive stocks in the fall amid rising long-term interest rates but didn’t really participate in the recovery as the strong dollar puts a dent in its international earnings. But a recession is likely to pressure rates lower. And Brookfield has crucial assets likely to perform very well in a recession as well as growth projects coming online. A strong dollar is already reflected in the price and BIP’s recession and inflation resilience should take center stage as the year progresses. (This security generates a K1 form at tax time). BUY

Brookfield Infrastructure Partners (BIP)
Next ex-div date: February 28, 2023, est.

Eli Lilly and Company (LLY – yield 1.2%) – The stock has shown rare weakness of late. The price has fallen about 5% YTD despite it being an up market so far. Guidance for 2023 came in about 7% below expectations and the strong dollar, loss of a patent, and no more covid drug sales weighted on expectations. But that’s just temporary noise. Lilly is still expected to deliver annual earnings growth of 19% over the next five years. And the main catalyst for the stock price this year will be the two incredible drugs in the pipeline that are potential future mega-blockbusters. HOLD

Eli Lilly and Company (LLY)
Next ex-div date: February 14, 2023, est.

Intel Corporation (INTC – yield 5.3%) – INTC has had a nice move off the low and is up 11% in just a little over a week. A move a little higher will bring the stock to price levels not seen since late summer. It may be early to declare that the bottom is in but it’s certainly possible. If the market takes another drubbing, INTC could make a new low, but the stock should be significantly higher than it is now by the end of the year. The situation will surely improve for technology at some point. Hopefully, a big turnaround isn’t that far off. Intel’s individual prospects should significantly improve as growth investments come to fruition. HOLD

Intel Corporation (INTC)
Next ex-div date: February 4, 2023, est.

Qualcomm Inc. (QCOM – yield 2.7%) – It’s been a wild ride for this one-of-a-kind chipmaker. After returning over 25% in 2021, QCOM was down 38% in 2022. That said, QCOM has outperformed the market with a 46% total return since it was added to the portfolio in late November of 2019. And that’s even after an epic horrific year. Technology stocks can turn around fast and make up for lost time as the environment changes, and it likely will at some point in the new year. Before long, the market, which tends to anticipate six to nine months ahead, may start pricing in a recovery. HOLD

Qualcomm Inc. (QCOM)
Next ex-div date: February 28, 2023, est.

Visa Inc. (V – yield 0.9%) – V has been hot in the recent rally. The stock is now up over 6% this year and over 220 per share, the highest level since last April. V is also up over 25% from the low made in the fall. Last year’s bear market was terrible for cyclical and financial stocks. But V held up remarkably well under the circumstances, returning -3.4% for 2022. And circumstances in the market are likely to get a whole lot better in 2023. V is typically one of the first stocks to recover when the market eventually turns. We’re seeing the evidence of that already. HOLD

Visa Inc. (V)
Next ex-div date: February 9, 2023, est.

NextEra Energy (NEE – yield 2.0%) – This traditional and clean energy utility rolled into one is a good stock to own in just about any market. But the current circumstances make the stock a must-own. We are likely heading into recession, an environment where the relative performance of utilities thrives. Defense is in. There’s something about a looming recession that turns investors toward the safest stocks. NEE also has a higher level of growth than its peers and should benefit along with the alternative energy sector when the market recovers. BUY

NextEra Energy Inc. (NEE)
Next ex-div date: February 23, 2023, est.

Xcel Energy (XEL – yield 2.7%) – This clean energy utility stock keeps going, albeit slowly. XEL is still in an uptrend that began in October. It is up over 22% since the October low and posted a positive 6.44% return for 2022. That may not sound like much, but XEL outperformed the market by better than 25% last year. It’s a great stock to own anytime. But heading towards a likely recession it’s one of the very best. BUY

NextEra Inc. (NEE)
Next ex-div date: February 23, 2023, est.

USB Depository Shares (USB-PS – yield 5.6%) – After rallying sharply after being added to the portfolio as longer-term rates plunged, this preferred has moved back to the price at which it was initially purchased. I see this as another opportunity to lock in a 6% yield on investment-grade fixed income if you haven’t bought USB-PS already. Such rates may not last. As income investors, we don’t want to miss the best opportunity in the last 15 years to lock in a strong fixed rate. BUY

U.S. Bancorp Depository Shares (USB-PS)

Next ex-div date: January 15, 2023, est.

Invesco Preferred ETF (PGX – yield 5.9%) – Ditto what I said about USB-PS. Longer-term rates are still near the highest level in 15 years. And most economists are predicting a recession next year. This provides diversification from stocks with a high income ahead of a period when interest rates could fall back. BUY

Invesco Preferred ETF (PGX)
Next ex-div date: January 24, 2023, est.

Dividend Calendar

Ex-Dividend Dates are in RED and italics. Dividend Payments Dates are in GREEN. Confirmed dates are in bold, all other dates are estimated. See the Guide to Cabot Dividend Investor for an explanation of how dates are estimated.

The next Cabot Dividend Investor issue will be published on February 8, 2023.