I believe that this asset class certainly has a place in yield oriented portfolios, but I wouldn’t overweight preferred equity funds at this time and would instead remain neutral. Why? While preferred funds are certainly providing a healthy, relatively high yield in a low yield environment, the extra yield comes with a lot of volatility.

Currently, preferred funds are offering a yield similar to that of a high yield bond fund, but preferred funds are also offering about 50% more volatility. For instance, the yield on the iShares S&P U.S. Preferred Stock Index Fund (NYSEARCA: PFF) is now approximately 6.5%, roughly in line with the yield of the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEARCA: HYG). But at the same time, PFF’s three-year trailing volatility is more than 15% compared with less than 10% for HYG.  Past performance is no guarantee of future results.  For standardized performance for PFF, please click here.

To be sure, preferred stocks are generally more volatile than bonds and this makes sense given their lower place in the capital structure. However, there is another reason for the heightened volatility of preferred funds today.

The S&P U.S. Preferred Stock Index is composed of mostly financial companies. In fact, today, more than 85% of the issuers in the index are financials. This heavy concentration in the financial sector is also contributing to preferred funds’ volatility — the financial sector is now the most volatile sector in the market.

As such, preferred funds modeled on the index are essentially acting as proxies for financial stock funds, but with equity-like risk and bond-like returns. For those with a positive view on financials, this may be an acceptable risk-reward tradeoff. But as I currently hold an underweight view of global financials, I’m advocating a neutral allocation to the preferred stock asset class for now.

Source: Bloomberg

Russ Koesterich is the iShares Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

The author is long PFF and HYG.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.

Index constituents are subject to change.

In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Preferred stocks are not necessarily correlated with securities markets generally. Rising interest rates may cause the value of the Fund’s investments to decline significantly. Payment of dividends is not guaranteed. Removal of stocks from the index due to maturity, redemption, call features or conversion may cause a decrease in the yield of the index and the Fund.  Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

As of May 11, CEMB had an average yield to maturity of 4.95%, while EMB’s yield was 4.99%.  If I’m taking on more risk with CEMB by investing in corporate vs. sovereign debt, clients have asked, why aren’t I receiving a higher yield in return? The answer is because in this case, the risk associated with corporate emerging market bonds might not be as elevated as many investors would think.

First, let’s look at the amount of duration, or interest rate risk, of these two funds. As measured by its duration of 5.5 years, CEMB has less interest rate risk than EMB, which has a duration of 7.42 years as of May 14.

Now, let’s look at the holdings of EMB and CEMB. EMB holds securities backed by emerging market sovereign governments, like Peru, Russia and the Philippines.

CEMB meanwhile gives investors access to the corporate debt of companies domiciled in emerging market countries. It holds the debt of big companies like Brazilian oil company PetroBras International and South African electricity producer, Eskom Holdings. Although the issuers in CEMB are based in emerging markets, many have investment grade credit ratings, including a fair number with AA or A ratings. As the chart below illustrates, the composition of CEMB is slightly higher on the credit rating spectrum than EMB:

Credit Rating Breakdown:

Investors might assume that emerging market corporate bond ETFs would consist of bonds that have lower credit ratings than those in emerging market sovereign ETFs, making them riskier holdings that provide a higher yield. But this chart illustrates that is not always the case, and it helps to explains why a fund like CEMB would have a yield similar to that of EMB.

How could investors consider using CEMB in a portfolio?

1.) Diversify away from US corporate debt: For investors who own a fund like LQD, which holds investment grade US corporate debt, CEMB offers an opportunity to diversify away from US corporate debt while potentially picking up additional yield. LQD’s average yield to maturity was 3.52% as of May 11. Additionally, with low correlations to other fixed income sectors and equities, emerging market corporate bonds can add diversification to investment portfolios. Past performance is no guarantee of future results.

2.)   Access the emerging market consumer: As Russ Koesterich has noted, emerging market growth continues to create hundreds of millions of new middle-class consumers. By 2025 China, India and Brazil are respectively expected to be the 2nd, 4th, and 9th largest consumer markets in the world, according to McKinsey. The emerging market corporations whose bonds are held in CEMB are selling their wares to this growing consumer base.

3.)   Gain access to emerging market growth with less volatility than emerging market equities. For the past 10 year, emerging market corporate bonds have had total return volatility of 12.5% as compared to 24.4% for emerging market equities, using data from Morningstar and MSCI, as of April 30.

Matt Tucker, CFA is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog.  You can find more of his posts here.

Past performance is no guarantee of future results.  For the standardized performance of these funds, please click here: CEMB, EMB, LQD.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com.

Holdings are subject to change. To view the complete list of holdings for CEMB, please click here.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as interest rates rise.  Diversification may not protect against market risk.

It’s a sensitive topic to be sure, and perhaps that’s why so many people avoid it.  But since we all never know which day will be our last, it’s key to have one’s estate planning in order. And the recent sudden death of a friend’s spouse made me realize just how important this is. So now that tax season is over, here’s a quick checklist of some important steps to consider when preparing for the worst.

Craft, or Update, a Will: In a will, you detail who will inherit your property and care for your young children, if you have them, in the event that something happens to you or your significant other. If you haven’t yet written a will, you’re letting state law make these important decisions for you and what the state decides may not line up with what you’d want, or what’s best for your family.

Even though I do my own taxes, I would never consider doing my own will. Why? If I screw up my taxes, I can fix them, but the same is not true for a will. Still, for die-hard do-it-yourselfers, here are some resources to help you get started writing a will. Legal information publisher Nolo has some helpful pieces on its site including information on what kind of will you’ll need (e.g. is a basic one enough?) and what to include in your will, as well as a tool to help you complete your will online.

If you already have a will (or an estate plan for that matter), take some time to reread and update it, especially if your life circumstances have changed since you first wrote the will. The Pilot and I, for instance, first created our will when we had young children and it mostly dealt with who would watch them if both of us passed away. Since then, we’ve had to update our will to reflect that both of our daughters are now adults. Other life changes that may warrant will updating include a divorce and a remarriage. And one last piece of will-related wisdom: be sure to discuss your will plans with your inheritors before you pass to help prevent future family strife.

Consult with an Estate Attorney: If you expect to die with assets that will be subject to estate taxes, if you have a complicated inheritance plan or if you’re not sure you want to write a will yourself, it’s a good idea to have a lawyer help you craft your will. The tax consequences of passing away can be very dramatic and it’s easier to mitigate at least some of those consequences with the right legal guidance. It’s also just a simply a smart idea to consult with a lawyer in general as he or she can help you with aspects of your estate planning beyond your will including helping you set up a trust, figure out life insurance and optimize charitable contributions, among other tasks.

Check Your Account Beneficiaries: Just as it’s important to make sure your will is up to date, it’s also important to ensure that the beneficiaries you have listed on everything from 401(k) plans to investment accounts to life insurance policies are current.

Read Other Helpful Resources: The advice above is just the tip of the iceberg when it comes to preparing for passing. There are other steps you’ll want to consider including making sure you have adequate life insurance, set aside money to cover funeral expenses and write medical directives. With the government now recommending people create social-media wills, you may also even want to manage what happens to your online presence after you die.

Thankfully, there are a number of online resources that can help you can gain a better sense for the full spectrum of what planning for passing entails. Here are just a few resources worth reading as you get started: this guide from Nolo on “12 Simple Steps to an Estate Plan” this helpful article on estate planning for every age and this run through of getting your estate in order “before you punch out.”

Thinking about this subject is never fun, but having these matters in order provides peace of mind.  After making a few updates to my own estate plan, I can forget about it for awhile and go back to enjoying life!

Here are just a few of the concerning core inflation data points:

1.)    At 2.31%, April’s core inflation figure was the highest since September 2008.

2.)    April was the seventh month in a row in which core inflation was above the Fed’s stated target of 2%.

3.)    April’s core inflation reading was nominally above the 20-year average.

To be clear, this doesn’t suggest that alarmist predictions for Weimar-style inflation are about to come true. As I’ve mentioned before, it’s hard to argue that inflation in the United States is about to accelerate in any meaningful way this year. Wage growth is slow, most of the US manufacturing sector is still struggling with excess capacity and up until late last year, the dearth of bank lending prevented any acceleration in the money supply.

That said, while double-digit inflation still looks fanciful, the rise in core inflation shows that prices are slowly creeping up and US consumers and investors are likely accepting, and becoming accustomed to, higher prices and higher valuations without even noticing. In other words, US consumers and investors may be the proverbial frog in the pot of slowly heating cold water and this is only likely to continue.

High unemployment will probably prevent any meaningful acceleration in wages, though the skills mismatch between employees and potential employers may still result in some wage acceleration. In addition, monetary conditions are no longer quite so innocuous when it comes to inflation. Bank lending to businesses – measured by commercial and industrial loan demand – is now rising 13% year over year and is close to a 3 ½-year high. Meanwhile, M2 has been growing at about 10% year over year since last summer. Though it still takes time for growth in the money supply to translate into inflation, the monetary environment is slowly turning.

For investors, there are a couple of implications:

1.)    Recognize purchasing power erosion: Even if inflation stabilizes at current levels, over the long term 2.3% inflation would still cause prices to rise by 50% in less than two decades time. In other words, inflation of this magnitude would cause a one-third erosion in purchasing power over the next 18 years. This is an important consideration for investors with large cash positions. And for bond investors – particularly those with large Treasury positions – this is one more reason to question the wisdom of accepting sub-2% yields for the next decade.

2.)    Consider equities and commodities: While uncertainty over Europe and Chinese growth are likely to keep volatility high this summer, investors should consider using near-term market weakness to add to long-term equity and commodity positions. To be sure, neither asset class is likely to offer double-digit returns over the long term. However, both may help investors keep their purchasing power from being slowly heated away.

Source: Bloomberg

Russ Koesterich is the iShares Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

While the election certainly raised the odds of Greece eventually leaving the euro (as many market watchers have pointed out), it’s too soon to conclude that a Greek exit – or “Grexit” as some are calling it — is imminent. With it looking extremely unlikely that any of the Greek parties will be able to form a government, Greece’s fate now hinges on the results of a second election, expected to occur as early as mid-June.

Here’s a look at what the outcome of that election could mean for Greece.

• If the June election does not produce a more definitive result and or the fringe parties emerge even more victorious: If this occurs, it’s difficult to imagine a scenario under which Greece will fulfill its various bailout accord obligations. Should Greece abandon its pledges, it’s unlikely that Germany and the rest of Europe will support additional funding and the risk of Greece leaving the euro goes up dramatically. Were this to happen, the reverberations would go well beyond Greece. While the European banking system is arguably stronger than it was a year or two ago, it’s still fragile, particularly in Spain. An imminent and disorderly exit from the euro would leave investors speculating on which country is next. Systematic stress is already evident with Spanish 10-year bond yields back above 6% and Italian bond yields creeping in that direction.
• If the election produces a vote slightly more favorable for the two main political parties: The two main Greek political parties – New Democracy and the Socialists (PASOK) –traditionally capture between 75% and 80% of the vote. In the May election, they scraped by with less than a third. But a coalition government in Greece is still possible. Because of Greece’s parliamentary rules — the winning party gets a 50-seat bonus in parliament — the two main parties, even with their poor showing, came within a hair’s breadth in May of actually getting the necessary 151 seats in parliament to form a coalition. With 70% of Greeks still stating that they want to stay in the euro, the prospect of economic chaos may be enough to produce a better result in June. If the two main parties can scrape together a coalition government, Greece is likely to abide by most of the previous accords and remain in the euro, at least for now.

In the interim, volatility is likely to remain elevated, as I’ve warned before. As such, investors should consider:

1. Focusing on large- and mega-cap dividend payers, accessible through the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares S&P Global 100 Index Fund (NYSEARCA: IOO).
2. Having a modestly higher allocation to defensive sectors such as global telecommunications, accessible through the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA: IXP).
3.  Remaining underweight Italy and Spain.

Source: Bloomberg

Russ Koesterich is the iShares Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

The author is long IXP, IDV and IOO

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments typically exhibit higher volatility.

First, despite a recent rise in bank lending, most of the extra stimulus money created by the Federal Reserve is still sitting on bank balance sheets.  Also, as this money starts hitting the supply, there will likely be a lag before inflation hits. Historically, it has taken about two to three years before growth in the money supply has translated into a meaningful acceleration in inflation.  And while the Fed recently slightly raised its inflation forecasts through the end of 2014, even Fed officials are saying that they expect inflation to remain low.

Even so, many investors are still worried about rising prices and are looking for inflation hedges. For these investors, the chart below provides a nice look at how various investments stack up when it comes to preparing a portfolio for inflation.

Not surprisingly, Treasury Inflation Protection Securities, or TIPS, come out on top.  However, it’s important for investor to keep in mind that while TIPS provide an effective inflation hedge and having a benchmark allocation to this asset class is prudent, the many investors clamoring into TIPS are currently contributing to, and accepting, an average negative real yield across the entire TIPS curve. In addition, TIPS will not perform well if real yields rise along with rising interest rates.

What are your preferrred inflation hedges?

Russ Koesterich is the iShares Chief Investment Strategist and a regular contributor to the iShares Blog.  You can find more of his posts here.

Source: BlackRock

TIPS can provide investors a hedge against inflation, as the inflation adjustment feature helps preserve the purchasing power of the investment. Because of this inflation adjustment feature, inflation protected bonds typically have lower yields than conventional fixed rate bonds and will likely decline in price during periods of deflation, which could result in losses.

But in a recent paper, “Debt Overhangs: Past and Present,” authors and economists Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff suggest that the correct answer might be closer to 2030. Given their previous work on the aftermath of credit bubbles and the impact of public debt, investors have every reason to take their prediction seriously.

According to the paper, the United States and much of the rest of the developed world are now contending with debt levels unprecedented since the aftermath of World War II. Historically, excessive public sector debt – defined as gross public debt in excess of 90% of gross domestic product – has resulted in slower growth for a very long time. Episodes of excessive public debt are associated with GDP being about 1% lower per year than in other periods, and – here is the catch — the paper concludes that episodes of excessive public debt have an average duration of 23 years!

In many developed countries, including the United States, it would appear that we are already living with the consequences of our ever-growing debt burden. For instance, growth in the United States remains anemic nearly 3 years after the recession ended. Since mid-2009, the United States has averaged 1.8% annual growth, roughly half of its long-term average. This is in contrast to previous post World War II recessions, when the public debt level wasn’t so high. In those recessions, the deeper the downturn, the more robust the recovery was that followed.

What does this mean for investors?

1.) Consider rethinking earnings estimates for certain companies. While many investors worry about margin compression, the real risk to long-term US earnings may come from overly optimistic revenue projections, particularly for companies focused on the United States. The biggest determinant of US earnings growth is US economic growth. If economic growth is modestly slower going forward, investors should lower their long-term earnings estimates as well.

2.) Consider raising allocations to emerging markets. Equity multiples are influenced by investor expectations for growth. All else equal, countries with higher expected growth tend to trade at a premium. If the United States, Japan, and large parts of Europe experience slower growth thanks to their high public debt levels, they are likely to trade at slightly lower multiples in the future. And to the extent that emerging markets are not weighed down by the same debt baggage, they are unlikely to experience the same headwind as developed markets and are likely to trade more in line with developed markets than they have in the past.

A slow growth world does not necessarily mean the death of equities or the absence of opportunities. It does, however, suggest that investors need to have realistic expectations for the US economy, and for most of the developed world. Slower growth, lower interest rates and lower multiples are arguably consequences of higher public debt. And if the authors are right, this may be an issue we’re still contending with in two decades time.

Sources: “Debt Overhangs: Past and Present” by Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff

Bloomberg

People who implement market views with stocks have historically hesitated to implement their views via bonds.

Why?  Because it’s hard to build bond portfolios by hand, one bond at a time. In the old days, if an investor had a view on corporate bonds, they’d have to research, price and source the bond themselves (potentially hundreds of times over, in order to achieve diversification).  And if, for example, the investor wanted to shift out of corporate bonds and into another market, they’d have to research and build the new portfolio, not to mention go through the hassle and cost of liquidating the original portfolio of corporate bonds.

Creating and managing a portfolio of hundreds of bonds is not easy.  It doesn’t serve as great fodder for interesting dinner conversation, either.  As a result, many investors turned to active mutual fund managers to outsource their fixed income exposure – rather than having a view themselves, they relied on the manager to have a view for them.

However, with the advent of fixed income ETFs, investors are starting to build fixed income portfolios on their own.  Fixed income ETFs offer many of the same benefits as mutual funds (like diversification), with added transparency and liquid access.

In addition, investors are discovering that they do have a view on fixed income, enough so that they don’t wish to outsource it to someone else.  Because the thing is, if you have a view on the market, then you have a view on fixed income.  I’ll explain.

Let’s say you believe that the economy is starting to recover.   As applied to equities, an investor might buy high beta stocks, consumer cyclicals, or growth stocks. In fixed income, that same view means buying high yield corporates, investment grade corporates, or commercial mortgage backed securities.  Same idea, just applied in a different asset class.

Here are a few more examples:

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.

The bottom line? Regardless of your market views, you now have the ability to implement them in both equities and fixed income. No translation necessary.

Diversification may not protect against market risk. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. Mortgage-backed securities (“MBS”) represent interests in “pools” of mortgages and are subject to credit, prepayment and extension risk, and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain MBS. An investment in the Fund(s) is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

In my opinion (which differs from that of some other market watchers), the answer is a qualified yes. I believe that investors should consider lightening up on certain positions and getting more defensive. But my belief is not based on the month of the year, but rather on current market volatility.

In fact, according to my team’s research, the summer seasonality myth doesn’t hold up. With the exception of September, which has historically been a month to avoid, no month shows a significant long-term performance bias, either positive or negative. In addition, higher average returns in January, March, and April versus May or June likely don’t reflect anything other than chance and, as it turns out, July has generally been one of the better months for the markets.

I’m in favor of lightening up on equity exposure now because of my outlook for market volatility. Last February, I warned that equity market volatility appeared too low. At that time, the Chicago Board Options Exchange Volatility Index (VIX), an index otherwise known as the “fear gauge” was around 17 to 18. After initially dipping, volatility did return in April, with the VIX climbing to 21 and the market correcting around 4%.

But now, even with last week’s spike in volatility, volatility once again appears too low, raising the likelihood for another jump in volatility and an accompanying modest pullback in equities.

As of late last week, the VIX was in the mid to high teens. However, two major drivers of market volatility – credit conditions and leading indicators – suggest that the VIX should now be in the low to mid 20s range, and not surprisingly it reached around 20 today.

From a credit conditions perspective, bond investors still appear somewhat more nervous than equity investors – traditionally a warning sign of upcoming volatility. Meanwhile, leading indicators suggest that economic conditions have not improved sufficiently to justify volatility at current low levels. In other words, while market conditions remain stable, they aren’t strong enough to justify volatility being below its long-term average.

So what will happen to the market if we do see the spike in volatility I expect? Historically, for every 1% increase in market volatility, stocks have lost around 15 basis points. This implies that if the VIX rises toward the mid 20s, we are likely to see a modest pullback in equities.

Investors looking to insulate their portfolios in anticipation should consider adopting a more defensive stance through lowering exposure to technology equities, raising allocations to defensive sectors such as the global telecommunication sector and shifting styles toward global mega cap stocks and high dividend funds.

Following last Friday’s selloff, global telecom, accessible through the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA: IXP), has outperformed the global market  since the market’s April peak. Meanwhile, the iShares High Dividend Equity Fund (NYSEARCA: HDV) traded to a new high last week despite a pickup in market volatility. Other potential iShares solutions include the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA: IDV) and the iShares S&P Global 100 Index Fund (NYSEARCA: IOO).

Source: Bloomberg

The author is long IXP, IDV and IOO

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.  Narrowly focused investments typically exhibit higher volatility.  There is no guarantee that dividends will be paid.