Category: Bonds

A Client Asks: What’s the Benefit of Inflation?

One of our retired clients sent us the following question recently:

“I can’t understand the FED condoning and promoting any inflation rate. To me inflation means that the value of money is simply depreciating at the inflation rate. Further, any investment paying less than the inflation rate is losing money. A quick review of CD rates and government bonds show it is a rare one that even approaches the promoted 2.25% rate. It seems to me to be a de-facto admission of wanting to screw conservative investors and forcing them into riskier investments… Where is there any benefit to the financial well-being of the ordinary citizens?”

I suspect that there are a lot of people who feel the same way. It’s a good question. Who wants ever rising prices?

Here’s how I addressed his question:

Let me answer your inflation question first. My personal opinion is that 0% inflation is ideal, and I suspect that you agree. However, lots of people see “modest” rates of inflation (say 2%) as healthy because it indicates a growing economy. Here’s a quote from an article you may want to read:

Rising prices reflect a growing economy. Prices typically rise for one of two reasons: either there’s a sudden shortage of supply, or demand goes up. Supply shocks—like a disruption in the flow of oil from Libya—are usually bad news, because prices rise with no corresponding increase in economic activity. That’s like a tax that takes money out of people’s pockets without providing any benefit in return. But when prices rise because demand increases, that means consumers are spending more money, economic activity is picking up, and hiring is likely to increase.

A case can be made that in a dynamic economy you can never get perfect stability (e.g. perfectly stable prices), so it’s better for there to be more demand than supply – driving prices up – rather than less demand than supply – causing prices to fall (deflation). Of course we have to realize that “prices” here includes the price of labor as well as goods and services. That’s why people can command raises in a growing economy – because employers have to bid up for a limited supply of labor. On the other hand, wages grow stagnant or even decline when there are more workers available than jobs available.

But for retirees on a fixed income, inflation is mostly a negative. Your pension is fixed. Social Security is indexed for inflation, but those “official” inflation numbers don’t take food and fuel costs into consideration, and those tend to go up faster than the “official” rate. The stock market also benefits from modest inflation.

Which gets us to the Federal Reserve, which has kept interest rates near zero for quite a while. It’s doing this to encourage business borrowing, which in turn is supposed to lead to economic expansion.  However, the actual effect has been muted because other government policies have been detrimental to private enterprise. In effect you have seen the results of two government policies in conflict. It’s really a testimony to the resilience of private industry that the economy is doing as well as it is.

The effect on conservative investors (the ones who prefer CDs or government bonds to stocks) has been negative. It’s absolutely true that after inflation and taxes the saver is losing purchasing power in today’s low interest rate environment. The FED is not doing this to intentionally hurt conservative investors, but that’s been part of the collateral damage. The artificially low rates will not last forever and the Fed has indicated they want to raise rates. They key question is when, and by how much?

Are you flunking the retirement readiness test?

A recent article in Financial Advisor proposed an interesting analogy: “Imagine boarding a jet and heading for your seat, only to be told you’re needed in the cockpit to fly the plane.”

That’s the situation many people are finding themselves in today.  Once upon a time, employers set up pension plans managed by investment professionals.  You worked and when you retired the pension checks began coming for the rest of your life.

That ended when 401(k) plans began replacing defined benefit pension plans.

Once, employers made the contributions, investment pros handled the investments and the income part was simple: You retired, the checks started arriving and continued until you died. Now, you decide how much to invest, where to invest it and how to draw it down. In other words, you fuel the plane, you pilot the plane and you land it.
It’s no surprise that many people, especially middle- and lower-income households, crash. The Federal Reserve’s latest Survey of Consumer Finances, released in September, found that ownership of retirement plans has fallen sharply in recent years, and that low-income households have almost no savings.

But it’s not only the low-income workers who lack basic financial wisdom.

Eighty percent of Americans with nest eggs of at least $100,000 got an “F” on a test about managing retirement savings put together recently by the American College of Financial Services. The college, which trains financial planners, asked over 1,000 60- to 75-year-olds about topics like safe retirement withdrawal rates, investment and longevity risk.
Seven in 10 had never heard of the “4 percent rule,” which holds that you can safely withdraw that amount annually in retirement.
Very few understood the risk of investing in bonds. Only 39 percent knew that a bond’s value falls when interest rates rise – a key risk for bondholders in this ultra-low-rate environment.

If you fall into this category and want to find out what help is available, contact us.  We’ll be glad to chat; no sales pitch and no pressure.

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Municipal Bond Risk

Municipal bonds are found in the portfolios of many higher income investors.  They have experienced great returns over the last 30 years.  Part of that has come from interest payments and part has come from bonds price appreciation.  Remember, falling interest rates (and we have seen interest rates fall since 1980) leads to higher bond prices.

The problem for bond investors is that rising interest rates have the opposite effect: bonds go down in price when rates go up.  And today’s low rates are largely being engineered by Federal Reserve policy of low, low rates to spur a slow-growth economy with high unemployment.  When the Fed stops easing, we can expect rates to rise, and perhaps rise rapidly.

Here’s Morgan Stanley’s take:

Investors in the $3.7 trillion municipal market will probably face negative returns in 2014 following declines this year, the first back-to-back annual losses since at least the 1980s, according to Morgan Stanley.
The company’s base-case scenario for city and state debt in 2014 calls for a loss of 1.7 percent to 4.1 percent, Michael Zezas, the bank’s chief muni strategist, said in a report released today. A year ago, he correctly predicted that munis would lose money in 2013 as yields rose from the lowest since the 1960s.

In addition, we have seen a rash of municipal bankruptcies which causes investors to be concerned about getting their money bank if a city defaults on its obligations as Detroit is set to do.

For investors who have accumulated large municipal bond positions either as individual bonds or as bond mutual funds, caution is the watchword.

Income Investing: Investors No Longer Taking a 'Fixed' Approach

While interest rates on bonds have risen slightly from the absolute bottoms, investors looking for income are still not satisfied with the rates that they can get today.  Adding to their concerns is the expectation that when the federal reserve slows “quantitive easing” interest rates will rise to significantly higher levels.  And that means that the bond they buy today will probably go down in value.

As a result, income investors are actually looking at dividend paying stocks to provide the cash flow that they need.  One other advantage of this strategy is that many companies have been raising their dividends regularly, something that bonds don’t do.

With rising interest rates, what to do about bonds.

With interest rates increasing investors are noticing that their bonds are not doing nearly as well as their stocks.  In fact many investors may have lost money on bonds this year.  For example, the typical tax exempt bond fund has lost between 4 – 5{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} year-to-date.  What should investors do about bonds when the likelihood of rising interest rates is high?

The October issue of Financial Planning magazine give us an insight into what happened in the past when interest rates rose.

During the five-year period from 1977 through 1981, the federal discount rate rose to 13.42{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} from 5.46{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}, an increase of nearly 800 basis points, or 145.8{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}. During that period, the five-year annualized return of U.S. T-bills was an impressive 9.84{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.  But T-bills are short-term bonds.

But bonds did not fare nearly as well. The Barclays one- to five-year government/credit index had a five-year annualized return of 6.61{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}, while the intermediate government/credit index had a 5.63{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} annualized return. The long government/credit index got hammered amid the rising rates, and ended the five-year period with an annualized return of -0.77{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}. Finally, the aggregate bond index had a five-year annualized return of 3.05{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93}.

As every investor should know, bonds go down in price when interest rates go up but that decline is offset by the interest paid on the bonds.  If an investment manager knows what he is doing and protects his portfolios by avoiding exposure to long-dated government bonds the results will be acceptable. An annualized return of 5.63{030251e622a83165372097b752b1e1477acc3e16319689a4bdeb1497eb0fac93} is quite good when rates are increasing.

But one important note: It does not seem prudent to avoid bonds entirely during periods of rising interest rates. Bonds are a vitally important part of a diversified portfolio containing a wide variety of asset classes – during all times and seasons. Rather than trying to decide whether to be in or out of bonds, the more relevant issue would seem to be whether to use short-duration or long-duration bonds.

This, of course, is consistent with a strategic approach to portfolio design. Rather than completely remove an asset class from a portfolio, advisors and clients would be well advised to thoughtfully modify the components of an asset class. To use a nautical metaphor, rather than swapping boats, we simply trim the sails.

 

Stop worrying about the Federal Reserve

There are lots of people fixated on trying to figure out what the federal reserve is going to do with interest rates and when they are going to do it.  If you are a retail investor, you are not going to beat the professionals in that game, so stop trying.  Instead, let the pros handle it and relax by looking at the view from 30,000 feet.  Here’s what the bond experts at Oppenheimer are telling us in a messge titled Why Fed Watching Is Likely a Waste of Your Time

What to Remember for the Long Haul

For long-term investors, I believe there are essentially five important points to keep in mind.

1) Overall global economic growth is slow but most likely the worst is over. While there may be hiccups every so often, it is unlikely that we will revisit the financial abyss in the near-to-medium term.

2) Real interest rates are quite low. Over any reasonable investment horizon, they are going to go up. That is true irrespective of what the U.S. economy looks like this quarter or who the next Fed chair is.

3) Because interest rates are so low now, the likelihood that returns from any part of the bond market will get you to a comfortable retirement based on their real returns is virtually zero. You most likely have to have a significant portion of savings in assets that provide better real returns, albeit with greater risk.

4) That said, you can’t just put all your money in stocks. There will be future periods of equity underperformance. In order to make sure you don’t panic and go all cash at the worst point in the cycle, have some part of savings devoted to bond or bond-like instruments now. Even if they aren’t generating a lot of income, those investments may provide protection during equity downturns, which is as important.

5) Income, not price appreciation, is typically going to be a significant part of overall returns. Therefore, wherever you can, and whatever risks you are comfortable with, seek out income-generating investment options. As always, past performance does not guarantee future results.

Good advice.

7 retirement planning myths debunked

If you ever plan to retire, you have to have a plan.  The days of depending on an employer pension and government benefits are rapidly disappearing and, especially if you are under 50, you are living in a  “yoyo” economy — short for “you’re on your own.”

There are a bunch of myths about retiring that need to be abandoned.

  •  It’s OK to postpone saving for retirement until other needs are taken care of.  Wrong.  There are always “other things” that interfere with saving for retirement and if you let them get in the way, you’ll never start.
  • Medicare will take care of almost all your health care needs.  In reality it will cover about half.
  • You’ll need far less income in retirement to maintain the same standard of living.  Only if you decide to become a hermit.
  • You can claim Social Security early and still get full benefits later.  Wrong.  When you begin taking benefits you are locked in (unless you pay it all back).
  • You should rely heavily on bonds rather than stocks as you get older.  Only if you plant to die soon and expect zero inflation.
  • Any retirement target-date fund will allow you to “set it and forget it.”  Target date funds vary widely in performance and there are no guarantees associated with them.
  • You’ll be able to make up a savings shortfall by retiring later or working part-time in retirement.  That’s a hope, not a plan.  You may not be physically able to work after retirement.   Because of the costs of benefits, many employers are reluctant to hire older workers.

A plan is needed, and needs to be constantly updated to keep you on the path to the kind of retirement that you want.

What is an asset class?

Financial professionals constantly talk about asset classes, but what does that mean?  In the broadest sense, asset classes refer to a group of securities that have similar risk/return characteristics.  So, for example, in the broadest terms, stocks, bonds and cash represent the three most common asset classes.  Each has different risk and return characteristics and behave differently in response to a variety of economic and political events.  Stocks react most to corporate profitability, bonds to interest rates and cash to inflation.     That does not mean that these are the only issues that these assets react to but they are the predominant ones.

Most managers divide these broad assets classes into subgroups that act differently at different times.  Stocks, for example, can be divided into large cap, small cap, foreign or domestic.  Bonds can be subdivided into government, agency, municipal, corporate, foreign or domestic.  These classes can be divided again into their own subgroups.   The challenge for the investor is to find ways of participating in these investments.  This is where the expertise of the professional investment advisor comes into play.

Why is this important?  Because investment management is often about risk control and this is often achieved by balancing various assets classes to achieve the degree of risk to which a portfolio is subjected.  Modern portfolio theory demonstrates that investment with low correlation to the rest of the portfolio can lower over-all volatility even if the underlying investment itself is volatile.

 

The risks of bond investing.

For many investors, bonds are more mysterious than stocks.  Most people know that a bond is a loan and you are the lender. Who’s the borrower? Usually, it’s either the U.S. government, a state, a local municipality or a big company like General Motors. All of these entities need money to operate — to fund the federal deficit, for instance, or to build roads and finance factories — so they borrow capital from the public by issuing bonds.

There are several risks that you take when you buy a bond (or to put it another way, lend your money).

  • The first risk that you need to be concerned about is “credit risk.”  This is the risk that the bond issuer (the borrower) can’t pay the interest or principal back.  You may know how that works if you lend money to a friend.  It works exactly the same way in the bond world.  If a bond issuer can’t pay, the bond is said to be in “default.”  At that point you cannot be sure if you will get any of your money back.
  • A second risk with bonds is known as “interest rate risk.”  When a bond is issued it has a stated interest rate which is usually fixed for the life of the bond.   If interest rates go up during the bond’s lifetime, the value of the bond will go down.  If you need to sell it during this time you may get back less than you paid.
  • A third risk is the erosion of your “purchasing power.”  When you buy a bond, your money has a known purchasing power.  As an example, you know that you can get a cup of coffee at most places for about $1.25 (more at Starbucks) .   If you buy a bond that does not come due for 30 years you can be fairly sure that that same cup of coffee will cost a lot more due to inflation.  Yet if you buy the typical bond for $1000, you will get back $1000 at maturity and that may not buy nearly as many cups of coffee.  That lost purchasing power needs to be offset by the interest payment you receive.

This is a greatly simplified discussion of bond risk, but it gives you a starting point to try to determine how bond investing should be viewed.

What is a municipal bond?

Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities, which use the money to build schools, highways, hospitals, sewer systems, and many other projects.

When you purchase a municipal bond, you are lending money to a state or local government entity, which in turn promises to pay you a specified amount of interest (usually paid semiannually) and return the principal to you on a specific maturity date.  Most municipal bonds can be redeemed prior to maturity.  This is a date specified in the “Offering Statement” and is known as the “Call Date.”

Not all municipal bonds offer income exempt from both federal and state taxes.  Most states exempt the interest paid by municipal bonds issued by entities within that state but tax interest earned on bonds from other states.  There is an entirely separate market of municipal issues that are taxable at the federal level, but still offer a state—and often local—tax exemption on interest paid to residents of the state of issuance.

Municipal bonds are issued in denominations of $5000.  Most investors in municipal bonds buy them on the secondarily market.  The actual price paid for a bond may be either more or less than “par” which is defined as 100 cents on the dollar.  The stated interest on a bond is referred to as the “coupon” rate.  Bonds are priced so that bonds of equal quality with the same maturity (or call) date have the same yield to maturity.

The municipal bond market is a specialized market and requires an in-depth knowledge of issuers, quality, yields and prices.

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