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Bonds Have Risks Other Than Rising Interest Rates. Dividend Stocks are not Substitutes for Bonds.

24 Sunday Jul 2016

Posted by wmosconi in academics, asset allocation, bond basics, bond market, Bond Mathematics, Bond Risks, bonds, Fabozzi, finance, finance theory, financial advice, Financial Advisor, financial goals, financial markets, Financial Media, financial planning, financial services industry, Fixed Income Mathematics, foreign currency, Frank Fabozzi, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investments, math, MBS, personal finance, rebalancing, rebalancing investment portfolio, rising interest rate environment, rising interest rates, risk, risks of bonds, Search for Yield, statistics, types of bonds, volatility, yield

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asset allocation, bond basics, Bond Risks, bonds, dividend stocks, education, finance, financial advice, Financial Advisor, Financial Advisors, financial markets, financial planning, financial services, financial services industry, individual investing, interest rates, investing, investment advice, investments, mathematics, personal finance, portfolio, portfolio allocation, portfolio management, rising interest rates, risks of bonds, Search for Yield, statistics, types of bonds, volatility, yields

The main reason why Financial Advisors are recommending that individual investors sell bonds is that interest rates are likely to rise over the next 3-5 years or more.  Although those sentiments have been a familiar refrain over the last 3-5 years though.  Well, I would tend to agree that interest rates are poised to rise at some point toward the end of this decade.  However, interest rate risk is only one of the risks of bonds.  In fact, the size of the bond market dwarfs the stock market.  When Financial Advisors are talking about bonds, they tend to be referring only to US Treasury bonds, corporate bonds, and municipal bonds.  Interest rate risk greatly affects these bonds indeed.  With that being said, they tend to conflate the interest rate risk of these bonds with the entire bond market.  Remember that interest rates have dropped from 16.30% on the 1-month US Treasury bill back in 1981 to roughly 0.25% today.  Therefore, bond prices have been rising for over 35 years and most financial professionals outside of the fixed income markets have forgotten (or if they are younger than 50) how bonds normally work, especially in a rising interest rate environment.

But does it even matter really? Yes.  Here is an urgent note to all individual investors:  “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”.  What I mean by this is that the volatility of stocks is far greater than bonds historically.  Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now.  However, your risk tolerance must be taken into account at all times.  While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk.  For example, as most people are aware, the S&P 500 index (which represents most of the biggest companies in America) was down over 35% in 2008.  Many of those stocks are included in the push to have individual investors buy dividend payers.  With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon.  If you handle the volatility of the stock market well, there is no need to be concerned.  However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield.  Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap.  The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities.  Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment.

While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future just taking into account normal volatility in the stock market historically (every 36 months or so in any given quarter).  Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?The purpose of this blog post is to discuss the risk factors associated with bonds in greater detail.  Most bonds, such as Treasury notes and bonds, corporate bonds, and municipal bonds, will go down in value when interest rates go up.  Conversely, they will go up in value when interest rates decrease.  This characteristic of these types of bonds is called an inverse relationship.  For a primer on how most bonds function normally, I have posted supplementary material alongside this post.  You can refer to it to brush back up on bonds and how they work, and I also provide a historical look at interest rates over the last 35 years.  Here is the link to that prior blog post:https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks-supplementary-information-on-how-bonds-work/

There are many risk factors associated with investments in bonds.  A great overview of those risks can be found in Fixed Income Mathematics the Fourth Edition by Dr. Frank Fabozzi who teaches at Yale University’s School of Management.  Most fixed income traders, portfolio managers, and risk managers use his Handbook of Fixed Income Securities as their general guidebook for approaching dealing with the trading, investing, and portfolio/risk management of owning fixed income securities.  Suffice it to say that he is regarded as one of the experts when it comes to the bond markets.  Dr. Fabozzi summarizes the risks inherent in bonds on page 109 of the first text referenced above.  The risks are as follows:

  • Interest-rate risk;
  • Credit risk;
  • Liquidity risk;
  • Call or prepayment risk;
  • Exchange-rate risk.

Most of fixed income folks and myself would add inflation risk, basis risk, and separate credit risk into two components.  Bonds have two types of risk as it relates to payment of principal and interest.  The first risk is more commonly thought of and referred to as default risk.  Default risk is simply whether or not the company will pay you back in full and with timely interest payments.  Credit risk also can be thought of as the financial strength of the company.  If a company starts to see a reduction in profits, much higher expenses, and drains of cash, the rating agencies may downgrade their debt.  A downgrade just means that the company is less likely to pay back the bondholder.Here is an example to illustrate the difference more fully:  a company may have a AA+ rating from Standard & Poor’s at the beginning of the year, but, due to events that transpire during the year, the company may get downgraded to A- with a Negative Outlook.  Now the company is still very likely to pay back principal and interest on the bonds, but the probability of default has gone up.  As a point of reference, AAA is the highest and BBB- is the lowest Standard & Poor’s ratings to be considered investment grade.  You will note that the hypothetical company would need to be downgraded four more times (BBB+, BBB, BBB- to BB+) to be considered non-investment grade or a “junk” bond.   Bond market participants though will react to the downgrade though because new potential buyers see more risk of default given the same coupon.  So even though the company may not default eventually on the actual bond, the price of the bond goes up to compensate for the interest rate required by the marketplace on similarly rated bonds to attract buyers.Now I will address the full list of risks affecting bonds outlined by Dr. Fabozzi above.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.

All bonds have what is referred to as credit (default portion) risk.  Credit risk in general is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser known or thought about by individual investors is interest-rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest-rate risk relates to the fact that interest rates may rise, while you hold the bonds (spoken about at length in the beginning of this blog post).  When financial pundits make blanket statements about selling bonds, they are referring to this one risk factor normally.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation or closer to inflation from when you bought the bond, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.  Call risk refers to instances where some companies have the option to redeem your bonds in the future at an agreed upon price.  This is normally done only when interest rates fall. Prepayment risk is a more specialized case of call risk and refers to people paying their mortgages (or credit cards, home equity loans, student loans, etc.) back sooner than expected.  Most people group these two risks into a category called reinvestment risk.  Think about the concept in this manner:  many people refinanced their mortgages because interest rates went down.  They did so because they could lower their total mortgage payment.  Well, companies do the same thing if they have the option.  Companies can redeem bonds at higher interests and issue new bonds at lower interest rates.  Chances are that, if you are the owner of the redeemed bonds, you will be unable to find as high of an interest payment currently if you want to buy a bond with similar characteristics of the company issuing the bonds you own before.The other three risks I mentioned above are less commonly discussed and not quite as important.

Exchange-rate risk exists because sometimes a company issues bonds in a currency other than its own.  For example, you will sometimes hear the terms Yankee bonds or Samurai bonds.  Since the company is paying you interest and principal in a foreign currency that money may be worth more or less depending on what happens in foreign exchange markets in the future.

Liquidity risk refers to the phenomenon that there are certain crisis times in the market where very few, if any bond market participants, are willing to buy the bonds you are trying to sell.  Therefore, you might have to take a bigger loss in order to entice someone to buy the bonds given the current macro environment.

Basis risk is a more obtuse type of risk that institutions deal with.  Basis risk essentially refers to anytime when interest rates on your bond are pegged to another interest rate that is different but normally behaves in a certain way (referred to as correlation).  Now most of the time, the behavior will follow the historical pattern.  However, during times of stress like a liquidity and/or credit crisis, the correlations tend to break down.  Meaning you can think you are “hedged” but, if the historical relationship does not hold up, your end return will be nothing like what you had expected.  These two risks are not something that individual investors need to focus on for the most part, since these types of bonds are not normally owned by them.I will admit that this list is quite lengthy and, quite possibly, a bit too detailed and/or complicated.  However, I wanted to lay them all out for you.  Why?  When you hear Financial Advisors recommend that you sell a large portion of your bonds, and/or hear the same investment advice from the financial media, they normally are really only referring to interest-rate risk primarily and secondarily inflation risk as well.  As you can see from the description above, the bond market is far more complex than that to make a blanket statement.Now, as I usually say, I would never advise individual investors to take a certain course of action in terms of selecting specific bonds or not selling bonds to move into more stocks.  However, I am saying that you should feel comfortable enough to ask your Financial Advisor why he/she recommends that you sell a portion of your bonds.  If the answer relates only to interest-rate risk, I would probe the recommendation further.  You can explain that you know that is the case for Treasury notes/bonds, municipal bonds, and corporate bonds.  However, there are a whole host of other fixed income securities with different characteristics and risks.  Now I am not referring solely to Mortgage Backed Securities (MBS), although the residential and commercial markets for these are in the trillions of dollars.  There are bonds and notes that have floating interest rates which means that as interest rates go up, the interest rate you receive on that security goes up.  Not to mention that different countries are experiencing different interest rate cycles than the US (stable or downward even).The complete list is too in-depth to cover in a single blog post.  My goal was to provide you with enough information to at least ask the question(s).  Your risk tolerance and financial goals might make a move from bonds to stocks the best course of action.  With that being said, you also have the option of selling bonds and keeping the money in cash or investing in the different types of bonds offered in the fixed income markets while keeping your total allocation to fixed income nearly the same.  Thinking holistically about your portfolio, you may be increasing the riskiness of your portfolio beyond your risk tolerance or more than you are aware unbeknownst to you by moving from bonds into stocks.  This is something you definitely want to avoid.    It can turn out to be a rude awakening and hard lesson to learn one or two years from now.

Are Stocks Currently Overvalued, Undervalued, or Fairly Valued? Answer: Yes.

10 Tuesday May 2016

Posted by wmosconi in academia, academics, asset allocation, Average Returns, business, CAPE, CAPE P/E Ratio, Consumer Finance, Cyclically Adjusted Price Earnings Ratio, Education, finance, finance theory, financial advice, financial goals, financial markets, Financial Media, Financial News, financial planning, financial services industry, Forward P/E Ratio, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investments, Nobel Prize, Nobel Prize in Economics, P/E Ratio, passive investing, personal finance, portfolio, risk, Robert Shiller, Schiller, Shiller P/E Ratio, statistics, stock market, Stock Market Returns, Stock Market Valuation, stock prices, stocks, Valuation, volatility

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Confusing and frustrating as it may be, the answer about the current valuation of stocks will always be different depending on who you ask. Various economists, mutual fund portfolio managers, research analysts, financial news print and TV personalities, and other parties seem to disagree on this very important question.  Financial professionals will offer a wide range of financial and economic statistics in support of these opinions on the current valuation of stocks.  One of the most often cited statistics in support of a person’s opinion is the P/E ratio of the stock market at any given point in time.   Many financial professionals use it as one of the easiest numbers to be able to formulate a viewpoint on stock valuation.  However, when it comes to any statistic, one must always be skeptical in terms of both the way the number is calculated and its predictive value.  Any time one number is used to describe the financial markets one must always be leery.  A closer examination of the P/E ratio is necessary to show why its usage alone is a poor way to make a judgement in regard to the proper valuation of stocks.

The P/E ratio is short for Price/Earnings ratio. The value is calculated by taking the current stock price divided by the annual earnings of the company.  When it is applied to an entire stock market index like the S&P 500 index, the value is calculated by taking the current value of the index divided by the sum of the annual earnings of the 500 companies included in the index.  One of the very important things to be aware of is that the denominator of the equation may actually be different depending on who is using the P/E ratio.  Some people will refer to the P/E ratio in terms of the last reported annual earnings for the company (index).  Other people will refer to the P/E ratio in terms of the expected earnings for the company (index) over the next year.  In this particular case, the P/E ratio is referred to as the Forward P/E ratio.  Both ratios have a purpose.  The traditional P/E ratio measures the reported accounting earnings of the firm (index).  It is a known value.  The Forward P/E ratio measures the profits that the firm (index) will create in the future.  However, the future profits are only a forecast.  Many analysts prefer to use the Forward P/E ratio because the value of any firm (or index of companies) is determined by its future ability to generate profits for its owners.  The historical earnings are of lesser significance.

The P/E ratio is essentially a measure of how much investors value $1 worth of earnings and what they are willing to pay for it. For example, a firm might have a P/E ratio of 10, 20, 45, or even 100.  In the case of a firm that is losing money, the P/E ratio does not apply.  In general, investors are willing to pay more per each $1 in earnings if the company has the potential to grow a great deal in the future.  Examples of this would be companies like Amazon (Ticker Symbol:  AMZN) or Netflix (Ticker Symbol:  NFLX) that have P/E ratios well over 100.  Some companies are further along in their life cycle and offer less growth opportunities and tend to have lower P/E ratios.  Examples of this would be General Motors or IBM that have P/E ratios in the single digits or low teens, respectively.  Investors tend to pay more for companies that offer the promise of future growth than for companies that are in mature or declining industries.

When it comes to the entire stock market, the P/E ratio applied to a stock market index (such as the S&P 500 index) measures how much investors are willing to pay for the earnings of all the companies in that particular index. For purposes of discussion and illustration, I will refer to the S&P 500 index while discussing the P/E ratio.  The average P/E ratio for the S&P 500 index over the last 40 years (1966-2015) was 18.77.  When delivering an opinion on the valuation of the S&P 500 index, many financial professionals will cite this number and state that stocks are overvalued (undervalued) if the current P/E ratio of the S&P 500 index is above (below) that historical average.  If the current P/E ratio of the S&P 500 index is roughly in line with that historical average, the term fairly valued will usually be used in relation to stocks.  The rationale is that stocks are only worth what their earnings/profits are over time.  There is evidence that the stock market can become far too highly priced (as in March 2000 or December 2007) or far too lowly priced (as in 1982) based upon the P/E ratio observed at that time.  Unfortunately, the relative correlation between looking at the difference between the current P/E ratio of the stock market and the historical P/E ratio does not work perfectly.  In fact, it is only under very extreme circumstances and with perfect hindsight that investors can see that stocks were overvalued or undervalued in relation to the P/E ratio at that time.

Here are the historical P/E ratios for the S&P 500 index from 1966-2015 as measured by the P/E ratio at the end of the year. Additionally, the annual return of the S&P index for that year is also shown.

Year P/E Ratio Annual Return
2015 22.17 1.30%
2014 20.02 13.81%
2013 18.15 32.43%
2012 17.03 15.88%
2011 14.87 2.07%
2010 16.30 14.87%
2009 20.70 27.11%
2008 70.91 -37.22%
2007 21.46 5.46%
2006 17.36 15.74%
2005 18.07 4.79%
2004 19.99 10.82%
2003 22.73 28.72%
2002 31.43 -22.27%
2001 46.17 -11.98%
2000 27.55 -9.11%
1999 29.04 21.11%
1998 32.92 28.73%
1997 24.29 33.67%
1996 19.53 23.06%
1995 18.08 38.02%
1994 14.89 1.19%
1993 21.34 10.17%
1992 22.50 7.60%
1991 25.93 30.95%
1990 15.35 -3.42%
1989 15.13 32.00%
1988 11.82 16.64%
1987 14.03 5.69%
1986 18.01 19.06%
1985 14.28 32.24%
1984 10.36 5.96%
1983 11.52 23.13%
1982 11.48 21.22%
1981 7.73 -5.33%
1980 9.02 32.76%
1979 7.39 18.69%
1978 7.88 6.41%
1977 8.28 -7.78%
1976 10.41 24.20%
1975 11.83 38.46%
1974 8.30 -26.95%
1973 11.68 -15.03%
1972 18.08 19.15%
1971 18.00 14.54%
1970 18.12 3.60%
1969 15.76 -8.63%
1968 17.65 11.03%
1967 17.70 24.45%
1966 15.30 -10.36%

Average             18.77

The P/E ratio for the S&P 500 index has varied widely from the single digits to values of 40 or above. The important thing to observe is that very high P/E ratios are not always followed by low or negative returns, nor are very low P/E ratios followed by very high returns.  In terms of a baseline, the S&P 500 index returned approximately 9.5% over this 40-year period.  As is immediately evident, the returns of stocks are quite varied which is what one would expect given the fact that stocks are known as assets that exhibit volatility (meaning that they fluctuate a lot because the future is never known with certainty).  Thus, whenever a financial professional says that stocks are overvalued, undervalued, or fairly valued at any given point in time, that statement has very little significance.  Whenever only one data point is utilized to give a forecast about the future direction of stocks, an individual investor needs to be extremely skeptical of that statement.  The P/E ratio does hold a very important key for the future returns of stocks but only over long periods of time and certainly not over a short timeframe like a month, quarter, or even a year.

An improvement on the P/E ratio was developed by Dr. Robert J. Shiller, the Nobel Prize winner in Economics and current professor of Economics at Yale University. The P/E ratio that Dr. Shiller developed is referred to as the Shiller P/E ratio or the CAPE (Cyclically Adjusted Price Earnings) P/E ratio.  This P/E ratio takes the current value of a stock or stock index and divides it by the average earnings of a firm or index components for a period of 10 years and also takes into account the level of inflation over that period.  The general idea is that the long-term earnings of a firm or index determine its relative valuation.  Thus, it does a far better job of measuring whether or not the stock market is fairly valued or not at any given point in time.  However, another very important piece of the puzzle has to do with interest rates.  Investors are generally willing to pay more for stocks when interest rates are low than when interest rates are high.  Why?  If it is assumed that the future earnings stream of the company remains the same, an investor would be willing to take more risk and invest in stocks over the safety of bonds.  A quick example from everyday life is instructive.  Imagine that your friend wants to borrow $500 for one year.  How much interest will you charge your friend on the loan?  Let’s say you want to earn 5% more than what you could earn by simply buying US Treasury Bills for one year.  A one-year US Treasury Bill is risk free and, as of May 10, 2016 yields interest of 0.50%.  Therefore, you might charge your friend 5.5% on the loan.  Now back in the early 1980’s, one-year US Treasury Bills (and even savings accounts at banks) were 10% or higher.  If you were to have provided the loan to your friend then, you would not charge 5.5% because you could simply deposit the $500 in the bank.  You might charge your friend 15.5% on the loan assuming that the relative risk of your friend not paying you back is the same in both time periods.  It is very similar when it comes to investing in stocks.  Due to the fact that stocks are volatile and future profits are unknown, investors tend to prefer bonds over stocks as interest rates rise.  This phenomenon causes the value of stocks to fall.  Conversely, as interest rates fall, the preference for bonds decreases and investors will choose stocks more and prices go up.  Now this assumes that the future earnings of the company or index constituents stay the same in either scenario.

With that information in mind, a better way to gauge the relative valuation of stocks in terms of being overvalued, undervalued, or fairly valued, would be to look at the Shiller P/E ratio in combination with interest rates. It is most common for investors to utilize the 10-year US Treasury note as a proxy for interest rates.  Here are the historical values for the Shiller P/E ratio and the 10-year US Treasury note over the same 40-year period (1966-2015) as before:

Year CAPE Ratio 10-Year Yield
2015 24.21 2.27%
2014 26.49 2.17%
2013 24.86 3.04%
2012 21.90 1.78%
2011 21.21 1.89%
2010 22.98 3.30%
2009 20.53 3.85%
2008 15.17 2.25%
2007 24.02 4.04%
2006 27.21 4.71%
2005 26.47 4.39%
2004 26.59 4.24%
2003 27.66 4.27%
2002 22.90 3.83%
2001 30.28 5.07%
2000 36.98 5.12%
1999 43.77 6.45%
1998 40.57 4.65%
1997 32.86 5.75%
1996 28.33 6.43%
1995 24.76 5.58%
1994 20.22 7.84%
1993 21.41 5.83%
1992 20.32 6.70%
1991 19.77 6.71%
1990 15.61 8.08%
1989 17.05 7.93%
1988 15.09 9.14%
1987 13.90 8.83%
1986 14.92 7.23%
1985 11.72 9.00%
1984 10.00 11.55%
1983 9.89 11.82%
1982 8.76 10.36%
1981 7.39 13.98%
1980 9.26 12.43%
1979 8.85 10.33%
1978 9.26 9.15%
1977 9.24 7.78%
1976 11.44 6.81%
1975 11.19 7.76%
1974 8.92 7.40%
1973 13.53 6.90%
1972 18.71 6.41%
1971 17.26 5.89%
1970 16.46 6.50%
1969 17.09 7.88%
1968 21.19 6.16%
1967 21.51 5.70%
1966 20.43 4.64%

Average                19.80                          6.44%

These two data points provide a much better gauge of whether or not stocks are currently overvalued or undervalued. For example, take a look at the Shiller P/E ratio in the late 1970’s and early 1980’s.  The value of the Shiller ratio is in the single digits during this time period because interest rates were higher than 10%.  Lately interest rates have been right around 2.0%-2.5% for the past several years.  Therefore, one would expect that the Shiller P/E ratio would be higher.  Now the historical average for the Shiller P/E ratio was 19.80 over this period.  The Shiller P/E ratio was in the neighborhood of 40 during 1998-2000 which preceded the bursting of the Internet Bubble in March 2000.  The Shiller P/E ratio was at its two lowest levels of 7 and 8 in 1981 and 1982, respectively which is when the great bull market began.  However, while this Shiller P/E and interest rates are better than simply the traditional P/E ratio, there are flaws.  The Shiller P/E in 2007 was 24.02 right (and interest rates were around 4.0% which is on the low side historically) before the huge market drop of the Great Recession between September 2008 and March 2009.  In fact, the S&P 500 index was down over 37% in 2008, and the Shiller P/E did not provide an imminent warning of any such severe downturn.  Therefore, even looking at these two measures is imperfect but better than the normal P/E ratio in isolation.

To summarize the discussion, individual investors will always be told on a daily basis by various sources that the stock market is currently overvalued, undervalued, and fairly valued at the same time. One of the most commonly used rationales is a reference to the current P/E ratio in relation to the historical P/E ratio.  As we have seen, this one data point is a very poor indicator of the future direction and relative value of stocks at any given period of time, especially for short periods of time (one year or less).  The commentary and opinions provided by financial “experts” to individual investors when the P/E ratio is mentioned normally relates to the short term.  By looking back at the historical data, it is clear that this one data point is really only relevant over very long periods of time.  The Shiller P/E ratio in combination with current interest rates is a great improvement over the traditional P/E ratio, but it is even imperfect when it comes to forecasting the future returns of the stock market.  There are two general rules for individual investors to take away from this discussion.  Whenever a comment is made about the current value of stocks and only one statistic is provided, the opinion should be taken with a “grain of salt” and weighed only as one piece of information in determining investment decisions that individual investors may or may not make.  Additionally, and equally as important, if a financial professional cites a statistic about stock valuation that you do not understand (even after doing some research of your own), you should always discard that opinion in most every case.  Individual investors should not make major investment decisions in terms of altering large portions of their investment portfolios of stocks, bonds, and other financial assets utilizing information that they do not understand.  It sounds like common sense, but, in the sometimes irrational world of investing, this occurrence is far more common than you imagine.

The Top 5 Most Read Articles in my Investing Blog During 2015

29 Tuesday Dec 2015

Posted by wmosconi in asset allocation, bond market, bonds, Consumer Finance, Fed, Federal Reserve, finance, finance theory, financial advice, Financial Advisor, financial advisor fees, financial advisory fees, financial goals, financial markets, financial planning, financial services industry, Individual Investing, individual investors, interest rates, investing, investing advice, investing information, investing tips, investment advice, investment advisory fees, investments, passive investing, personal finance, portfolio, reasonable fees, reasonable fees for financial advisor, reasonable fees for investment advice, reasonable financial advisor fees, rebalancing, rebalancing investment portfolio, rising interest rate environment, rising interest rates, risk, risk tolerance, statistics, stock market, stock prices, stocks, Yellen

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The most popular articles read over the past year included some writings from a couple of years ago and were also on a myriad of topics. The listing of articles below represents the most frequent viewings working downward.

  1. Are Your Financial Advisor’s Fees Reasonable? Are You Actually Adding More Risk to Your Ability to Reach Your Long-Term Financial Goals? Here is a Unique Way to Look at What Clients Pay For.

 This article has consistently drawn the most attention from readers of my investing blog. Individual investors have learned from me and many others that one of the most important components of being successful long-term investors is by keeping investment costs as low as possible.  This particular writing examines investing costs from a different perspective.  In general, the higher the investment costs an individual investor incurs, the higher the allocation to riskier investments he/she must have to reach his/her financial goals.

Link to the complete article: https://latticeworkwealth.com/2013/10/26/are-your-financial-advisors-fees-reasonable-are-you-actually-adding-more-risk-to-your-ability-to-reach-your-long-term-financial-goals-here-is-a-unique-way-to-look-at-what-clients-pay-for/

2. Are Your Financial Advisor’s Fees Reasonable? Here is a Unique Way to Look at What Clients Pay For.

 This article is closely followed by the previous one in terms of popularity and forms the basis for that discussion actually. The general concept contained in this writing is that most asset managers now charge investors a fee for managing their investments based upon Assets under Management (AUM).  The fee is typically 1% but can be 2% or higher.  The investment costs to the individual investor per year are the total balance in his/her brokerage account multiplied by the fee which is commonly 1%.  However, the 1% grossly misrepresents the actual investment costs because the individual investor starts off with the total balance in his/her brokerage account.  The better way to express the fees charged per year is to divide the AUM percentage by the growth in the portfolio over the year.  That percentage answer will be quite a bit higher.

Link to the complete article: https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/

3)  Rebalancing Your Investment Portfolio – Summary

 Earlier in the year, I compiled a three-part series that examined the concept of rebalancing one’s investment portfolio. Rebalancing is an excellent investing strategy to learn about and apply at the end of the year.  Rebalancing in its simplest definition is the periodic reallocation of the investment percentages in one’s investment portfolio back to an original model after a passage of time.  This summary of rebalancing provides a look at rebalancing that is helpful for novice individual investors through more advanced folks.

Link to the complete article: https://latticeworkwealth.com/2015/11/25/rebalancing-your-investment-portfolio-summary/

4)  How to Create an Investment Portfolio and Properly Measure your Performance: Part 2 of 2

 While this article is the second part of a discussion on the creation of an investment portfolio, it is arguably the more important of the two because it looks at a topic too often not relayed to individual investors. This writing talks about the importance of measuring the performance of your investment portfolio’s investment returns.  The financial media tends to focus solely on comparing your portfolio to the performance of the S&P 500 Index.  That comparison is “apples to oranges” the vast majority of the time because most individual investors have many different types of investments in their portfolios.  Therefore, I show you how institutional investors measure the performance of their investment portfolios.  The concept is broken down into smaller parts so it is very understandable and usable for individual investors.

Link to the complete article: https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/

5)  How Can Investors Survive in a Rising Interest Rate Environment? – Updated

 Although this particular article was first published a couple of years ago, the content is even more valuable today. The Federal Reserve increased the target range for the Federal Funds Rate by 0.25% on December 16, 2015 and has indicated that more interest rate increases are likely in the future.  Thus, we have entered a period in which interest rates are generally headed higher over the next several of years.  Most financial pundits will bemoan this type of environment because higher interest rates mean that the prices of most bonds go down.   It makes it harder to earn any investment returns from bonds.  However, there are a number of investments and investment strategies that benefit from an increasing interest rate environment.  This article examines six different things individual investors can do.

Link to the complete article: https://latticeworkwealth.com/2013/11/30/how-can-investors-survive-in-a-rising-interest-rate-environment-updated/

 

I hope you enjoy these popular articles from my investing blog. My goal is to keep on releasing more information in 2016 to assist individual investors in navigating the world of investing.  Thank you to all my readers in the United States and internationally!

The Results are in for my January CNBC Experiment: It Proves Nothing and Everything. What?

07 Friday Feb 2014

Posted by wmosconi in asset allocation, beta, bonds, business, Consumer Finance, currency, Education, EM, emerging markets, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, foreign currency, forex, fx, Individual Investing, interest rates, investing, investments, math, NailedIt, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility, Yellen

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Sometimes the most important lessons in the individual investing sphere are complicated and simple at the same time.  At the very beginning of January, I recommended a little experiment that related to the financial market coverage on CNBC.  The specific details of this “thought experiment” can be found in the original blog post from January 1st:

https://latticeworkwealth.com/2014/01/14/happy-new-year-beginning-thoughts-and-information-for-international-viewers-2/

The brief version of the exercise related to watching Monday and Friday coverage of the current events in the global financial markets during the month.  The simple exercise was to watch CNBC’s Squwak Box every Monday during the course of the month.  The second part was to watch the last hour of the Closing Bell segment.  What was the logic?  The Monday show is a three-hour program, and there are many current issues considered and opinions from various market participants (e.g. traders, money managers, economists, investment strategists, research analysts, etc.).  Monday is critical due to the fact that the market participants cannot trade on Saturday and Sunday.  You might think of it as “forced” time to think and/or reflect about how current events are affecting investment opportunities and risks.  Friday’s reflections from the same market participants is focused more on trying to explain the “vagaries and vicissitudes” (i.e. volatility of the stock market and changing opinions) of the markets ups and downs over the course of the week.  Furthermore, many commentators and guests try to explain why the predictions on Monday did not or did match up with the ideas expressed at the beginning of the week.

The overall point of this experiment was to “drive home” the fact that trying to time the market or predict its direction over the short term is extremely challenging and can seem hopeless.  Toward the end of December, the general investment thesis for the majority of money managers was that the stock market was poised to have a very positive January due to the fact that the financial markets did not really dive after the Federal Reserve announced the reduction of the tapering program, commonly referred to as QE (quantitative easing).  Additionally, the main belief was that bonds were one of the least attractive investments to own.  Most people assumed that the 10-year US Treasury Note was headed up to the 3.0% level.  Things seemed pretty simple and not too many headwinds in the near future.  So what happened during January?

The main event that most people remember was the currency difficulties of a number of emerging market countries.  The financial media focused a lot on the Turkish lira (TRY) and the Argentine peso (ARS).  Turkey had political problems, and Argentina has a huge problem as it relates to political leadership (or the absence thereof) and dwindling currency reserves.  There were other currencies that experienced trouble as well like the South African rand (ZAR).  The other important development was that the Japanese yen (JPY) reversed its direction and strengthen versus the US dollar (USD).  Oddly enough, the Argentine Merval stock index was one of the best performers over the course of the month.  No one saw this coming to such an extent.  You might term this an exogenous event as anything that occurs outside of your current model to build a portfolio or invest in individual stocks/bonds.  It is largely unknown and hard to predict.  (As an aside, this is NOT the same thing as a “black swan”.  That term is overused and conflated with many other things.  Refer to Dr. Nassim Taleb for a further definition of the termed that he famously coined years ago).  These events tend to be unknowns and have a greater impact because the general level of the perception of risk changes almost instantly and affect market sentiment and momentum.  Market participants need to alter their models rather quickly in order to account for the occurrence of these events.

The other big event was the movement of the yield on the 10-year US Treasury note.  Instead of following a general path of rising, the interest rate actually fell.  The yield on this instrument drifted down roughly 40 basis points (0.4%) from the 3.0% level.  What most people fail to realize is that interest rates go down if economic data turns out to be worse than expected normally (e.g. December jobs of 70,000 and the lowest labor force participation rate since the 1980s), but, more importantly, there is a “flight to quality” phenomenon that occurs over and over again.  There tends to be a bit of a “mini panic” when unexpected and impactful events occur.  If all else fails, institutional investors like hedge fund managers tend to buy US Treasury bills, notes, and bonds for safety.  The additional demand causes bond prices to go up and, by definition, yields will go down.

The combination of bad economic data and dealing with the currency woes in the emerging markets causes many short-term traders and speculators to buy these risk-free assets and figure out how to trade later.  It is sort of an example of reflexivity.  The bottom line for individual investors is that many sold bonds and purchased dividend stocks instead.  The exact opposite happened:  bond yields went down and dividend stocks sold off.  The worst short-term investing strategy was to search for yield in the stock market rather than the bond market due to rising interest rates.  For more information you can refer to one of my former posts on how to look at the various risk factors associated with bonds.  Trust me, there is a lot more to bonds than simply interest rate risk.  Here is the link to a former blog post that addresses this very issue:

https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks/

There were many other smaller events that happened over the course of the month that affected the general volatility experience in the financial markets.  At the end of the day, even the “experts” had a monumental task trying to explain all the macroeconomic events, currency movements, and interest rate implications throughout January.  If the task was so difficult for them, it is normally advisable for individual investors to not follow the market daily and get caught up in temporary “greed and fear” of traders and speculators.  Investment ideas and predications can change from day to day and even minute to minute in the short term.  It is much more important for individual investors to develop a long-term financial plan that will allow them to reach future financial goals.  You then blend that with your risk tolerance.  For example, how likely would you have been to sell the positions in your portfolio given the volatility experienced during the course of January?  An outlook of five years is normally a great start for that plan.  If you look out into the future with a longer timeframe like an annual basis in terms of adjusting the components of your asset allocation, you are less likely to constantly trade the securities in your personal portfolio.  The frenetic pace of traders/speculators and the volatility of the stock and bonds markets makes it seem that you MUST do something, anything!

If you would like to learn a bit more about behavioral finance, you can refer to this blog post from last year (note context of examples referred to is from August 2013 when the piece was published):

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

One of the most important things to learn in investing is how to control your emotions.  It is easy to map out your investment strategy and risk tolerance on paper.  Many asset managers who have experienced a multitude of secular bull and bear markets refer to this phenomenon as your EQ versus your IQ.  Thus, when actual “money” is involved, volatility and uncertainty in the financial markets brings forth challenges that even the best money managers have a hard time keeping up their nerve.  The other takeaway is that people’s investment recommendations can change on a dime.  Market participants can be very hopeful on one day and think the sky is falling the next day.  Trying to time the market is so difficult that you end up developing a portfolio allocation for your investments that assumes that general events with transpire.  All the planning in the world cannot account for all possibilities of geopolitical and global events that might really cause the market to go down more than normal in a short time period.

The whole point of this “thought experiment” was to encourage you to take a long-term view of investing in the financial markets.  It is a lot less stressful, less complicated, and tends to lead to better overall investment returns (i.e. you do not “sell low and buy high” as much because everyone tells you to).  For more information on stepping back and thinking about the long term, I have included a final blog post.  You always need to remember that your financial professional (or yourself if you manage your own investments) who advises you about investment decisions is forever impacted by the start of their investment career.  They tend to be biased and make investment recommendations based upon how things used to be when they started in the business.  It is very hard to separate your “biases” from the present day.  Here is the link:

https://latticeworkwealth.com/2013/08/18/before-you-take-any-investment-advice-consider-the-source/

Well, I hope you learned a few things by participating in my experiment and maybe even had a little bit of fun.  Please feel free to leave a comment or send me an email directly at latticeworkwealth@gmail.com with more specific feedback and/or questions.  Sometimes you can learn a great deal just by being an observer of financial market volatility.  What is the nothing part of this learning journey?  The moral of the story is that everyday guests appearing on CNBC or other commentators will let you know that the stock market with either go up, go down, or stay unchanged.  Obviously everyone knows that simple concept to begin with.  Thus, it is hard to choose who to listen too because of so many divergent opinions.  Lastly, you should realize that this same experiment would have worked with the other business networks and large financial news publications like the Wall Street Journal, Financial Times, Barron’s.

A Bond is a Bond is a Bond, Right? Should You Sell Bonds to Buy Stocks?

02 Thursday Jan 2014

Posted by wmosconi in asset allocation, bonds, business, Consumer Finance, Education, Fed Tapering, Federal Reserve, finance, financial planning, Individual Investing, interest rates, investing, investments, MBS, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stocks, volatility

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I have heard over and over from financial pundits toward the end of last year and now 2014 coverage in financial publications that the great rotation of investors from bonds to stocks is finally occurring.  While there is definitely heavy selling of bond mutual funds going on, the bond market is actually quite complex.  The main reason why Financial Advisors are recommending that individual investors sell bonds is that interest rates are likely to rise over the next 3-5 years or more.  Well, I would agree that interest rates are poised to rise.  However, interest rate risk is only one of the risks of bonds.  In fact, the size of the bond market dwarfs the stock market.  When Financial Advisors are talking about bonds, they tend to be referring only to Treasury bonds, corporate bonds, and municipal bonds.  Interest rate risk greatly affects these bonds.  With that being said, they tend to conflate the interest rate risk of these bonds with the entire bond market.  Remember that interest rates have dropped from 16.30% on the 1-month US Treasury bill back in 1981 to roughly 0.05% today.  Therefore, bond prices have been rising for over 30 years and most financial professionals outside of the fixed income markets have forgotten (or if they are younger than 50) how bonds normally work, especially in a rising interest rate environment.  But does it even matter really?

Yes.  Here is an urgent note to all individual investors:  “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”.  What I mean by this is that the volatility of stocks is far greater than bonds historically.  Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now.  However, your risk tolerance must be taken into account at all times.  While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk.  For example, as most people are aware, the S&P 500 index (which represents most of the biggest companies in America) was down over 35% in 2008.  Many of those stocks are included in the push to have individual investors buy dividend payers.  With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon.  If you handle the volatility of the stock market well, there is no need to be concerned.  However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield.  Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap.  The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities.  Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment.  While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future just taking into account normal volatility in the stock market historically (12-36 months).  Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?

The purpose of this blog post is to discuss the risk factors associated with bonds in greater detail.  I have already spoken about this at length in posts last year.  Most bonds, such as Treasury notes and bonds, corporate bonds, and municipal bonds, will go down in value when interest rates go up.  Conversely, they will go up in value when interest rates decrease.  This characteristic of these types of bonds is called an inverse relationship.  For a primer on how most bonds function normally, I have posted supplementary material alongside this post.  You can refer to it to brush back up on bonds and how they work, and I also provide a historical look at interest rates over the last 30 years.

 

There are many risk factors associated with investments in bonds.  A great overview of those risks can be found in Fixed Income Mathematics the Fourth Edition by Dr. Frank Fabozzi who teaches at Yale University’s School of Management.  Most fixed income traders, portfolio managers, and risk managers use his Handbook of Fixed Income Securities as their general guidebook for approaching dealing with the trading, investing, and portfolio/risk management of owning fixed income securities.  Suffice it to say that he is regarded as one of the experts when it comes to the bond markets.  Dr. Fabozzi summarizes the risks inherent in bonds on page 109 of the text referenced above.  The risks are as follows:

1)       Interest-rate risk;

2)      Credit risk;

3)      Liquidity risk;

4)      Call or prepayment risk;

5)      Exchange-rate risk.

Most of fixed income folks and myself would add inflation risk, basis risk, and separate credit risk into two components.  Bonds have two types of risk as it relates to payment of principal and interest.  The first risk is more commonly thought of and referred to as default risk.  Default risk is simply whether or not the company will pay you back in full and with timely interest payments.  Credit risk also can be thought of as the financial strength of the company.  If a company starts to see a reduction in profits, much higher expenses, and drains of cash, the rating agencies may downgrade their debt.  A downgrade just means that the company is less likely to pay back the bondholder.

Here is an example to illustrate the difference more fully:  a company may have a AA+ rating from Standard & Poor’s at the beginning of the year, but, due to events that transpire during the year, the company may get downgraded to A- with a Negative Outlook.  Now the company is still very likely to pay back principal and interest on the bonds, but the probability of default has gone up.  As a point of reference, AAA is the highest and BBB- is the lowest Standard & Poor’s ratings to be considered investment grade.  You will note that the hypothetical company would need to be downgraded four more times (BBB+, BBB, BBB- to BB+) to be considered non-investment grade or a “junk” bond.   Bond market participants though will react to the downgrade though because new potential buyers see more risk of default given the same coupon.  So even though the company may not default eventually on the actual bond, the price of the bond goes down to compensate for the interest rate required by the marketplace on similarly rated bonds to attract buyers.

Now I will address the full list of risks affecting bonds outlined by Dr. Fabozzi above.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.  All bonds have what is referred to as credit (default portion) risk.  Credit risk in general is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser known or thought about by individual investors is interest-rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest-rate risk relates to the fact that interest rates may rise, while you hold the bonds.  When financial pundits make blanket statements about selling bonds, they are referring to this one risk factor normally.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation or closer to inflation from when you bought the bond, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.  Call risk refers to instances where some companies have the option to redeem your bonds in the future at an agreed upon price.  Prepayment risk is a more specialized case of call risk and refers to people paying their mortgages (or credit cards, home equity loans, student loans, etc.) back sooner than expected.  Most people group these two risks into a category called reinvestment risk.  Think about the concept in this manner:  many people refinanced their mortgages because interest rates went down.  They did so because they could lower their total mortgage payment.  Well, companies do the same thing if they have the option.  Companies can redeem bonds at higher interests and issue new bonds at lower interest rates.  Chances are that, if you are the owner of the redeemed bonds, you will be unable to find as high of an interest payment currently if you want to buy a bond with similar characteristics of the company issuing the bonds you own before.

The other three risks I mentioned above are less commonly discussed and not quite as important.  Exchange-rate risk exists because sometimes a company issues bonds in a currency other than its own.  For example, you will sometimes hear the terms Yankee bonds or Samurai bonds.  Since the company is paying you interest and principal in a foreign currency that money may be worth more or less depending on what happens in foreign exchange markets in the future.  Liquidity risk refers to the phenomenon that there are certain crisis times in the market where very few, if any bond market participants, are willing to buy the bonds you are trying to sell.  Therefore, you might have to take a bigger loss in order to entice someone to buy the bonds given the current macro environment.  Basis risk is a more obtuse type of risk that institutions deal with.  Basis risk essentially refers to anytime when interest rates on your bond are pegged to another interest rate that is different but normally behaves in a certain way (referred to as correlation).  Now most of the time, the behavior will follow the historical pattern.  However, during times of stress like a liquidity and/or credit crisis, the correlations tend to break down.  Meaning you can think you are “hedged” but, if the historical relationship does not hold up, your end return will be nothing like what you had expected.  These two risks are not something that individual investors need to focus on.

I will admit that this list is quite lengthy and, quite possibly, a bit too detailed and/or complicated.  However, I wanted to lay them all out for you.  Why?  When you hear Financial Advisors recommend that you sell a large portion of your bonds, and/or hear the same investment advice from the financial media, they normally are really only referring to interest-rate risk primarily and secondarily inflation risk as well.  As you can see from the description above, the bond market is far more complex than that to make a blanket statement.

As I usually say, I would never advise individual investors to take a certain course of action in terms of selecting specific bonds or not selling bonds to move into more stocks.  However, I am saying that you should feel comfortable enough to ask your Financial Advisor why he/she recommends that you sell a portion of your bonds.  If the answer relates only to interest-rate risk, I would probe the recommendation further.  You can explain that you know that is the case for Treasury notes/bonds, municipal bonds, and corporate bonds.  However, there are a whole host of other fixed income securities with different characteristics and risks.  Now I am not referring solely to Mortgage Backed Securities (MBS), although the residential and commercial markets for these are in the trillions of dollars.  There are bonds and notes that have floating interest rates which means that as interest rates go up, the interest rate you receive on that security goes up.  Not to mention that different countries are experiencing different interest rate cycles than the US (stable or downward even).

The complete list is too in-depth to cover in a single blog post.  My goal was to provide you with enough information to at least ask the question(s).  Your risk tolerance and financial goals might make a move from bonds to stocks the best course of action.  With that being said, you also have the option of selling bonds and keeping the money in cash or investing in the different types of bonds offered in the fixed income markets while keeping your total allocation to fixed income nearly the same.  Thinking holistically about your portfolio, you may be increasing the riskiness of your portfolio beyond your risk tolerance or more than you are aware unbeknownst to you by moving from bonds into stocks.  This is something you definitely want to avoid.    It can turn out to be a rude awakening and hard lesson to learn one or two years from now.

How Can Investors Survive in a Rising Interest Rate Environment? – Updated

30 Saturday Nov 2013

Posted by wmosconi in asset allocation, bank loans, Bernanke, bonds, business, Consumer Finance, Education, Fed, Fed Taper, Federal Reserve, finance, financial advisor fees, financial planning, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, LIBOR, math, MBS, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility, Yellen

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I probably get this question asked of me more than any other these days, especially by retirees.  Investors were once able to place money into bank certificate of deposits (CDs) or into money market funds and easily earn more interest than the rate of inflation.  Unfortunately, the financial crisis of 2008 changed all that in a major way.  While the events surrounding the dark days of the close of Lehman Brothers, the bailout of AIG, and the nearly $800 billion TARP program, were not the sole cause of this phenomenon, they certainly did not help.  The Federal Reserve (Fed) led by the chairman, Ben Bernanke, had to lower interest rates to avoid the credit and liquidity crisis of that time period.  The Fed brilliantly avoided a meltdown and depression.  The side effect is that financial market participants have gotten used to low interest rates.  You will hear the term “taper” thrown about now.  The Fed is not going to raise interest rates yet; rather, they are going to slow their purchase of Treasury instruments and mortgages on the open market.  They are not raising the Fed Funds rate (do not worry about what that is exactly), but, since they were buying approximately 70% of all US Treasuries issued, bond market investors are worried that this demand/supply imbalance will naturally cause interest rates to rise (interest rates have already gone up).  Well, if interest rates will be higher, shouldn’t that be better for bond investors?

An urgent side note to all investors is as follows:  “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”.  What I mean by this is that the volatility of stocks is far greater than bonds historically.  Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now.  However, your risk tolerance must be taken into account at all times.  While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk.  For example, as most people are aware, the S&P 500 (which represents most of the biggest companies in America) was down over 35% in 2008.  Many of those stocks are included in the push to have individual investors buy dividend payers.  With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon.  If you handle the volatility of the stock market, there is no need to be concerned.  However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield.  Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap.  The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities.  Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment.  While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future.  Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?

The short answer is no to the question posed at the end of the first paragraph.  Before we can answer that question and look at some investment strategies and potential purchases, we need to review how a bond works.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.  All bonds have what is referred to as credit risk.  Credit risk is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser know is interest rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest rate risk relates to the fact that interest rates may rise, while you hold the bonds.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.

How do bonds work in terms of prices?  Most bonds are issued at a price of 100 which is referred to as par.  Corporate bonds and Treasury notes/bonds are usually sold in increments of $1,000, and municipal bonds are sold in increments of $5,000.  The value of a bond is calculated by taking the current price divided by 100 and then multiplied by the number of bonds you own.  Bonds are sold in the primary market (when first sold to retail and institutional investors) such that the coupon (interest rate) is equal to the current interest rate prevailing in the marketplace at that time (sold at par which is 100).  Bonds can be bought and sold after that issue date though.  If interest rates rise or fall after issuance, how does the price of a bond adjust?  If interest rates go up, bond prices will go down.  If interest rates go down, bond prices will go up.  Why?  It is referred to as an inverse relationship.  Think about it this way.  If you own a bond that has a 6% coupon and interest rates rise to 8%, will you be able to see that bond to other investors?  The answer is no if you decide to hold firm to a price of 100.  Why should another bond investor buy a 6% bond when he/she can just buy a bond with very similar characteristics as yours and earn 8%?  The only way that you can sell your bond is to lower the price such that the bond investor will earn 8% over the course of that bond’s life until maturity which is when the company or other entity has to pay the money back in full).  Luckily for you, the process works in reverse as well though.  If interest rates go down to 4%, you have the advantage.  If you hold a bond with a 6% coupon as in the aforementioned example, bond investors will pay more than 100 in order to get that higher interest payment.  How much more?  Bond investors will bid the price up until the bond earns an equivalent of 4% until maturity.  Why is this important to you as an investor today?

Let’s take a quick look at history.  Most financial professionals are not old enough to remember or have been in business long enough to remember the interest rate environment back in the early 1980s.  In the early 1980s, interest rates on bonds were incredibly high compared to today.  The economy was stuck in a rut of higher inflation and low or no growth which was called “stagflation”.  How high were interest rates?  The interest rate on a 3-month Treasury bill was 16.3% back in May 1981, and the prime rate topped out around 20.5% soon after.  For more information on the interest rates of this time period, please refer to this link:  http://www.mbaa.org/ResearchandForecasts/MarketEnvironment/TreasuryYields&BankRates,1980-83.htm. The Federal Reserve chairman back then, Paul Volcker (Fed chairman prior to Alan Greenspan and the same gentleman as the so-called “Volcker rule” of today), instituted a monetary policy based upon the teachings of the famous economist, Milton Friedman, from  the University of Chicago.  Friedman was really the start of monetarism.  Monetarism is simply the effect of the money supply in any economy on interest rates.  In general, as more money in the economy is available, interest rates will go down.  As less money is available, interest rates will go up.  Why?  Think about it in this manner.  If you have to get a loan from a family member and you are the only person asking for a loan, chances are your interest rate will be lower than if that same family member is asked by 15 different individuals.  So the Fed of that time period began buying all types of bonds on the open market.  The hope was that, as the money supply grew, interest rates would fall.  As interest rates fell, it would give more incentive to companies to take out loans to buy equipment and build plants and also to incent consumers to take out mortgages and buy homes or purchase consumer goods with credit cards.  Needless to say, the policy eventually worked.  It started what most refer to as the great bull market in bonds in roughly 1982.

There are only two ways you can make money when you own a normal bond.  First, you earn money from the coupon paid over the life of the bond.  Second, in a falling interest rate environment, you earn money by selling your bonds at a higher price.  Therefore, you can earn money from interest and capital gains.  In a rising interest rate environment, you can only earn money from the coupon.  What individual investors, and some money managers even, fail to realize is this simple fact of finance.  The yield on a 3-month US Treasury bill today is roughly 0.06%.  No, that is not a misprint!  The yield on these bills has gone down over 16% over the past 30 years or so.  The bond market has never seen such an extended period of falling interest rates.  Now interest rates did not fall in a straight line, but the trend has been toward lower interest rates for decades now.  That anomalous occurrence is coming (has come) to an end.  What can individual investors do then?

There are a number of things you can do to deal with the specter of rising interest rates.  I do not recommend any specific securities to purchase.  However, these investment strategies are something to consider.  They are as follows:

1)       Purchase an ETF that invests in floating rate fixed income securities

Investors are accustomed to bonds issued with a fixed coupon.  Yes, that is the most common.  However, there are other bonds that have an interest rate which is variable over the life of that bond.  Why would a company want to consider this?  There are two reasons why.  The first reason is that some companies need to borrow money from financial market participants constantly and for short periods of time.  The second reason is that certain companies that have liabilities which float over time.  Why?  They may have revenues that float over time as well.  It is much more complicated than that, but I do not want to get too bogged down into the details.  The most commonplace is a financial instrument known as commercial paper (CP) which is an example of the first reason.  CP is any financial instrument with a maturity of up to 270 days.  Firms, such as General Electric or Goldman Sachs, will sell CP to institutional investors for purposes of raising working capital.  It might be to pay short-term bills, or it might be to fund operations until money comes from previous sales at a later date.  Whenever CP is issued, the current interest rate prevails.  There are ETFs out there (only a few right now though, such as the iShares Floating Rate Note ETF – Ticker Symbol:  FLOT) that invest in CPs or other variations thereof.  The ETF will hold these fixed income securities with very short maturities.

2)      Purchase a target maturity bond ETF

 

When you purchase a bond mutual fund, you are pooling your money with other investors.  You do NOT own the bonds that the mutual fund invests in.  The mutual fund firm will calculate the value of their bond holdings each day and divide it by the number of shares outstanding to arrive at the net asset value (NAV) of the mutual fund.  The mutual fund will allow mutual fund investors to buy additional shares at that price or sell shares at that price.  Isn’t that just semantics and really is the same thing?  Absolutely not!  When you own a bond mutual fund, the holdings of the mutual fund are constantly changing.  You will see an SEC yield quoted and a weighted average maturity (WAM) of the bond mutual fund show in years.  If interest rates rise and you need to sell, the NAV of the bond mutual fund will go down.  Since the bond mutual fund needs to earn as much interest for its bond investors as possible, they will constantly take new inflows from investors, interest payments, and principal payments to invest in bonds issued today.  Therefore, the NAV of the bond mutual fund has to go down.  Since you are never holding the actual bonds to maturity, in a rising rate interest environment, you will receive interest payments from the bond mutual fund, but the value of the bonds held by the bond mutual fund will fall gradually, ceteris paribus.

 

Since interest rates have been falling for so long, most individual investors do not know this.  How do you combat that?  Well, BlackRock and other ETF providers have developed a new type of ETF which is based upon a target maturity.  How do they work?  You can purchase an ETF that might be in existence for five years, for example.  The ETF will invest in bonds with five years to maturity and then disband the ETF after five years.  Thus, as a bond investor, you are only subject to default risk.  As you will recall, default risk is the risk that an entity will not pay back the principal and interest on the bond.

 

3)      Purchase a floating rate instrument directly with a credit enhancement

There are fixed income securities sold which have interest rates that are set very frequently.  One of these instruments is known as a put bond or floater.  Put bonds or floaters are fixed income securities that are sold with an interest rate that is “reset” (i.e. adjusted to reflect current interest rates) on a periodic basis.  For example, they might be reset daily, weekly, or monthly.  Therefore, if you own a floater and interest rates go up, you will earn that new interest rate.  If interest rates go down, you will earn that interest rate.  You do not lose your original principal.  The interest rate is always chosen such that the floaters will sell at par.  Now owning a floater that is tied directly to a company, non-profit, charter school, municipality or other entity is a risky proposition.  You are subject to the credit risk of that entity, and they might default.  However, you can get around being exposed to the credit risk of that entity.  It is possible to purchase floaters (most are actually issued this way) which have a credit enhancement.  A credit enhancement is something that the obligor (i.e. the entity that issues the bonds and needs the money) purchases.  The types of credit enhancements are not that important; the concept is more significant for individual investors.  A floater with a credit enhancement means that, if the obligor defaults, the entity providing the credit enhancement will pay the principal and interest then.  Banks and bond insurers offer credit enhancements.  Therefore, when you purchase a floater with a credit enhancement, you are essentially exposed to the credit risk of the entity providing the credit enhancement and not the issuer (i.e. obligor).  Yes, you still have credit risk.

With that being said, there are floaters out there which have a credit enhancement from Bank of America, JP Morgan, US Bank, Wells Fargo, or Assured Guaranty.  The interest rate will be lower than the interest rate that the company itself would be able to get by accessing the bond market directly.  However, it will save you the time of trying to do a credit analysis of a small manufacturing firm with $50 million in annual revenues.  You can contact a middle market or larger full service brokerage firm to see if they offer put bonds or floaters for sale.  If they say no, but they offer Auction Rate Securities (ARS), it is not the same thing at all.  ARS have very different characteristics which rear their ugly head during liquidity crises like the financial crisis of 2008.

4)      Purchase mortgage back securities (MBS)

 

MBS may have a bad name from the financial crisis of 2008.  I am not referring to MBS that invest in subprime loans.  Subprime loans are speculative in nature.  I am talking about mortgages issued to individuals with good credit scores.  You can purchase an MBS issued by GNMA (Ginnie Mae), FNMA (Fannie Mae), or the FHLB (Freddie Mac).  The GNMA is a government sponsored enterprise (GSE), and FNMA and FHLB are sometimes referred to as “quasi” in nature.  These MBS essentially purchase thousands of mortgages that meet certain requirements in terms of size of the loan and credit of the borrower.  The mortgages are pooled together and sold to investors.

These securities are essentially pass through instruments.  Pass through instruments mean that the principal and interest payments flow through to the owners of the MBS.  Why might you want to own these?  In a rising interest rate environment, people with mortgages will not refinance their mortgages.  Why would you get rid of your 4% 30-year fixed rate mortgage and change to a 5% 30-year fixed rate mortgage?  As interest have been falling over the past several decades, it has been advantageous to refinance ones mortgage to a lower rate.  There are bond mutual funds that invest in MBS.  However, they fall subject to the same phenomenon that I mentioned above.  You are investing in a pool and do not own the MBS directly.  If interest rates go up and you need to sell that bond mutual fund, the NAV on the bond mutual fund will go down.  You can inquire at your local brokerage firm about MBS.  Now if your broker or Financial Advisor talks to you about collateralized mortgage obligations (CMOs) being the same thing basically, that is not the case.  CMOs do offer different characteristics which may be attractive, but they are much harder to analyze.

 

5)      Purchase bank loan ETFs with a floating rate

Most corporations borrow money from banks with a floating interest rate.  The interest rate adjusts at certain points and is calculated as a spread over some benchmark interest rate.  The most common benchmark is LIBOR and specifically 3-month LIBOR since many bonds reset quarterly.  Banks will package these loans together and sell them as syndicated loans to various interested institutional investors.  The advantage of these securities is that the interest rate will move up in a rising interest rate environment.  Additionally, most corporate treasurers will enter into an agreement, called an interest rate swap, to change the corporation’s payments into essentially a fixed interest rate.  The complexity of the interest rate swap is not important to discuss in great detail.  The point is that the corporation will then have a fixed interest payment and knows how much they will have to pay over time.  Thus, there will be no surprises if interest rates spike.  Therefore, you are exposed to the credit risk of the corporation for each bank loan.  Remember though that there is diversification in each of these syndicated bank loans because the ETF’s investment advisor will buy many bank loans to diversify the default risk of any one corporation.  One example of an ETF is offered by PowerShares and is called the PowerShares Senior Loan Portfolio ETF (BKLN).  A number of closed-end mutual funds offer similar products.  However, you should always be aware of the management fee assessed by the advisor overseeing the investments.  The expense ratio for many of these closed-end mutual funds is significantly above 1% which tends to offset the benefit of owning such a security because your investment returns will be lower as a result.

6)      Consider purchasing bonds issued by international firms or different countries

 

International firms and different countries have bonds that sell at different interest rates.  The nice thing about these bonds is that they are affected by different factors or the economy may be in a different stage than the US.  It is akin to the multiverse concept of Mohammed El-Erian of PIMCO.  El-Erian tells investors that the global economy is not simply something that is changing in one direction or in one way.  Rather, he states that different countries or regions can be moving in the same or opposite directions at any given time.  Furthermore, bonds issued outside of the US provide diversification to your investment portfolio.  It is the concept of not “having all your eggs in one basket”.  It is one other option for you.  There are countries which are in the process of lowering interest rates, so you can benefit from the interest rate payment and capital gains then.

 

One other thing you can do is to just reduce your duration.  Duration is simply the time it takes for your bonds to mature.  Under normal market conditions, bonds with shorter maturities have lower interest rates than bonds will longer maturities.  Believe it or not, that is not always the case though.  When short-term interest rates are lower than long-term interest rates, bonds with shorter maturities are less sensitive in terms of price movement than longer maturities.  I do not consider this an investment strategy really.  It is just a way of lowering risk.  As previously mentioned, when you hear financial professionals speak about searching for yield in other ways like investing in dividend stocks or MLPs (master limited partnerships), that is not investing in fixed income securities.  Given your risk tolerance, you should have a set allocation to fixed income securities.  You might decide to replace some of that allocation with a higher level of other stocks or other instruments.  However, that is a choice, and you are normally increasing the risk of your portfolio.  I am not saying that is good or bad.  I am simply saying that implementing this strategy comes with tradeoffs.

A New Paradigm for Investing Available on Amazon.com – FREE for Thanksgiving Holiday

27 Wednesday Nov 2013

Posted by wmosconi in asset allocation, Bernanke, bonds, business, Charlie Munger, Consumer Finance, Education, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial advisor fees, financial planning, GIPS, GIPS2013, Individual Investing, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investment advisory fees, investments, math, Modern Portfolio Theory, MPT, personal finance, portfolio, risk, statistics, stock prices, stocks, Suitability, volatility, Warren Buffett, Yellen

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Greetings to all my loyal readers of this blog.  In keeping with the Thanksgiving spirit, I have decided to make my first two books absolutely FREE for the rest of the week.  These two books on Amazon.com are available for download onto a Kindle.  Additionally, there is a Kindle app for iPhones and Android devices which is free to download.  Please feel free to check out the titles below.  I have provided links to make it easier.   My email address is latticeworkwealth@gmail.com.

The books are as follows:

1)      A New Paradigm for Investing:  Can Your Financial Advisor Answer These Questions?:

http://www.amazon.com/New-Paradigm-Investing-Financial-ebook/dp/B00F3BDTHW/ref=sr_1_1?s=books&ie=UTF8&qid=1381107823&sr=1-1&keywords=A+New+Paradigm+for+Investing+by+William+Nelson

2)       Spend 20 Hours Learning About Investing to Prepare for 20+ Years in Retirement

http://www.amazon.com/Learning-Investments-Prepare-Retirement-ebook/dp/B00F3KW9T2/ref=sr_1_1?s=books&ie=UTF8&qid=1379183661&sr=1-1&keywords=William+Nelson+Spend+20+Hours

The first book listed is normally $9.99 but available for FREE until November 30th.  The other book is normally $2.99, but it is also FREE for the same time period.

I would like to thank my international viewers as well.  I also wanted to especially thank some selected followers of my @NelsonThought and @LatticeworkWlth Twitter accounts (each of whom I would recommend following for the content and insight):

Followers on @NelsonThought:

The Wealth Report @wsjexperts – #wsjexperts

The Royce Funds @RoyceFunds

Research Magazine @Research_Mag

Barron’s Online @BarronsOnline

Vanguard FA @Vanguard_FA

Cleveland Fed Research @ClevFedResearch

Pedro da Costa @pdacosta

Muriel Siebert & Co. @SiebertCo

Roger Wohlner, CFP® @rwohlner

Ed Moldaver @emoldaver

Sylvia Maxfield @sylviamaxfield

The Shut Up Show @theshutupshow

Berni Xiong (shUNG) @BerniXiong

Followers on @LatticeworkWlth:

Euro-banks @EuroBanks

Direxion Alts @DirexionAlts

Charlie Wells @charliewwells

AbsoluteVerification @GIPStips

Investment Advisor @InvestAdvMag

Gary Oneil @GaryONeil2

MJ Gottlieb @MJGottlieb

Bob Burg @BobBurg

Melody Campbell @SmBizGuru

TheMichaelBrown @TheMichaelBrown

Phil Gerbyshak @PhilGerbyshak

MuniCredit @MuniCredit

D.J. Rob-Ski @DJRobSki

Quick and Effective Way to Learn about Investing in Stocks and Bonds

21 Wednesday Aug 2013

Posted by wmosconi in bonds, business, Education, finance, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks, Warren Buffett

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With the advent of the Internet and a plethora of financial news publications and television networks, there is an amazing amount of information available on investing and investments.  With that being said and obvious, why would you even read this?  Well, as I have said before, knowledge is power!  Now take a look at that cliché again but more closely.  Could you substitute the word information for knowledge?  Would it mean the same thing?  I am hoping you say that the answer is a resounding No.  Having access to information and having a lot of facts can be a detriment in some respects actually.  Is that how it feels with individual investing from your perspective?  You could spend months searching terms on the web, going to mutual fund websites, reading academic studies, keeping up with the current market moving news, and researching individual companies.  Would that really help you?  If you are waiting for someone to divine some wisdom for you in terms of when to invest and what to invest in, you will be waiting for many, many years.  Knowledge is taking information and constructing a framework that is actionable.

My recommendation to you is to read the following information in pieces.  Pick one or two items off the list to read per day. You can feel free to skip certain numbers if you are familiar with the concept already.  Let’s begin our discussion.

1)      How the Current News Affects Your Investments:

 

Learning how to invest in the financial markets can feel very overwhelming. Especially when you are retired or going to retire soon.  If you need to live on your “nest egg” and do not want to work again, where do you even begin?  I suggest that you never make rash decisions and adjust your entire portfolio based upon one day’s news.  For more information about that concept, please refer to this link:  https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/.

 

2)      Do I Even Have Enough Money to Make Investing Worthwhile?:

 

The short answer is YES.  The funny thing is that if you leave these decisions in the hands of a financial professional you will be spending hundreds of thousands of dollars.  If you have a 401(k) or 403(b) retirement plan, this matters to you as well.  For information on how investment advisory and asset management fees add up, please refer to the following link:  https://latticeworkwealth.com/2013/07/11/is-learning-about-investing-worth-it-how-about-224000-or-320000-worth/.

 

3)      Learning About How to Create a Simple Model Investment Portfolio:

 

How should you allocate your investments?  Which asset classes or sectors are the best to choose from?  Before you can tackle that issue, you should look at more general portfolio construction concepts.  You can find the link here:  https://latticeworkwealth.com/2013/07/16/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-1-of-2/.

 

4)      You Need to Properly Assess Your Risk Tolerance:

 

 If the stock market goes down 10% and you are so nervous that you sell, you probably should not invest in stocks at all.  You have a very low risk tolerance and will not sleep well.  The most important thing to learn here is that gain and losses are not proportional.  In fact, if you view the financial markets in that way, you probably should NEVER have more than 50% of your portfolio in stocks.  If you are worried about a bear market occurring (bear market is defined as a 20% or more drop), you probably should either not have any stocks or invest NO more than 20% of your money in the stock market.  For more information about how stock market fluctuations affect your investment portfolio, please go to this link:  https://latticeworkwealth.com/2013/07/08/double-edged-sword-of-the-power-of-compounding/.

 

5)      Differences Between Active and Passive Investing:

 

Once you understand how different annual returns affect the value of your portfolio, you can start learning about how well you are doing and how to set a realistic target return for your portfolio.  The first thing to do is to learn about the difference between active and passive investing.  There is a third, emerging category which too many say is passive investing.  It is called enhanced indexing.  For a longer discussion of the difference between active and passive investing, you can refer to the following:  https://latticeworkwealth.com/2013/07/05/difference-between-active-and-passive-investing/.

 

6)      Measuring How Well Your Investment Portfolio is Performing:

 

I would never assert that active or passive investing is better. However, I will say that you need to ensure that your chosen investing approach is working.  If you are choosing an active approach, your investment portfolio should be beating the market over the long run.  If it does not, why would you spend all the time searching for ways to beat the market? Refer to this link to understand more about how to properly measure the investment performance of your portfolio:  https://latticeworkwealth.com/2013/07/19/how-to-create-an-investment-portfolio-and-properly-measure-your-performance-part-2-of-2/.

 

7)      Investing in Individual Stocks and Bonds Should Be Left to Professionals:

 

If investing is starting to sound boring, it can be in a certain sense.  If you are looking to make 100% per year by buying stocks, you are going to be sorely disappointed.  It can seem so easy when you watch TV shows.  You also can lose a lot of money though.  The real pros spend hours upon hours learning about a particular company prior to buying the stock.  How much time?  Probably more than you would imagine.  Refer to this article:  https://latticeworkwealth.com/2013/08/09/you-purchased-a-stock-now-what/.

 

8)      Does Hiring a Financial Professional Make Sense:

 

After reading all this information, it may seem like it is better to let a financial professional manage your money.  If you are going to a financial professional to seek advice, you should know why you are going.  What can’t you do yourself?  Here is a unique way to think about this topic:  https://latticeworkwealth.com/2013/08/07/are-your-financial-advisors-fees-reasonable-here-is-a-unique-way-to-look-at-what-clients-pay-for/.

 

9)      List of Questions to Ask Any Financial Professional:

 

If you still think that going to a financial professional is the best option for you, I will not fault you for that.  What types of questions should you ask?  Here is a suggested list of questions:  https://latticeworkwealth.com/2013/08/12/important-list-of-questions-to-ask-when-selecting-a-financial-advisor/.

 

10)   Learn How a Financial Professionals Start in Investing Field Can Bias Them:

 

You will find that most financial professionals are biased based upon the time when they first started the profession.  Therefore, their advice might be “stuck in time” so to speak and not apply to your situation.  For a more detail explanation of this idea, you can refer to this post:  https://latticeworkwealth.com/2013/08/18/before-you-take-any-investment-advice-consider-the-source/.

 

 

11)   Understanding Why You Have Some Advantages over Institutional Investors:

 

You have different experiences and expertise in everyday life.  You can be more objective when it comes to investing and how the financial markets work.  Want to learn more:  https://latticeworkwealth.com/2013/08/11/why-did-i-choose-to-include-latticework-in-my-investment-firms-name-well-because-of-charlie-munger-of-course/.

 

12)   Learn That You Can Survive as an Individual Investor as Interest Rates Rise:

 

Do you keep hearing that higher interest rates are going to wreak havoc on the financial markets now and for years to come?  Should you not start investing until interest rates stabilize?  What if interest rates are going to continue to rise?  These are important questions, and I try to answer this question in the following post:  https://latticeworkwealth.com/2013/08/14/what-can-investors-do-in-a-rising-interest-rate-environment/.

You have finally reached the end of the list.  Do you feel smarter?  I sure hope you do.  My goal was to provide you with a framework to start your quest.  If you would like to learn more, I have a recommended reading list.  It will most likely take you 20 hours or so to read these books.  However, if you can save hundreds of thousands of dollars, would you say it is worth it?  Remember you are likely to live for over 20 years during your retirement years.  Here is the list:  https://latticeworkwealth.com/2013/07/23/spend-20-hours-learning-about-investments-to-prepare-20-years-of-retirement-2/.

Please feel free to send me your comments or other questions at latticeworkwealth@gmail.com.  You can post them directly on my blog as well.

What Can Investors Do in a Rising Interest Rate Environment?

14 Wednesday Aug 2013

Posted by wmosconi in bonds, business, finance, interest rates, investing, investing, investments, stocks, bonds, asset allocation, portfolio, investments, stocks

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bonds, business, finance, interest rates, investing, investments, retirement, rising interest rates, stocks

I probably get this question asked of me more than any other these days, especially by retirees.  Investors were once able to place money into bank certificate of deposits (CDs) or into money market funds and easily earn more interest than the rate of inflation.  Unfortunately, the financial crisis of 2008 changed all that in a major way.  While the events surrounding the dark days of the close of Lehman Brothers, the bailout of AIG, and the nearly $800 TARP program, were not the sole cause of this phenomenon, they certainly did not help.  The Federal Reserve (Fed) led by the chairman, Ben Bernanke, had to lower interest rates to avoid the credit and liquidity crisis of that time period.  The Fed brilliantly avoided a meltdown and depression.  The side effect is that financial market participants have gotten used to low interest rates.  You will hear the term “taper” thrown about now.  The Fed is not going to raise interest rates yet; rather, they are going to slow their purchase of Treasury instruments and mortgages on the open market.  They are not raising the Fed Funds rate (do not worry about what that is exactly), but, since they were buying approximately 70% of all US Treasuries issued, bond market investors are worried that this demand/supply imbalance will naturally cause interest rates to rise (interest rates have already gone up).  Well, if interest rates will be higher, shouldn’t that be better for bond investors?

The short answer is no.  Before we can answer that question and look at some investment strategies and potential purchases, we need to review how a bond works.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.  All bonds have what is referred to as credit risk.  Credit risk is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser know is interest rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest rate risk relates to the fact that interest rates may rise, while you hold the bonds.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.

How do bonds work in terms of prices?  Most bonds are issued at a price of 100 which is referred to as par.  Corporate bonds and Treasury notes/bonds are usually sold in increments of $1,000, and municipal bonds are sold in increments of $5,000.  The value of a bond is calculated by taking the current price divided by 100 and then multiplied by the number of bonds you own.  Bonds are sold in the primary market (when first sold to retail and institutional investors) such that the coupon (interest rate) is equal to the current interest rate prevailing in the marketplace at that time (sold at par which is 100).  Bonds can be bought and sold after that issue date though.  If interest rates rise or fall after issuance, how does the price of a bond adjust?  If interest rates go up, bond prices will go down.  If interest rates go down, bond prices will go up.  Why?  It is referred to as an inverse relationship.  Think about it this way.  If you own a bond that has a 6% coupon and interest rates rise to 8%, will you be able to see that bond to other investors?  The answer is no if you decide to hold firm to a price of 100.  Why should another bond investor buy a 6% bond when he/she can just buy a bond with very similar characteristics as yours and earn 8%?  The only way that you can sell your bond is to lower the price such that the bond investor will earn 8% over the course of that bond’s life until maturity which is when the company or other entity has to pay the money back in full).  Luckily for you, the process works in reverse as well though.  If interest rates go down to 4%, you have the advantage.  If you hold a bond with a 6% coupon as in the aforementioned example, bond investors will pay more than 100 in order to get that higher interest payment.  How much more?  Bond investors will bid the price up until the bond earns an equivalent of 4% until maturity.  Why is this important to you as an investor today?

Let’s take a quick look at history.  Most financial professionals are not old enough to remember or have been in business long enough to remember the interest rate environment back in the early 1980s.  In the early 1980s, interest rates on bonds were incredibly high compared to today.  The economy was stuck in a rut of higher inflation and low or no growth which was called “stagflation”.  How high were interest rates?  The interest rate on a 3-month Treasury bill was 16.3% back in May 1981, and the prime rate topped out around 20.5% soon after.  For more information on the interest rates of this time period, please refer to this link:  http://www.mbaa.org/ResearchandForecasts/MarketEnvironment/TreasuryYields&BankRates,1980-83.htm. The Federal Reserve chairman back then, Paul Volcker (Fed chairman prior to Alan Greenspan and the same gentleman as the so-called “Volcker rule” of today), instituted a monetary policy based upon the teachings of the famous economist, Milton Friedman, from  the University of Chicago.  Friedman was really the start of monetarism.  Monetarism is simply the effect of the money supply in any economy on interest rates.  In general, as more money in the economy is available, interest rates will go down.  As less money is available, interest rates will go up.  Why?  Think about it in this manner.  If you have to get a loan from a family member and you are the only person asking for a loan, chances are your interest rate will be lower than if that same family member is asked by 15 different individuals.  So the Fed of that time period began buying all types of bonds on the open market.  The hope was that, as the money supply grew, interest rates would fall.  As interest rates fell, it would give more incentive to companies to take out loans to buy equipment and build plants and also to incent consumers to take out mortgages and buy homes or purchase consumer goods with credit cards.  Needless to say, the policy eventually worked.  It started what most refer to as the great bull market in bonds in roughly 1982.

There are only two ways you can make money when you own a normal bond.  First, you earn money from the coupon paid over the life of the bond.  Second, in a falling interest rate environment, you earn money by selling your bonds at a higher price.  Therefore, you can earn money from interest and capital gains.  In a rising interest rate environment, you can only earn money from the coupon.  What individual investors, and some money managers even, fail to realize is this simple fact of finance.  The yield on a 3-month US Treasury bill today is roughly 0.06%.  No, that is not a misprint!  The yield on these bills has gone down over 16% over the past 30 years or so.  The bond market has never seen such an extended period of falling interest rates.  Now interest rates did not fall in a straight line, but the trend has been toward lower interest rates for decades now.  That anomalous occurrence is coming (has come) to an end.  What can individual investors do then?

There are a number of things you can do to deal with the specter of rising interest rates.  I do not recommend any specific securities to purchase.  However, these investment strategies are something to consider.  They are as follows:

1)       Purchase an ETF that invests in floating rate fixed income securities

Investors are accustomed to bonds issued with a fixed coupon.  Yes, that is the most common.  However, there are other bonds that have an interest rate which is variable over the life of that bond.  Why would a company want to consider this?  There are two reasons why.  The first reason is that some companies need to borrow money from financial market participants constantly and for short periods of time.  The second reason is that certain companies that have liabilities which float over time.  Why?  They may have revenues that float over time as well.  It is much more complicated than that, but I do not want to get too bogged down into the details.  The most commonplace is a financial instrument known as commercial paper (CP) which is an example of the first reason.  CP is any financial instrument with a maturity of up to 270 days.  Firms, such as General Electric or Goldman Sachs, will sell CP to institutional investors for purposes of raising working capital.  It might be to pay short-term bills, or it might be to fund operations until money comes from previous sales at a later date.  Whenever CP is issued, the current interest rate prevails.  There are ETFs out there (only a few right now though, such as the iShares Floating Rate Note ETF – Ticker Symbol:  FLOT) that invest in CPs or other variations thereof.  The ETF will hold these fixed income securities with very short maturities.

2)      Purchase a target maturity bond ETF

 

When you purchase a bond mutual fund, you are pooling your money with other investors.  You do NOT own the bonds that the mutual fund invests in.  The mutual fund firm will calculate the value of their bond holdings each day and divide it by the number of shares outstanding to arrive at the net asset value (NAV) of the mutual fund.  The mutual fund will allow mutual fund investors to buy additional shares at that price or sell shares at that price.  Isn’t that just semantics and really is the same thing?  Absolutely not!  When you own a bond mutual fund, the holdings of the mutual fund are constantly changing.  You will see an SEC yield quoted and a weighted average maturity (WAM) of the bond mutual fund show in years.  If interest rates rise and you need to sell, the NAV of the bond mutual fund will go down.  Since the bond mutual fund needs to earn as much interest for its bond investors as possible, they will constantly take new inflows from investors, interest payments, and principal payments to invest in bonds issued today.  Therefore, the NAV of the bond mutual fund has to go down.  Since you are never holding the actual bonds to maturity, in a rising rate interest environment, you will receive interest payments from the bond mutual fund, but the value of the bonds held by the bond mutual fund will fall gradually, ceteris paribus.  Since interest rates have been falling for so long, most individual investors do not know this.  How do you combat that?  Well, BlackRock and other ETF providers have developed a new type of ETF which is based upon a target maturity.  How do they work?  You can purchase an ETF that might be in existence for five years, for example.  The ETF will invest in bonds with five years to maturity and then disband the ETF after five years.  Thus, as a bond investor, you are only subject to default risk.  As you will recall, default risk is the risk that an entity will not pay back the principal and interest on the bond.

 

3)      Purchase a floating rate instrument directly with a credit enhancement

There are fixed income securities sold which have interest rates that are set very frequently.  One of these instruments is known as a put bond or floater.  Put bonds or floaters are fixed income securities that are sold with an interest rate that is “reset” (i.e. adjusted to reflect current interest rates) on a periodic basis.  For example, they might be reset daily, weekly, or monthly.  Therefore, if you own a floater and interest rates go up, you will earn that new interest rate.  If interest rates go down, you will earn that interest rate.  You do not lose your original principal.  The interest rate is always chosen such that the floaters will sell at par.  Now owning a floater that is tied directly to a company, non-profit, charter school, municipality or other entity is a risky proposition.  You are subject to the credit risk of that entity, and they might default.  However, you can get around being exposed to the credit risk of that entity.  It is possible to purchase floaters (most are actually issued this way) which have a credit enhancement.  A credit enhancement is something that the obligor (i.e. the entity that issues the bonds and needs the money) purchases.  The types of credit enhancements are not that important; the concept is more significant for individual investors.  A floater with a credit enhancement means that, if the obligor defaults, the entity providing the credit enhancement will pay the principal and interest then.  Banks and bond insurers offer credit enhancements.  Therefore, when you purchase a floater with a credit enhancement, you are essentially exposed to the credit risk of the entity providing the credit enhancement and not the issuer (i.e. obligor).  Yes, you still have credit risk.  With that being said, there are floaters out there which have a credit enhancement from Bank of America, JP Morgan, US Bank, Wells Fargo, or Assured Guaranty.  The interest rate will be lower than the interest rate that the company itself would be able to get by accessing the bond market directly.  However, it will save you the time of trying to do a credit analysis of a small manufacturing firm with $50 million in annual revenues.  You can contact a middle-market or larger full service brokerage firm to see if they offer put bonds or floaters for sale.  If they say no, but they offer Auction Rate Securities (ARS), it is not the same thing at all.  ARS have very different characteristics which rear their ugly head during liquidity crises like the financial crisis of 2008.

4)      Purchase mortgage back securities (MBS)

 

MBS may have a bad name from the financial crisis of 2008.  I am not referring to MBS that invest in subprime loans.  Subprime loans are speculative in nature.  I am talking about mortgages issued to individuals with good credit scores.  You can purchase an MBS issued by GNMA (Ginnie Mae), FNMA (Fannie Mae), or the FHLB (Freddie Mac).  The GNMA is a government sponsored enterprise (GSE), and FNMA and FHLB are sometimes referred to as “quasi” in nature.  These MBS essentially purchase thousands of mortgages that meet certain requirements in terms of size of the loan and credit of the borrower.  The mortgages are pooled together and sold to investors.  These securities are essentially pass through instruments.  Pass through instruments mean that the principal and interest payments flow through to the owners of the MBS.  Why might you want to own these?  In a rising interest rate environment, people with mortgages will not refinance their mortgages.  Why would you get rid of your 4% 30-year fixed rate mortgage and change to a 5% 30-year fixed rate mortgage?  As interest have been falling over the past several decades, it has been advantageous to refinance ones mortgage to a lower rate.  There are bond mutual funds that invest in MBS.  However, they fall subject to the same phenomenon that I mentioned above.  You are investing in a pool and do not own the MBS directly.  If interest rates go up and you need to sell that bond mutual fund, the NAV on the bond mutual fund will go down.  You can inquire at your local brokerage firm about MBS.  Now if your broker or Financial Advisor talks to you about collateralized mortgage obligations (CMOs) being the same thing basically, that is not the case.  CMOs do offer different characteristics which may be attractive, but they are much harder to analyze.

 

5)      Consider purchasing bonds issued by international firms or different countries

 

International firms and different countries have bonds that sell at different interest rates.  The nice thing about these bonds is that they are affected by different factors or the economy may be in a different stage than the US.  It is akin to the multiverse concept of Mohammed El-Erian of PIMCO.  El-Erian tells investors that the global economy is not simply something that is changing in one direction or in one way.  Rather, he states that different countries or regions can be moving in the same or opposite directions at any given time.  Furthermore, bonds issued outside of the US provide diversification to your investment portfolio.  It is the concept of not “having all your eggs in one basket”.  It is one other option for you.  There are countries which are in the process of lowering interest rates, so you can benefit from the interest rate payment and capital gains then.

 

One other thing you can do is to just reduce your duration.  Duration is simply the time it takes for your bonds to mature.  Under normal market conditions, bonds with shorter maturities have lower interest rates than bonds will longer maturities.  Believe it or not, that is not always the case though.  When short-term interest rates are lower than long-term interest rates, bonds with shorter maturities are less sensitive in terms of price movement than longer maturities.  I do not consider this an investment strategy really.  It is just a way of lowering risk.  Now when you hear financial professionals speak about searching for yield in other ways like investing in dividend stocks or MLPs (master limited partnerships) that is not investing in fixed income securities.  Given your risk tolerance, you should have a set allocation to fixed income securities.  You might decide to replace some of that allocation with a higher level of other stocks or other instruments.  However, that is a choice, and you are normally increasing the risk of your portfolio.  I am not saying that is good or bad.  I am simply saying that implementing this strategy comes with tradeoffs.

 

If any of you have comments on investing in a rising interest rate environment or more questions, please feel free to add them to this post.  You also may feel free to send me an email at latticeworkwealth@gmail.com.

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