bonds

Letters to Our Children #7: Know Your Assets

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Our previous letters have talked about the three buckets you have for your money: short term, long term, and in-between. Each one serves different purposes. Today we will dive into the details of the different assets you can put into those buckets.

The simplest and most familiar asset class is cash. It has a fixed value and is completely liquid, available to spend any time you want. While the change jar on your counter is not exactly an investment, you can put it in a savings account and generate a little bit of interest. Short term certificates of deposit and Treasury bonds can also be considered cash equivalents as long as the maturity is within a few months. They can not be spent without notice, but could be turned into cash quickly for major expenses.

Longer duration CDs and bonds fall into another asset class: fixed income. You can expect higher interest by accepting longer maturities and shakier credit ratings, so fixed income will generate more income than cash. There is a reason for this: your risk exposure also increases. Buying bonds with poorer credit quality increases the risk that the borrower will go broke and default. And if you lock in your money long term at a fixed interest rate, you will be in for pain if inflation and interest rates rise. This can make fixed income investing difficult in a low interest rate environment.

The third main asset class are equities, or stocks. These are what you are thinking of when you talk about the stock market. Stocks represent partial ownership in a given company. Exchange-listed stocks are liquid, and owning a share of a rapidly growing company offers the potential for higher returns. But again, these returns come at a trade-off of volatility and risk. There is no fixed face value or interest rate on equities, and the market price can change rapidly.

There are also alternative investments outside of these three main asset classes. Most alternative investments are tangible assets such as real estate or physical commodities. These assets are largely speculative: they do not grow on their own and do not pay out interest. As such, we do not generally recommend them.

Different assets are useful for each bucket. Your short-term bucket needs both liquidity and stability, so it should be mostly or entirely in cash. Your long-term bucket can tolerate more volatility and will probably want to seek higher returns, so equity investments may be more appropriate. The intermediate-term bucket can hold a range of investments, although you will probably want a healthy proportion of cash and short-term investments.

Your financial situation is unique, and there is no one-size-fits all approach. Clients, if you want to discuss what is in your buckets, please call or email us.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

CDs are FDIC Insured to specific limits and offer a fixed rate of return if held to maturity.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Stock investing involves risk including loss of principal.

Alternative investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

It Works Until It Doesn’t

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Money poured into tech stocks in the late 1990s. Then it went into residential real estate in the middle 2000s. No wonder: prices marched higher, year after year—until they didn’t.

We humans usually believe that recent trends will continue. When friends and neighbors and coworkers are getting in on the action, it is easy to join them.

A powerful narrative that seems to be creating a lot of wealth is hard to resist. “We have entered a new era.” “This time is different.” “You can’t lose money in real estate.”

Popularity pushes values farther and farther away from the underlying economics, and a reversal usually follows. The bubble pops; a great number of people are surprised. Some end up with losses instead of the gains they felt sure about making.

Our analysis suggests that a new kind of bubble is upon us. The zero interest rate policy or ZIRP of the Federal Reserve Board for most of the past decade led to a scramble for yield. This moved the valuation on many kinds of investments that pay income into very rich territory, in our opinion.

For example, we were recently pitched on a “cash substitute” with a 5% yield, in a supposedly liquid form. Sounds great, right? Perhaps too good to be true.

Indeed, when we took the proposition apart, we found it was made largely out of corporate bonds in financially weak companies—junk bonds, in other words. To make matters worse, the manager pursued opportunities in a thinly-traded part of the market—odd lots, small amounts of each bond that are unattractive to other buyers.

This idea will work until it doesn’t. When the next economic slowdown creates cracks in the theory, investors who believed they owned a “cash substitute” may be sensitive about losses of any size. As they cash out, the manager may be forced to sell into a market with even fewer buyers.

The silver lining for us is that dislocations bring opportunities. Prices overshoot in both directions. One of our roles is to try to spot these anomalies, and figure out which ones are attractive opportunities for you. (We have no guarantees of success in this.)

Clients, if you would like to talk about this or anything else, please email us or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

All investing, including stocks, involves risk including loss of principal.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

 

Change is Still Constant

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We wrestled for a long time with the issue of how to build portfolios in a zero-interest environment. The crushing of interest rates distorted values in the investment markets. The old ways of thinking carried too much risk, in our opinion. (When interest rates rise, bond prices tend to fall.)

So about a year ago, we settled on the concept of ballast. This enables us to tailor portfolios to address individual preferences. Different clients can have differing portfolios, while retaining common elements that enable efficient management.

Ballast refers to holdings that might be expected to fall and rise more slowly than the overall stock market. Ballast may reduce the volatility of the overall portfolio, thereby making it easier to live with. And it may serve as a source of funds for buying bargains when the market seems to be low. We’ve been able to put this thinking into effect.

A little over a year ago, monetary policy in the U.S. shifted from zero interest to a plan to raise interest rates over time. As we foresaw, this has not been great for bond prices. But now U.S. Treasury securities actually have a little bit of a yield these days, with short term maturities recently reaching over 1% for the first time in years.1

The return of interest rates on lower volatility, short term, liquid balances makes it easier to hold cash and cash substitutes as part of a portfolio structure. As interest rates continue to normalize, returns on cash could increase.

We like the portfolio framework, shown above, that we developed a year ago. We will continue to assess clients that may be suitable for this strategy. As the economic environment changes, we will review the need to adjust the tactics used in each layer of the portfolio. Change is still constant.

We will update you soon on the trends we are seeing in our long term core investments. Clients, if you would like to talk about this or anything else, please email us or call.

1Effective Federal Funds Rate. Federal Reserve Economic Data, Federal Reserve Bank of St. Louis. Accessed March 2018.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Tactical allocation may involve more frequent buying and selling of assets and will tend to generate higher transaction cost. Investors should consider the tax consequences of moving positions more frequently.

When the Tide Goes Out

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A lot of money talk uses words that evoke water: liquidity, a wave of buying or selling, money sloshing around. We have described large sums of money going into a particular sector as a tsunami.

The extreme actions taken by central banks around the world, instead of goosing economic activity, have actually caused people to become more cautious, spend less, and save more money. The primary effect has been a huge increase in demand for supposedly safe bonds and other fixed income investments.

In our lifetimes, there have been several investment manias that featured large sums of money pouring into a single sector or type of asset. The real estate boom of the early 2000’s is fresh in our minds. The technology and growth stock boom of the late 1990’s grew into a classic bubble.

The biggest financial tsunami in history is the one we are in right now: the rush into bonds. Bloomberg recently reported on the International Monetary Fund’s concern over the global $152 trillion debt pile. The key for us is to understand how this happened: people and institutions demanded bonds in unprecedented quantities. Interest rates reached extremely low levels as the tsunami of money flooded the fixed income markets.

The market will supply whatever is demanded. Companies that didn’t need money borrowed, simply to lock up financing for years or decades ahead at the most favorable prices in history. Some consumers are taking on mortgage debt at the lowest interest rates ever just because they can. Governments around the world see little cost to borrow, so finance their deficits.

The global debt pile is like a coin with another side. That other side is the unparalleled tsunami of money into bonds and fixed income. Investors who believed they were being prudent have ramped up their holdings in the supposedly safe kinds of investments.

Some say you cannot spot a bubble when it is happening. We disagree. What cannot be known is when the bubble pops. To get back to our water words, we can’t know when the tide will go back out.

We believe that bonds will be punished severely in price when the tide goes out. There will be collateral damage to bond substitutes and other income investments. And other assets may rise in price, as money returns from the bond bubble and goes back into other, now-neglected sectors. Peril and opportunity go together.

This issue is the key to the investment markets for the next few years. We know that opportunities and threats are always present, and you know we’ll be working hard to sort out which is which. If you have questions about how this applies to your situation, please write or call.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

Can Investment Arithmetic Buy Your Groceries?

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One of the enduring concepts used by successful retirees and endowment funds alike is the idea that portfolio income is what pays the bills, not portfolio market value. Market values change from day to day and minute to minute. As we’ve written before, “Own the orchard for the fruit crop.” It helps one’s sanity to focus on the fruit crop (portfolio income), not the value of the orchard (market value.)

Imagine a company, XYZ Widgets, whose shares trade for $100 per share and pay annual dividends of $3 (a yield of 3% annually on the stock price.) The price of XYZ stock can go up or down in the short term, but historically there is little correlation between changes in the market price and changes in the dividend.

Let’s imagine that XYZ stock falls to $50. While companies may sometimes cut dividends they are often reluctant to do so, so XYZ may continue paying $3 per share. Despite the drop in stock price, shareholders would still get the same $3 with which to pay their bills. In fact, XYZ may then be an even better prospect for income investors: at $50 a share, that $3 dividend now gives them a 6% annual yield on their cost.

The same applies to bonds and other income-generating investments. A 5% bond issued at full price may be sold off down the road for cheaper if bondholders are worried about the company’s prospects for making good on their debts. If you bought that 5% bond for 50 cents on the dollar you would receive the same amount of interest, but now it would be equivalent to a 10% return on your investment each year. If the company recovered and was able to pay full price at maturity, you would receive 100 cents for every 50 cents worth of bonds you bought at a discount.

This arithmetic is one reason why investors who “buy low” often have an edge. A market downturn can have alarming effects on your retirement savings. But while the purchasing power of your retirement funds may go down, falling prices also allow you to buy income investments at higher yields.

There is no guarantee that you will be able to find high quality investments at such steep discounts, or that discount investments will turn out to be high quality. These examples are intended to illustrate the arithmetic of portfolio income, not as advice to any individual to buy a specific investment.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with your financial advisor prior to investing.

The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Investing involves risk including loss of principal. No strategy assures success or protects against loss.