fixed income

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.

When the Tide Goes Out

© Can Stock Photo Inc. / RobGooch

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.

The Medicine is Worse than the Disease

© Can Stock Photo Inc. / nebari

Monetary authorities took extreme measures during and after the financial crisis. These policies failed in their stated goal. More importantly, they have the potential for much mischief in the portfolios of the unwary in the months and years ahead.

Fed Chairman Ben Bernanke made it clear that the role of zero interest rates and Quantitative Easing was to push money into productive investments (or “risk assets”) that would help the economy grow. Instead, the biggest tidal wave of money ever flooded into supposedly safe assets, like Treasury bonds. Money flows into US stocks disappeared in the crisis, and basically have never come back. Zero interest worked exactly opposite the way it was supposed to. This obvious reality is totally ignored by the central bankers.

Current Federal Reserve Chair Janet Yellen continues to parrot the party line. Progress toward undoing the mistaken crisis policies has been excruciatingly slow. And the potential for damage to safety-seeking investors continues to mount. Similar policies, or worse, are in effect around the world.

Standard & Poor’s recently issued a report stating that corporate debt would grow from a little over $50 trillion now to $75 trillion by 2021, globally. Bonds are the largest single form of corporate debt, which is how investors are affected. This isn’t happening because corporations are investing so much money in new plants and equipment and research. It is merely meeting the demand of safety-seeking investors for places to put money. We think of this as “the safety bubble.” It appears to be the biggest bubble in history.

Standard & Poor’s is warning of future defaults from companies that borrowed too much money at these artificially low interest rates. Our concern is that when interest rates inevitably rise, people locked into low interest investments will see large market value losses even if their bonds are ultimately repaid.

We’ve written about the impact of higher inflation on today’s supposedly safe investments. Now the warning from S&P highlights another risk. The distortions created by counter-productive monetary policy are growing.

Of course, we believe our portfolios are constructed to defend against these risks, and to profit from the artificially low interest rates. We will continue to monitor these and other developments. If you have questions or comments, please email or call us.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

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.

Deflated Inflation Expectations

© Can Stock Photo Inc. / NataliyaShirokova

We’ve written before about inflation and its corrosive effect over time. The topic has become much more timely because of two developments:

1. The prospects for inflation have gone up with the large increase in the price of oil and other forms of energy. We could potentially see annual inflation indicators top 3% within the next six months.

2. Money continues to flood into long-term low rate fixed income, as safety-seekers buy bonds yielding in the 1 and 2 percent range.

It appears these trends are in for quite a collision. Our first principle is ‘Avoid stampedes in the markets.’ So we suspect that the safety-seekers may not end up with what they were seeking. If today’s 2% bond is repriced in a 3% world, capital losses may result.

Human tendency is to expect current conditions and trends to continue. So the prospects for inflation are pretty much ‘out of sight, out of mind,’ since we have not had much inflation for quite a while. But the large increases in the price of oil and other raw materials could potentially generate annual inflation rates in excess of 3% over the next few months. Crude oil, for example, bottomed at $28 per barrel in February 2016. Current prices in the $40’s, if they persist until February 2017, will exert a lot of upward pressure on inflation.1

One would expect that investors locked in at 2% yields when inflation is running at 3% will not sit still for it. The mystery is, will the stampede of money into bonds come stampeding back out if safety-seekers find losses on their supposedly safe investments?

The potential for profit lives in the gap between expectations and unfolding reality. We believe inflation expectations and corresponding investment yields are off the mark. We have no guarantees, but our opinion is inflation will be up and bond prices will be down in the months and years ahead. If you would like to talk about the ramifications on our portfolios or yours, write or call.

1Oil prices retrieved via Federal Reserve Bank of St. Louis


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Bond yields are subject to change. Certain call or special redemption features may exist which could impact yield.

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

Inflated Expectations

© Can Stock Photo Inc. / smuay

Back in 1970, gas was 25 cents a gallon and you could buy a liter of Coca-Cola for 15 cents. We all know that money is not what it used to be. When planning for the future, we need to remember that our money is not always going to be what it is now, either.

Conventional monetary policy aims for “normal” levels of inflation in the low 2-3% range per year. That may not sound like much, but it adds up. At this level of inflation, prices double approximately every 30 years. If you bury a dollar in the ground and dig it back up in 30 years, you can expect it to only buy half of what it could buy today.

For some people, this is fantastic news. If you take out a mortgage to buy a house, it gradually becomes easier for you to pay it off over the lifetime of the loan. At the end of a 30 year mortgage you’ll still be paying off the same amount, but the prices of everything else (including your wages) will have doubled. A small amount of inflation gives people incentives to invest and take risks with their money, helping make the economy more productive.

If you’re planning to retire on fixed assets, however, inflation poses a serious threat to you. With advances in healthcare it’s not unreasonable to expect new retirees to live another 30 years. After thirty years of inflation your retirement assets will only buy half as much in groceries and rent. Retirement funds that seem generous when you’re 65 may leave you in dire straits when you’re 95.

The simplest way to fix this is just to have more money than you’ll ever need—it doesn’t matter if your money loses spending power if you have even more money to spend. Of course, this is easier said than done! Saving diligently and spending wisely will only take you so far. If your retirement bucket isn’t big enough to weather inflation, you need to be able to grow your bucket. A balanced growth and income portfolio can potentially give you retirement income while still having some growth possibilities.

There are no guarantees; the future is full of uncertainty. Growth-oriented holdings can be volatile, and it takes steady nerves to watch the value of your retirement holdings going up and down. If you can tolerate it, though, including growth holdings as part of your retirement portfolio can give you a chance to stay ahead of inflation.


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

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.