Tag Archives: investments

Average returns distort retirement income assumptions

This post continues a series of thoughts on investment returns and misleading aspects of average annual returns. The articles started with my Tacoma News Tribune column June 4 and extended to include this post about cost basis returns.

Here, we look at how the sequence of investment returns becomes much more important when an investor has shifted to withdrawing assets rather than accumulating a retirement nest egg.

When you are accumulating assets, the order of annual returns doesn’t matter. Take the S&P 500 return of the past 10 years and apply it to an investment in any order you like.

2003

28.50%

2008

-37.02%

2004

10.74%

2009

26.49%

2005

4.77%

2010

14.91%

2006

15.64%

2011

1.97%

2007

5.39%

2012

15.82%

For example, if you start with $500,000 and apply the annual returns in sequential order, reverse order or any random mix, you will end 2012 with a balance of $982,188.30.

However, you cannot use the average annual return over this period and get the same result. The average annual return over this 10-year period is 8.72%. If you apply annual 8.72% compounded growth to the initial $500,000 you would have an ending balance of $1,153,624 – a positive difference of $171,436.

If you evaluate an investment by reviewing the average annual return, you can be easily led astray of reality. Even more problematic, if you apply an average annual return assumption to a retirement income projection, you could receive wildly misguided output.

The order of returns becomes much more important in the withdrawal years.

Consider this variation of the earlier example.

Start with a nest egg balance of $500,000 and take out $25,000 (5%) at the start of each year. For simplicity’s sake we won’t consider adjusting the withdrawals upward each year to offset inflation. Since you need the $25,000 for year one, the balance left invested is $475,000.

If we use the average annual return assumption, the balance at the end of 2012 is $721,159. Even though we removed $25,000 per year ($250,000 total), our ending balance increased nicely due to the assumed 8.72% annual return that was achieved from 2003-2012.

Now, not only is the average annual return misleading, but the sequence of those returns becomes important. If we do the math with the actual order that was experienced, at the end of 2012, the account balance is $611,575 – almost $110,000 less.

If we reverse the order of returns, the ending balance is $565,801.

What if we move that ugly -37.02% return from 2008 up to the first year of the assumed retirement (2003 in this case)? Even though the average return over the 10-year period remains the same, the order is detrimental to long-term financial security. After 10 years, the account balance has dropped to $440,976 – 39% less than the projected balance if simply applying the average annual return each year.

Return sequence A Return sequence B Return sequence C Return sequence D
8.72% return each year Actual order of S&P 500 returns 2003-2012 Reverse order of S&P 500 returns 2003-2012 Negative return first (2008’s -37.02 switches places with 2003 return)
End balance End balance End balance End balance
$721,159 $611,575 $565,801 $440,976

Stretch these examples out over 20+ years – more reflective of a full retirement – and you will see that even if you achieve the same average annual return over time, it’s possible that one order of returns could run out of money while a different sequence could more than offset the annual withdrawals with exceptional growth.

KEY TAKEAWAYS

  • Average annual returns are not a good proxy for the actual investor experience.
  • Using retirement calculators that rely on a simple average annual return assumption can be problematic. It’s important to use sophisticated enough analysis to generate many variations of return patterns. This way you can understand a range of possible asset projections and determine a probability that your money will last longer than you do.
  • This example uses an investment only in the S&P 500 Index of large U.S. stocks. It is not a globally diversified portfolio and is not reflective of an investment strategy that we would recommend, either while accumulating assets or withdrawing from them.
  • A globally diversified portfolio may have lower returns over time but also could be expected to experience less downside risk. This type of portfolio would not be expected to continue growing at the rate demonstrated here while withdrawals were also being made.

Have you determined how much money you’ll need to retire without too much concern about the impact of market returns?

How have you projected future account growth and the impact of withdrawals?

~ Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

 

Past performance is not indicative of future investment results.
The S&P 500 is an index of 500 U.S. stocks selected by a committee and meant to reflect the large-cap U.S. stock market.
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Cost basis returns understate performance

Continuing the theme of my June 4 column in the Tacoma News Tribune, here’s another element of evaluating investment returns that can be confusing:

In some cases, particularly with mutual funds that own bonds and pay out regular income, you could see performance reports that show investment gains while in actuality, you’ve invested more in the fund than it is currently worth.

This is sometimes a function of measuring your cost basis return. In taxable brokerage accounts (non-IRAs) your monthly statement identifies the month-end market value of a position as well as the cost basis. The basis is the total amount you have invested in the fund over time adding together the initial contribution, any subsequent contributions or withdrawals and any reinvestment of income paid out by the fund.

Here’s a simplified example of how a fund company could report positive performance while you actually have a capital loss (higher cost basis than current market value).

Imagine you make investment of $10,000 on the first day of year. You buy 1,000 shares at $10 each. The fund pays out income of $50 per month. That income is reinvested in five new shares each month, all purchased at $10. At the end of the year, you have 1,060 shares at $10 each for a total market value of $10,600.

The price return/capital appreciation of the fund for the year was zero. The share price started at $10 and ended at $10. The total return (price change plus income paid out) was 6% (you earned $600 on a $10,000 investment), in this case all income. Given this math, it’s possible for the price of the investment to go down but still have a positive total return. Imagine that the fund dropped to $9.90 per share at the end of the year. The 1,060 shares would be worth $10,494. The total return would be 4.94% (6% income return reduced by the -1% price return).

Now if this investment is in a taxable account (not a retirement account) you would also have a cost basis return that differs from the average annual return.

Going back to the example above, the fund produced a 6% return increasing in value from $10,000 to $10,600. Even though this $600 is new money to you, by reinvesting it in new shares of the fund, this amount is added to your cost basis which is now also $10,600. You are even with what you have contributed to the account. There was no growth in price per share but the fund can report a 6% total return.

Complicating this scenario is the fact that this is a taxable account. The $600 of income received was fully reinvested but you are responsible for paying tax on this income, reducing the after-tax return. This is one reason why it’s usually preferable to hold bond funds in a tax-deferred account like an IRA instead of in a taxable account.

This is also an example of how income is nice to have in a portfolio but ultimately the total return of capital appreciation plus income is more important where portfolio growth is required.

~ Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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How will the next generation manage wealth?

Reading the May edition of Registered Rep magazine, a couple nuggets of recent research caught my eye.

  • “Six out of 10 wealthy people believe that their children are not well prepared to handle an inheritance.”  – U.S Trust Insights on Wealth and Worth
  • “Lifetime value of what baby boomers stand to inherit: $8.4 trillion.” – Boston College, “Inheritance and Wealth Transfer to Baby Boomers”

Over the next few decades a lot of baby boomers will inherit from their parents. Some will inherit large sums. Many of these people won’t be prepared to manage these assets intelligently.

From our perspective managing an inheritance is no easy task. Most individuals have no formal training in wealth management. There is no school which combines classes in personal investing, estate and legal asset protection tactics, advanced accounting and asset protection tactics with training on how to work with other members of the family to manage, and sometimes give away, wealth.

Most baby boomers who have inherited know that they can hire professionals to help them with the various aspects of this responsibility. Accountants can do their taxes and recommend tax management strategies, attorneys can create wills and other asset protection devices, financial advisors can help manage the assets, etc.

The issue that most people have is coordinating all of these professionals to make sure that they are working together to provide the best solution for their situation.

In our experience, many advisors can offer excellent financial advice from their perspective, but that advice looks less useful when it is reviewed against the overall objective of the client.

We think that people who have inherited assets should ask the following questions when considering the management of this money:

  • What is the long-term goal for these assets?
  • What is the hierarchy for wealth management decisions? For instance, for some, wealth protection is much more important than reducing taxes.
  • Who will make decisions about these goals and how will they be made?

Once they have the answers to these questions, they need to determine if they are comfortable managing their investments themselves or if they should work to find a person who can help them coordinate the management of experts with the goal of better managing this process.

~ Allyn Hughes, CFP®, CLU®, ChFC® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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Stock market rally justified by earnings, reasonable market value

The U.S. stock market turned in a strong first month of 2013 as the S&P 500 gained 5.2%.

This coming after a 16% total return for the S&P 500 in 2012 has some wondering if the rally is close to exhaustion.

While we don’t expect double-digit gains to build throughout 2013, we don’t think the market is close to being overheated either. We’re not making a forecast but thought it might be helpful to see a couple charts that help explain value of the market. Of course, these charts and analysis portray a rational view and markets can become irrational from time to time. There’s no sense in trying to predict a return for the year or any short time frame. As Warren Buffett has said: “short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also grown-ups who behave in the market like children.” However, we can confidently forecast that you’ll want stock market exposure over long periods regardless of short-term results.

So on with the show.

Two charts from presentations I’ve watched recently demonstrate how market prices may have room to grow to catch up with the reported earnings of U.S. companies.

This view of S&P 500 inflection points is from J.P. Morgan. Look at the first peak, March 2000. A measure of market value is the price/earnings ratio of the market. What price are investors paying for each dollar of company earnings. At this euphoric time, the P/E ratio (based on forward earnings expectations) was over 25. It had become excessive and the market needed a cleansing to get back down to a P/E ratio closer to historic norms.

The recovery from the internet bubble peaked in October 2007. At that time, even though the price of the S&P 500 had surpassed the March 2000 price, the price/earnings ratio was 15.2, 40% below the 2000 P/E ratio. The market had not been bid up by speculative investors quite like in 2000. Of course, that didn’t stop a significant bear market due to the credit crisis and recession of 2008.

So where are we at today? The recovering S&P 500 has crossed a price of 1,500 again. But corporate earnings have also grown at a strong rate. This means the price is generally justified by the earnings. The forward price/earnings ratio at the end of 2012 was just 12.5, roughly half of the irrational exuberance peak of March 2000.

Add January’s price appreciation and the forward P/E ratio is about 13.3.

SP500InflectionPoints

The combination of earnings and investor confidence in the trajectory of those earnings will be critical to determining how long this rally will continue.

Here’s another view – from economist Fritz Meyer – demonstrating how the market price has some catching up to do if history can be trusted as a guide.

SPearningsJan2013

 

The black line of the S&P 500 price over the past 25 years has generally kept an edge above the red line (S&P 500 earnings). It’s clear to see however, that the late 1990s S&P 500 value and the 2007 value grew disconnected from the reality of earnings.

Since 2010, though, good corporate earnings have not been reflected in stock prices that grow at the same pace. The S&P 500 black line has spent most of the time below the earnings line. Look at projected earnings going forward for 2013 and 2014 and you could rightfully judge that there is justification for stock prices to continue growing without getting too expensive.

Recovering investor confidence could have something to do with that. If cash flows shift back toward stocks and away from the bond market, gains may continue.

Of course, there are many potential shocks to the global economy which could erode emerging confidence and disrupt the growth in corporate earnings. But at this point, even significantly lower earnings would justify the current value of the S&P 500.

The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s.

  • How confident are you in the stock market?
  • Have you changed the weight of stocks in your portfolio recently?

~ Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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Retirement decisions timeline

Age 49 and under. 401K contributions are limited to $17,500 in 2013. Traditional IRA and Roth IRA contributions limits are $5,500.

The income limit (AGI) for contribution to a Roth IRA in 2013 has a phaseout range from $178,000 to $188,000 for married-filing-jointly taxpayers and $112,000 to $127,000 for single taxpayers.

The income limit to make a tax-deductible contribution to a Traditional IRA in 2013 has a phaseout range from $95,000 to $115,000 for married filing jointly (if covered by an employer retirement plan also) and $59,000 to $69,000 for singles. If you are not covered by an employer retirement plan, tax-deductible contributions can be made up to $178,000 of AGI for married filers.

Age 50 and over. 401K contributions are limited to $23,000 with catch up provision. IRA or Roth IRA contributions levels are $6,500 with catch up provision.

Age 55. If you leave your job after age 55, you can begin to take 401K distributions from your former employer’s plan without paying any penalties. Income tax will still be due on the amount of the distribution.

Age 59½. Distributions from IRAs may be made without penalty. Income tax will still be due.

Age 61. Think about when you want to retire and determine when you want to start receiving Social Security if you will be eligible for it. The most likely reasons to start receiving it are: lack of employment or under-employment, lack of income from investments, or a shorter-than-average life expectancy.

Age 62. Eligibility for Social Security begins. The Social Security Administration no longer sends an annual estimate of your expected benefits. You will have to access the estimate at www.ssa.gov. Your Social Security benefit will be permanently reduced by 25-30% if you begin payments at 62 instead of your Full Retirement Age (FRA). Keep in mind that starting Social Security early may also reduce benefits available to your spouse by as much as 35%. And if you continue to work while you receive Social Security, your benefits will be reduced by one dollar for every two dollars you earn over $15,120 in 2013.If you were born on January 1st, you should refer to the previous year.

  1. If you were born on the 1st of the month, we figure your benefit (and your full retirement age) as if your birthday was in the previous month. If you were born on January 1st, we figure your benefit (and your full retirement age) as if your birthday was in December of the previous year.
  2. You must be at least 62 for the entire month to receive benefits.
  3. Percentages are approximate due to rounding.
  4. The maximum benefit for the spouse is 50% of the benefit the worker would receive at full retirement age. The % reduction for the spouse should be applied after the automatic 50% reduction. Percentages are approximate due to rounding.

Age 65. Medicare eligibility begins. From three months before you turn 65 to three months after you turn 65 you may sign up for Medicare Parts A, B and D. Sign up for Medicare Part D (prescriptions) from October 15 until December 7. If you (or your spouse) are covered by an employer-paid health plan, you have eight months after you retire before you will have to pay a penalty to join Medicare.

Age 66 or 67. Considered Full Retirement Age (FRA) for Social Security recipients. If you were born before 1954, you are eligible at age 66. From 1955 to 1959, your FRA increases from 66 years and 2 months to 66 years and 10 months. If you were born in 1960 or later, the FRA is 67. At FRA you can still continue to work without receiving reduced Social Security benefits.

Age 70. Last year to receive deferral credit for postponing receipt of Social Security benefits. There is no reason not to take Social Security at this point. If you continue to work, and your earnings are higher than previous inflation-adjusted earnings, your Social Security benefit will continue to be increased even if you are already receiving it.

The year you reach 70½. (Or, more precisely, April 1st after the year that you turn age 70 ½). Distributions from IRAs, and other tax-deferred retirement plans like 401K and 457 plans (except Roth IRAs) must be started. The distribution amount will be determined by dividing the total value of all tax-deferred retirement accounts as of the previous December 31 by your life expectancy using IRS tables. If you fail to take this distribution, or your distribution amount is less than the minimum required, the tax penalty is 50% of the amount you failed to remove from the account.

~ Allyn Hughes, CFP, CLU, ChFC — Brooks, Hughes & Jones, Partners in Wealth Management — Tacoma, WA

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Cost basis enters the spotlight for investment decisions

Cost basis is an often unloved but certainly important piece of information in managing investment decisions in non-retirement accounts. With the upcoming tax changes scheduled for 2013, however, cost basis and capital gains or losses could play a more important role than usual in your decisions before the end of the year.

Your cost basis is the total amount you have invested in any particular position or asset. In the case of a stock, bond or mutual fund, the cost basis is comprised of not only your initial investment but any additional purchase of new shares – whether they come via reinvested dividends or income or are simply new money invested.

Cost basis shouldn’t be overlooked because the basis can be an important variable in your after-tax returns. Being tax efficient can help you protect more of your gains.

In 2013 the long-term capital gains tax is scheduled to rise from 15% to 20% of the gain for most taxpayers and as high as 23.8% of the gain for high income earners. The current rate has been in place since May 2003. Although this tax will rise by a third, even the 20% rate is historically low. The average long-term capital gains tax since 1942 is 27.55%.

Considering the following scenarios may help you make tax-wise decisions about your investments before year end.

GO AHEAD AND SELL A WINNER

Generally, deferring taxable events as long as possible is preferable. But this year, realizing gains and paying the capital gains tax at the 15% rate, rather than a higher tax later, could effectively increase your after-tax return on your investment. Where gains are concerned, there is no rule that disallows you from repurchasing the same asset that was sold. Or, perhaps more appropriate, you can realize the gain by selling the asset and use the proceeds to further diversify your portfolio, managing risk.

CONSIDER HOLDING ON TO LOSERS (if the asset still fits your investment objective)

Realizing losses by selling positions that have declined below the cost basis is a common year-end task. But you may want to think twice about this strategy. One reason is that losses will be more valuable when used to offset capital gains in the future at higher tax rates.

Another less obvious reason is that while you may receive tax benefit by selling at a loss now, it’s possible that the benefit could be more than offset by future capital gains taxes that are higher. Here’s an example. Consider an investment with a $20,000 cost basis that declines to $15,000. You sell the position and realize a loss of $5,000 before December 31, 2012. You reinvest the proceeds for a new cost basis of $15,000, not the original $20,000. The reinvested money rises to $30,000, doubling your money, and you sell. Because of this tax increase, you would owe more in capital gains tax than if you had just held the initial position with a $20,000 basis and waited for it to grow to $30,000. The initial tax deduction of the $5,000 loss would be worth $750 assuming the 2012 15% capital gains rate. But the reinvested assets, growing from the lower cost basis would generate a higher future tax bill. Essentially, there would be an extra $5,000 of capital gain. With the future capital gains tax at 20%, the tax cost would be $1,000, a bigger drag on your after-tax return than the $750 tax deduction that was received upon selling the initial investment for a $5,000 loss.

NO TAXES ON CAPITAL GAINS FOR LOW INCOME EARNERS

If your taxable income happens to be under $70,700 (married filing jointly) or $35,350 (single taxpayer in 2012), you can sell investments with a long-term capital gain in 2012 and pay no tax. Next year, a 10% capital gains tax returns for individuals in the 15% tax bracket or lower. This may be most useful for people who have business losses or other causes for unusually low taxable income but they still have assets in a taxable investment account with gains.

TURN THE UNKNOWN INTO A GIFT

Many people have investments for which they do not know the cost basis. If it is not easy to compile an accurate historical basis for the holding, there is a simple solution with many benefits – gift it. If you donate the investment to a non-profit organization, you will receive a tax deduction for the date-of-gift market value and there is no need to determine what the basis is. You can receive a tax deduction for securities gifts up to 30% of your adjusted gross income. The charity receives the gift and does not have to pay a capital gains tax whenever it sells the position. If the position is of a size larger than you would comfortably gift normally, discuss funding a charitable gift annuity or other account that returns an income stream to you to supplement your retirement income.

DON’T DOUBLE PAY TAXES

Regardless of your situation, keeping track of cost basis is important so that you don’t unintentionally pay more tax than necessary. The most frequent problem investors face when determining their costs basis is not adding reinvested dividends or income to your initial purchase cost. This creates a form of double taxation. The reinvested income is taxed annually whether you reinvest it or not. If it is not included in growing the cost basis over time it is essentially taxed again as capital gain at the sale of the asset.

For many people who have held investments with reinvestment features over the years – or who have transferred a holding from a fund company to a brokerage or from one brokerage to another, keeping track of the cost basis can require a tedious search of old statements or trade confirmations.

All taxable mutual fund and brokerage account statements are now required to include cost basis. If your statement is missing information, the custodian of the account does not have complete records. You will need to go on a bit of a treasure hunt for the missing details. You should be sure to understand the basis before selling the position to make sure that it is accurately reported to the IRS by the custodian of the account.

Two other points are worth noting that may impact your decisions to sell investments and realize gains or losses. If you have a capital loss carryforward (losses beyond what you could deduct on your tax return in previous years) it may be more valuable to you to wait to next year to sell your winning investments to offset higher capital gains rates than this year.

And there is another way to gain tax efficiency and better after-tax returns that may be worth waiting for, if unpleasant to think about – your death.  If you like a holding and it is a good fit for your investment objective long term, there is no need to get strategic about the capital gain. Assets held until death in taxable accounts receive a basis step-up to the value on the date of death. It’s a nice benefit to your heirs and serves as one instance where death and taxes are not actually linked as certainties in life.

Have you reviewed the cost basis of your holdings for accuracy?

Are there steps you can take to improve after-tax returns on your investments?

By Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA

www.BHJadvisors.com

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Global stock market correlation increases risk

Correlation is a measure of how much or little investments move in sync with each other. Complete correlation is 1.0. Opposite correlation is -1.0.

To construct a truly diversified portfolio, it is preferred that holdings respond differently to various market conditions and economic cycles. If investments move together with high correlation, they offer less risk management.

Historically, non-U.S. stocks have added diversifying qualities to an overall investment portfolio because their correlation to U.S. stocks was not high. But that has changed significantly. While international stocks do provide access to different economies, currencies and sources of earnings, their performance pattern has become less distinguishable from U.S. stocks.

Consider this information from J.P. Morgan.

During the 2008 financial crisis, many investors realized that although a concentrated portfolio may build wealth, a diversified portfolio protects it. High correlations among volatile asset classes can rapidly reduce a portfolio’s value, and although equity correlations have remained elevated since the crisis ended, this is not a post-crisis phenomenon. As shown in this week’s chart, the correlation among international equity markets has been on an upward trend over the past 20 years, likely due to these markets becoming increasingly interlinked through technological advancement and easier investor access. Thus, given that markets remain macro-driven and average correlations are 5x higher today than in the mid 1990s, under-diversified investors could be at serious risk, once again making a strong case for taking a balanced and diversified approach to investing.

Source: MSCI, Standard & Poor’s, FactSet, J.P. Morgan Asset Management.

While we believe it is important to be a global investor, it is also important to include investments in your portfolio that are not highly correlated with global stocks. Using low correlation assets can be very important, particularly in times when global stocks are declining. Notice in the graphic that the peak of correlation among global stocks came at the height of the 2008-09 crisis, exactly when less correlation would have been most valuable.

Do you know what level of correlation your investments have to each other?

Is your portfolio built to buffer down-market risk more than chase all the return of bull markets?

What is your definition of diversification?

Past performance does not guarantee future results.

Diversification does not guarantee investment returns and does not eliminate the risk of loss.

By Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management — Tacoma, WA

www.BHJadvisors.com

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“Heads I win, tails you lose” — Challenges of investing in corporate bonds

I had a chance to read David Swenson’s “Unconventional Success, A Fundamental Approach to Personal Investment” recently. Swenson is the head of investing for Yale’s endowment.

This book was published in 2005 and does a good job of presenting Swenson’s thinking about investing before the market meltdown of 2008-2009. Before ’08-’09 he and his team created an enviable investment track record at Yale by investing in a variety of asset classes—many that had different performance attributes than U.S. stocks, but that also offered higher returns over long periods of time.

Although Swenson and his team invested in asset classes like timberland and commodities, the performance of Yale’s endowment during the melt down, however, was more like stocks than was expected. Yale’s endowment declined 24.6% ($5.6 billion) in fiscal year 2009 (7/01/08 through 6/30/09). Over the same time, the broad U.S. stock market – as measured by the Russell 3000 Index—lost 26.58%.

Swenson did lead the endowment to a solid recovery. The University’s longer term results remain in the top tier of institutional investors. Yale’s endowment posted average annual returns of 10.1% over the 10 years ending June 30, 2011, surpassing results for stocks, which returned 3.9% annually, and for bonds, which returned 5.1% annually.

Although somewhat out of date, the book gives Swenson’s insights about all aspects of the investment markets. One section that feels most relevant now highlights his thoughts about including corporate bonds in an individual’s investment portfolio.

Swenson doesn’t like corporate bonds because they have asymmetrical risks built into them. If a corporate bond is held to maturity, all that the investor can get for this investment is the coupon payments due and the principal returned. If interest rates decline, most corporate bonds will be called which will pay the investor a slight premium. Then the bondholder will have to go out and invest in another (lower paying) bond. Finally, the company could experience financial problems and the bond could become worthless. These characteristics give Swenson little reason to own corporate bonds. He sees very little upside and potentially a large downside.

Here is a little more information about the specific risks he sees with corporate bonds:

Credit Risk—Although the cash flow to debt ratios of most large U.S. companies have improved over the past two decades, the credit ratings of many of these companies have decreased. He thinks this is likely because two kinds of companies don’t take advantage of the debt market often–those companies that are relatively new and are fast growing, and those very large and successful (often highly rated) companies that have enough cash flow and other assets to internally finance their debt. That leaves the “middle-market” companies that need the financing but that may have higher levels of debt to their equity than these other firms.

Callability/Interest Rate Risk—Corporations frequently issue bonds with a call provision. This allows the issuer to redeem the bond if interest rates decline. If rates increase, the firm has locked in favorable funding for the bond until it matures. Swenson calls this a “heads I win, tails you lose” proposition because it favors the bond-issuing company regardless of the direction of interest rates—an asymmetrical result.

Liquidity—Compared to U.S. Treasury bonds, investment-grade (highly rated) corporate bonds offer yields that are slightly higher because of their less liquid nature. Swenson contends that these higher rates don’t necessarily pay for all of the additional risk that corporate bond holders take on compared to Treasury bonds.

Alignment of Interests—Shareholders of the stock in a company are helped when the value of the company’s debt obligations are reduced. Therefore, many corporate executives, whose compensation is likely tied to the share price, may make decisions which focus on the needs of the stock holders, and not the bond holders.

Swenson’s concept of the bond holder “having the deck stacked against them” seems all too important—especially in today’s very low interest rate environment.

This is reflected in Yale’s current asset allocation targets for the fiscal 2012 year:

  • Private Equity: 34%
  • Real Estate: 20%
  • Absolute Return: 17%
  • Natural Resources: 9%
  • Foreign Equity: 9%
  • Domestic Equity: 7%
  • Bonds and Cash: 4%

Traditional publicly-traded stocks and bonds make up 20% or less of the Yale portfolio. It’s not that Swenson doesn’t like corporate bonds, he doesn’t much care for Treasuries or foreign bonds either. Unfortunately, individual investors don’t have the same access to certain investment opportunities that multi-billion dollar endowments do.

~ Allyn Hughes, CFP®, ChFC®, CLU® — Brooks, Hughes & Jones, Partners in Wealth Management — Tacoma, Washington

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