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

Posted on July 17, 2012 | Leave a comment

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Although somewhat out of date, the book gives Swenson’s insights about all aspects of the investment markets.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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Farmland, agriculture commodities may outrun stocks or bonds

Posted on May 4, 2012 | Leave a comment

It’s no surprise that in a world racing past seven billion people, farmland and food crops have drawn attention as an investment theme.

According to a research paper from Absolute Return Partners titled The Protein Bomb, in 2011 farmland prices in the U.S. midwest increased by 22% on average. With much of the world — especially the emerging middle class in developing nations — shifting to a higher protein diet, increased need for grain to feed chicken, beef and pork requires increased crop output. When demand rises, farmland prices follow.

As the paper indicates, “Arable land is a finite resource and so is water. Demand on existing resources will be immense over the next few decades as living standards increase around the world.”

The paper goes on to evaluate why, when such a clear trend is developing, so few people have exposure to agriculture in their investment portfolios. Many institutional investors (pension funds, foundations, etc.) do allocate funds in this area but very few individual investors do. Part of the problem is the cyclical nature of agriculture commodities and the complexity of trading futures contracts based on assumed crop and livestock trends.

“However,” the paper continues. “if you can stomach the cyclical nature of this asset class, I find it hard to envisage an environment where the returns do not comfortably outpace returns on bonds and equities when looked upon over the next 5-10 years.”

If commodities investments and futures contracts leave you hesitant to add exposure to this theme, it’s still possible to participate through traditional stock holdings. You can stick to investments in machinery or fertilizer manufacturers and capture movement of the general theme without having to pick the right crop at the right time.

The perceived benefit of the farmland and agriculture theme is that investment returns in this area are driven by factors other than company earnings or interest rates. It’s largely a matter of supply and demand. This should effectively cause these investments to move in different patterns than stocks or bonds. There may be stock-like fluctuation in returns from one period to the next but adding diverse return drivers to your portfolio is a proven way to reduce risk of the overall investment mix.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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The premium for taking stock risk is shrinking

Posted on March 2, 2012 | Leave a comment

Following up on Gary’s Tacoma News Tribune column on February 2, here’s another way to look at expected investment returns.

Portfolio construction principles start with what is perceived to be the “risk-free return.”

In order to take a step up the risk ladder, investors need to be rewarded with more return than the risk-free asset. This return above the risk-free asset is called the equity risk premium. The historical equity risk premium for broad stock markets has generally been considered to be 4.5-6.0% per year. It used to be that the 10-year Treasury bond paid 4%. If you start at 4% and added 4.5-6.0% of equity risk premium, you could reasonably expect 8.5-10% returns on stocks, in line with historical averages.

Today, the return expectation has been squeezed from both ends. Currently, 10-year Treasuries pay approximately 2%. A recent survey by the Chartered Financial Analyst (CFA) Institute of prominent money managers suggested that the equity risk premium is now in the 3.5-4.0% range. So you add the two together and now you’ve got expected returns of the broad stock market at 5.5-6.0% per year. Oddly, at a time when risk seems more prominent, and therefore should command an even greater premium to take on the risk, prudent expectations for returns have declined considerably.

You could conclude that if stocks aren’t expected to reward you at the historical rate, why bother to take the risk? Instead, you could just focus on bonds. The problem is that bonds, especially in the U.S. seem less attractive than stocks on a risk-adjusted basis.

For many years, a common assumption of investors has been that with a broadly diversified mix of stocks and bonds, you should be able to double your money every 10 years. This rule of thumb requires an average annual return of 7.2%, assuming no withdrawals. Therefore, if returns are reduced, the double-your-money formula takes longer. At 6% returns, it takes 12 years to double. At 5% returns – assuming that some bonds have lessened the overall return expectation for a balanced portfolio – it’s closer to 14.5 years to double.

For someone who is still working and saving, there is opportunity to save more or work longer to overcome these lower expected returns. The big problem confronts current retirees who are withdrawing money to supplement their income. Lower returns on their remaining invested capital mean that even the “safe” withdrawal rate of 4% could be too high to guard against exceptional longevity or unexpectedly high expenses.

Ideally, over time, global debt and economic challenges will improve and expected returns will revert to more normal levels. But investment performance can be fleeting. That’s why it’s important to have an understanding of “what if?” as part of your retirement income plan.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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Dave Ramsey’s misleading expectations

Posted on May 17, 2011 | Leave a comment

Radio host and author Dave Ramsey has developed a big following by delivering basic advice about financial literacy and budget management. He has helped a lot of people take positive steps to get out of debt and invest for their future.

But recently, he’s being called out by many members of the financial advisor community — particularly across social media channels — for suggestions about investment returns that are overly optimistic.

This New York Times blog outlines Ramsey’s problematic assumptions: http://bucks.blogs.nytimes.com/2011/05/13/dave-ramseys-12-solution/?partner=rss&emc=rss

Ramsey has suggested in many formats that investors can expect 12% average annual returns from investing in U.S. large growth stocks. Because a 12% return would compound so nicely that a tremendous nest egg could be grown over a working career, Ramsey also suggests than retirees may afford to withdraw as much as 8% of their savings each year and not worry about running out of money.

The average return of the Russell 1000 Growth Index over the past 15 years has been 5.47%. 10 years, 1.62%. If you stretch the averages back to the 1920s to even out the highs and lows, you still wouldn’t get to a 12% return. And, of course, investing in any one portion of the global markets increases risk.

Ramsey’s withdrawal rate guidance could cause retirees to run out of money well before they run out of time. Most research in the financial industry supports a 4-5% withdrawal rate, adjusted annually for inflation.

As with most financial advice, applying rules of thumb or general statements to your personal situation can be misleading. Take the time to determine what steps are needed to help you build financial security and get a second opinion if you’re not comfortable with the process on your own.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, Washington

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Strategic vs. tactical investing, our approach

Posted on April 7, 2011 | Leave a comment

A growing theme in the investment professional literature revolves around the idea of strategic vs. tactical management of portfolios.

Strategic assets, or even individual positions, are generally those that are included at the core of the investment mix regardless of the market climate or economic cycle. They are a buy-and-hold component because they have strong prospects for long-term growth. It is even better when they are purchased at an attractive price.

In Berkshire Hathaway’s annual report, Warren Buffett provides a good explanation of what a strategic asset is, without labeling it as such. In writing about shares of companies that Berkshire owns such as Coca-Cola and American Express, Buffett explains his perspective:

In these businesses, “we measure our success by the long-term progress of the companies rather than by the month-to-month movements of their stocks. In fact, we would not care in the least if several years went by in which there was no trading, or quotation of prices, in the stocks of those companies. If we have good long-term expectations, short-term price changes are meaningless for us except to the extent they offer us an opportunity to increase our ownership at an attractive price.”

This philosophy has worked very well for Buffett and Berkshire Hathaway for 50+ years. It might continue to be successful for another 50, though Buffett himself writes that Berkshire’s edge is not what it once was. In today’s evolving global economy, however, we believe it has become more important to have a portion of the portfolio managed with a more tactical approach. This means evaluating specific market segments for their opportunity, or disadvantage, more continuously. There are points when it becomes clear that certain types of assets are either in or out of favor with the market. The difficulty is timing the entry and exit points of those investments and determining how much of the portfolio to expose to tactical shifts.

This is tricky business and the reason why we don’t employ fully tactical portfolio management – something that some investment managers believe in.

We don’t believe in rotating sectors of the stock market in an attempt to capture stock price movements. We don’t follow momentum signals or other technical indicators of trading activity meant to identify market direction, particularly short-term movement.  Our tactical approach is more thematic and based on fairly minor weight shifts in a portfolio.

For example, bond market conditions over the past six months have influenced two tactical decisions. We’ve tactically increased clients’ exposure to floating rate bank loans – which are expected to fare better in rising interest rate environments. We’ve also increased use of strategic income mutual funds which give the money manager flexibility to shift emphasis. Mostly we prefer this approach because the general shift has been away from U.S. Treasury or Agency bonds and more toward international bonds – where interest rates are higher and government balance sheets are in better shape than in the U.S. – and corporate bonds.

Other tactical emphasis, depending on the investor’s objective, may include the weight of commodities investments, dividend-paying stocks over growth companies, or the weight given to small companies vs. large.

We believe these moves, in moderation, add value over time by reducing risk. We don’t dramatically change the core elements of the portfolio, we just emphasize tactical shifts involving perhaps 10-15% of it. We think of this as using a tactical overlay on a strategic core.

~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA

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Even weak economy can produce good investment returns

Posted on February 3, 2011 | Leave a comment

Emerging market countries have earned a lot of attention from investors because of their  29.05% average annual return from 2003-2010 (MSCI Emerging Markets Index). Going forward, much of the assumption that emerging markets will continue to lead has to do with an expectation for stronger economic growth than in the U.S. or other developed market countries.

The theory goes that government balance sheets are in much better shape with less stimulus needed after the great recession. The emerging economies should also be aided by generally younger populations that don’t present demographic problems for government entitlement programs. And emerging middle class consumers with increasing income are expected to support big economic gains.

But economic strength — demonstrated by strong growth in Gross Domestic Product (GDP) — hasn’t historically translated into better investment market returns. Take a look at this chart from Financial Planning magazine using research from Dimensional Fund Advisors (DFA).

slow GDP growth, high returnsIt may be counterintuitive, but even shrinking economies can maintain market gains. It’s important to remember that future expectations are priced into the cost of investments. In many cases, results don’t turn out as well as expected and prices decline upon reality. On the flip side, when expectations are low (often due to economic struggle), it’s easier for surprises to occur, creating better returns than expected.

While we think it’s important to include a healthy weight to international stocks and bonds in your overall investment mix, it’s definitely not the time to give up on the U.S. and its sluggish economy.

~ Brooks, Hughes & Jones — Partners in Wealth Management — Tacoma, WA

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The Bond Market Conundrum of 2011 — Part II

Posted on December 22, 2010 | Leave a comment

Portfolio Management Preferences to Reduce Risk

LOOK BEYOND TREASURIES

U.S. investors have easy and relatively inexpensive access to a broader selection of bonds than they had in 1994.

  • Non-U.S. bonds provide U.S. investors access to different economic cycles, interest rates and currency values which can help reduce overall portfolio risk.
  • Floating rate bank loans are another portion of the bond market that actually do better in rising interest rate environments. These loans are very short term, resetting every 30-90 days.

High-yield corporate bonds (those below investment grade ratings) have historically performed much better than other bonds during periods of increasing interest rates.

Consider this research reported by Investment News writer Jeff Benjamin:

According to an analysis of the biggest interest rate moves over the 20-year period through June 2006, high-yield bonds are remarkably resilient against interest rate volatility. Between September 1987 and June 2006, there were six separate 12-month periods that saw the yield on the 10-year Treasury climb by between 117 and 222 basis points. The average total return of high-yield bonds for those same 12-month periods was 5.5%, with just one negative-return period.

THE TOUGHEST DECISION

If your investment mix currently includes a significant overweight to stocks, should you leave it that way or diversify to include bonds at a point when bond returns are not expected to be nearly as good as they have been over the past few decades?

While the potential to see the value of your bond holdings drop is discouraging, watching them decline perhaps a few percent should be much more palatable than watching a stock investment decline significantly more.

If global economic conditions receive any more shocks, it’s conceivable that U.S. and international stocks could return to a bear market, declining 20% or more. In this case, having some bond exposure creates downside protection in a broadly diversified investment mix. It may be a hollow victory for bonds if all they do is lose less, but their ability to steady a portfolio amid periods of stock volatility can be valuable.

Let’s not forget that since March 9, 2009, the U.S. stock market has been on an exceptional run. The S&P 500 Index gained 85.5% as of December 22. Small companies, as measured by the Russell 2000 Index gained 130.3%. A correction would not be surprising.

WHAT ABOUT MUNICIPAL BONDS?

The biggest fear in the municipal bond market isn’t so much interest rates as it is pure default by the municipality. Clearly, government entities at all levels are faced with significant deficits. Historically, municipal bond default rates have been very low, essentially not a concern expect in a few high profile cases (Orange County, CA, the WPPSS nuclear project here in Washington). Holding a diversified mix of many different types of municipal bonds can minimize default risk.

Many people assume that if cities or other municipal entities fail, the Federal Reserve will bail them out, saving value for bond holders. This could be the case but may serve to further bog down the economy.

Even if we see 50-100 imminent municipal defaults as Meredith Whitney forecast on 60 Minutes December 19, that is a small percentage of the overall municipal bond market. If your municipal bond exposure is in an actively managed mutual fund with an experienced analyst monitoring credit ratings, the default impact may not be all that significant.

IS CASH A BETTER BET?

Shifting the fixed income portion of your investment mix to cash comes with an opportunity cost. What if interest rates don’t move quickly and bonds continue to produce attractive total returns? What if U.S. interest rates increase slowly and bond returns decline moderately?

If your current bond holdings are in a portion of your portfolio that can’t take even a minor loss in the next two years, we think that this investment should be in cash. If you can afford to take a limited amount of risk, we think that concerns about bond declines may be overstated from a longer-term perspective. More importantly, cash holdings do not rally.

EXPECTATIONS ARE BUILT INTO MARKET PRICES

All investment markets are driven by future expectations. These expectations are already priced into stocks and bonds. Bond investors don’t generally expect the same tailwind that has filled their sails for most of the past generation. A less friendly headwind may already be evident in the price of bond funds.

WHY WE PREFER BOND MUTUAL FUNDS OVER INDIVIDUAL ISSUES

We feel more comfortable letting professional bond managers navigate the opportunity and pitfalls the market presents.  Bond fund managers spend their days building portfolios that are liquid, sensitive to the outlook for interest rates, and focused on managing the risks and returns for their investors.  Unless you are certain as an individual investor that you will hold individual bonds until they mature, receiving a payout of the bond’s face value, and that you have enough individual bonds to diversify away as many of the risks as possible, it is unlikely you will be able to outperform these professional  managers on an ongoing basis.

Considering the open issues and historical precedent, investors definitely need to ratchet down expectations for U.S. bond returns. But we don’t think you need to run away from U.S. bonds altogether. And your portfolio may be optimized by expanding to include international bonds.

Part I What Happens When Interest Rates Rise

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

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The Bond Market Conundrum of 2011 — Part I

Posted on December 22, 2010 | Leave a comment

What Happens When Interest Rates Rise

Given historically low U.S. interest rates, government stimulus efforts that seem likely to spark inflation and a massive flow of cash chasing returns, many investors think that it is not an ideal time to invest in U.S. bonds.

But does that mean that investors should move away from existing U.S. bonds holdings or avoid investing any new money in bonds?

U.S. bonds are not a compelling investment currently for a few reasons:

  • A very long bull market for bonds is running out of support from fundamental market factors that drive value
  • Massive cash inflow has flooded bond markets with buyers, driving prices up
  • Interest rates have nowhere to go but up, hurting bond prices

The interest rate concern seems to be the biggest, especially for investors who remember 1994 when many U.S. bond mutual funds lost money even after considering the income their bonds paid out.

Compounding the lack of clarity is the uncertainty of actual increases in interest rates. Bill Gross, manager of the PIMCO Total Return Fund, the largest bond mutual fund in the world, believes that the Federal Reserve will not be faced with a need to raise interest rates for at least another year, potentially well in to 2012. He is not alone in this assumption.

There’s also no telling how fast rates will rise once the economy seems healthy on its own unstimulated merits. Gross is far more worried about the economy and its impact on the U.S. stock and bond markets than he is on interest rate changes. Unemployment will have to come down and inflation will have to be more obvious before there is pressure to raise rates. If the recovery continues to be a jobless one, we could continue in our low interest rate environment for a long time.

It’s possible that short-term interest rates and long-term rates could take different paths. The Federal Reserve manipulates the economy and markets to influence short-term interest rates but the market itself has more influence on long-term interest rates.

Past bond market performance gives us an indication of what returns we may expect when interest rates rise (causing the value of many types of bonds to fall). The trouble is that previous cycles of climbing interest rates weren’t also paired with unemployment, deficits, an economy boosted by artificial stimulus, and political combativeness, all at the same time.

A REMINDER THAT BONDS CAN LOSE VALUE

In 1994, many investors thought that bonds would protect them from loss. This is true if you own individual bonds and hold them to maturity, collecting coupon payments along the way and retrieving the principal of the bond at maturity. But if you have to sell your bonds or the bond mutual fund you own sells bonds, they could be sold for less than their purchase price.

In February 1994, U.S. interest rates began a relatively swift climb. They increased from 3.0% to 6.0% in one year. In that time, the Vanguard Total Bond Market Index Fund had a total return of -1.51%. Declines in the price of the fund outweighed income paid out by the fund for a full year.

We don’t think that it is likely that once interest rates do begin to climb, that they will increase 3% in a year, but it is still a possible scenario.

A MORE LIKELY INCREASING RATES SCENARIO

It was just a few years ago that interest rates reached their most recent peak. In July 2004, interest rates climbed from 1.0% to 1.25%. They continued to climb until September 2007 when they peaked at 5.25%.

Bond mutual funds fared much better in this period than during 1994:

Fund Cumulative Total Return (income + price appreciation) from July 1, 2004 – Sept. 4, 2007
Barclays Aggregate Bond Index ETF 13.5%
Vanguard Total Bond Market Index Fund 14.19
Vanguard Long-Term Bond Market Index Fund 18.80
Vanguard Short-Term Bond Market Index Fund 11.69
iShares 1-3 year Treasury Bond ETF 11.03
PIMCO Total Return 16.44
Fidelity Strategic Income 25.99
Templeton Global Bond 39.36
Vanguard Total U.S. Stock Market Index Fund 42.41

This was not a period of exceptional bond returns. If you divide the cumulative total returns by three you get a rough annualized return. There were some reasonably good returns, particularly for non-Treasury bonds. Foreign bonds and corporate bonds in general that were not punished by the increasing interest rate environment.

Let’s take a closer look at the experience of the PIMCO Total Return Fund, managed by Gross. From July 1, 2004 through September 4, 2007, the fund had a price return of -2.24% but a total return of 16.44%.

If you invested $10,000 in this Fund, just as interest rates began to climb in July 2004 and reinvested dividends over the three years, the fund paid out $1,831.52. The negative price impact left the investment’s value at $11,605.72 on Sept. 4, 2007. While the total return is not significant, it did continue to outpace inflation. Reinvesting dividends also added 174 shares to the holding over the period, increasing future growth.

Certainly there are differences between our economic situation today and the previous two climbing-interest rate environments. We are coming out of a deeper recession and the market will have to deal with the impact of massive cash stimulus (quantitative easing) that was not a consideration in 1994 or 2004-07.

If we rewind the calendar for a full generation, back to 1973, we can see how the U.S. bond market performed in a wide variety of economic conditions, market expectations, and political changes.

In the 37 years since then, the Barclays U.S. Aggregate Bond Index has had a negative return over a calendar year three times (-2.91% in 1974, -2.92% in 1994 and -0.82% in 1999). The 37-year average annual return was 8.22%.

Part II Portfolio Management Preferences to Reduce Risk

Past performance does not guarantee future results.

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

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