A Quick Look at the Markets

I wanted to take a few minutes this morning to discuss recent market volatility and what, if anything, to do about it. We’ll get back to our list of bond alternatives next week.

For sure these continue to be unsettling times and the list of issues to be concerned about seems only to grow longer. Maybe that’s a little pessimistic, but that’s where my head is at on this Twosday morning.

Anyway, let’s jump right in by reviewing recent performance through last Friday of four popular index funds from Vanguard: Total US Stock Market (VTI), FTSE Developed Markets (VEA), FTSE Emerging Markets (VWO), and Total Bond Market (BND). Together these funds allow for a quick look at how global stocks and US bonds are doing.

First, year-to-date…

US stocks are down the most, followed by developed foreign stocks (primarily the UK, Europe, and Japan). Perhaps surprisingly, emerging markets (mostly Chinese, Taiwanese, and Indian stocks) have performed well so far this year. These latter two asset classes, and especially emerging markets, have been getting beat up for a while. We have to go back to 2017 to find a time when developed and emerging markets performed better than the US, so there was certainly room for some short-term improvement. And bonds, as we’ve discussed several times in recent weeks, are offering scant comfort lately.

Next let’s stretch out the timeline a bit and look at the last 12 months, again through last Friday…

As 2022 began US stocks, developed foreign, and US bonds all seemed to hit snags at about the same time, and for the same proximate reasons: inflation concerns, how the Fed would/could deal with it, and growing consternation about war in Europe.

Unfortunately, none of those issues are primed for a resolution anytime soon. As we’re all aware, inflation was tracking at 7.5% in January. That’s an average, of course, and the prices of many things we buy regularly are up more than that. The government’s inflation numbers are subject to multiple revisions and may show signs of slowing in the coming months. That’s what the Fed hopes. The markets, however, are assuming inflation will persist and the bond market is currently “pricing in” 4-5 quarter-point rate increases this year. The Fed could raise faster than that, and speculation has been growing for a half-point or even full-point increase at its rate-setting meeting next month. Much will depend on the inflation number for February and any meaningful revisions to prior months.

While inflation and the Fed’s policy response are active and open questions, gauging the outcome of another Russian foreign policy adventure is beyond my ability, and seems to be beyond our government’s ability too. Right or wrong, that adds to the uncertainty of the situation and unsettles investors in what would otherwise be, frankly, a non-event for most of the US economy and our financial markets.

Now let’s broaden our view to the last three years…

These standard asset classes move around a great deal throughout the year and over time. This is totally normal and occurs for a variety of reasons. Even bonds jump around every so often, and we see that in the little blue “W” during the worst of the financial market’s response to the pandemic in March of 2020.

These are arbitrary timeframes but they’re helpful in getting some perspective. To illustrate this point, let’s expand even further and look at performance from January 1st, 2008, a date that captures all four funds (one was created late in 2007). Take a look at the blue bond “W” in 2020 again in this longer-term context. It’s small enough to be a piece of lint on your computer or phone screen. Now add that to the myriad other market (and even cultural) shocks that took place since the Great Financial Crisis. Amid all this volatility, if given enough time the direction remains positive for stocks and bonds as they grow with the economy, each in their own way.

I don’t mention all of this to make light of our current predicament. We have much to be uncertain and concerned about. I hope that inflation moderates over the coming months. While a growing economy needs some inflation, too much too soon is harmful and destabilizes the financial system, even if only for a short while. I also hope that cooler heads prevail in the geopolitical realm. The world has been through much these past two years and a period of relative calm would be welcome by all, or at least by most of us. Fingers crossed.

In any case, as long-term investors we need to be able to weather bouts of uncertainty in hopes of eventually being compensated for our patience. And we will be compensated. If you’re still 10+ years from retirement, stay aggressive if possible. Time is on your side and your regular investments at lower prices will ultimately pay off. If you’re closer to retirement, re-confirm the details of your plan, keep your focus, and adjust as needed. And if you’re one of those who’ve left fulltime work behind, you’ll also want to double check your plan. You’re likely in better shape than you thought.

Beyond that, recent market volatility isn’t that bad. We’ve seen worse but it’s tough to swallow given the emotional roller coaster we’ve been on for almost two years now. To stay on track it’s best to focus on controlling what we can control, like the structure and maintenance of our investment portfolios, while trying (and sometimes failing) not to dwell on the rest.

Have questions? Ask me. I can help.

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Convertibles

In recent weeks we’ve been looking at bond alternatives given the asset class’s poor performance of late. As I’ve said before numerous times and in different ways, I’m not suggesting that you sell your bonds tomorrow and buy shares of an apartment building, a bunch of gold, or bitcoin. There’s no easy answer to the bond alternative question. Instead, I’m advocating for a balanced approach where you make sure your financial bases are covered before branching out into more exciting fixed income options.

It's important to remember a key benefit of bonds these days: ease of use. Since we typically access bonds via an exchange-traded index fund that usually trades for “free” within seconds, buying and selling good quality bonds is just a few clicks away. This helps make bonds a good store of cash beyond what you need to keep in the bank and what you don’t want to risk in the stock market. In other words, mostly we’re talking about bonds for the medium-term, perhaps three to ten years out. Beyond that, your savings really should be put to more productive use in the stock market, buying real estate, or perhaps even starting your own business.

Also recall that volatility risk is something to appreciate when thinking about bond alternatives. Too many investors have confused their time horizons and mismatched longer-term investments to shorter-term goals. Doing so is easy in a strong market because the rising tide effect offers lots of validation. But market mood can quickly change and that Warren Buffett quote about seeing who’s been swimming naked only after the tide has gone out can become a truism. Don’t let that be you.

(Look back at the last couple posts for a rough guide to determine how much, if any, of your bond allocation you can explore with.)

Here’s the next installment of our list of bond alternatives. I was going to include more categories this week, but this post was getting way too long. Instead, I added some extra detail regarding one category, convertible bonds. Next week we’ll look at floating rate bonds and fixed annuities.

As I mentioned previously, this list of bond alternatives isn’t meant to be exhaustive. I’m looking at investments that are relatively easy to find and buy. Also, this list should be taken as a jumping off point for your own research and not as specific investment recommendations.

Convertible Bonds

Like preferred stocks, convertibles are a hybrid of bonds and stocks built to facilitate borrowing by companies with lower credit ratings. These companies can choose to pay higher interest rates on traditional bonds or allow bondholders the right to convert the company’s bonds into shares of company stock if the stock appreciates. This “equity kicker” allows investors to stomach buying lower quality bonds at lower interest rates. Companies of all sizes issue convertibles but smaller growth-oriented companies like this setup because money is cheaper to borrow and, assuming they grow a lot, debt can be shifted to equity over time and make room for more borrowing.

Convertibles can make sense if you’re on the fence, so to speak. After all, if you’re bullish on the company you’d just buy the stock, right? But say you like the company but also like the relative safety that comes from owning the company’s bond. If the stock appreciates you convert the bond to stock and then, presumably, sell the stock and reinvest in another convertible, sort of like flipping a house. But if the stock doesn’t appreciate, you’d hopefully earn a small amount of interest along the way to getting your principle back when the bond matures. The company could still go bust in the meantime and default on the bond, but it’s a great company with lots of potential. Seems like a win-win, right? What has ever gone wrong with circular logic?

Besides the issuer risk fundamental to bonds, this is where volatility risk comes in. Convertibles lure investors with higher average returns but the catch is they’re riskier than core bonds and act more like stocks, especially during periods of uncertainty. You’ll see this playing out over two timeframes in the charts below.

The first chart is performance for all of 2021 for bonds (the green line), stocks (blue), and two popular convertible funds. The iShares Convertible Bond Fund, ticker symbol ICVT, is the orange line and the Calamos Convertible Fund, ticker symbol CCVIX, is the lavender/purple (I’m bad with colors). The second chart is the same set of investments over the past 30 days.

 

We see that convertibles did fine for most of last year as stocks rose. But then investors turned skittish nearing year-end and into last month. ICVT is over half invested in tech-oriented convertibles, so it really took a hit as tech faltered. The decline was nearly as swift for CCVIX, mostly for the same reason. And then in the second chart we see that both convertible funds have tracked with the stock market in the last month as volatility rose. We also see core bonds, the green line, losing ground, but to a lesser extent.

The Calamos fund performed better last year but has slightly underperformed ICVT during the past five years. This underperformance could be blamed on Calamos owning convertibles in riskier sectors of the US economy and holding less in tech, a sector that has done extremely well during the last five years. The fund has a longer track record than ICVT (which was created in 2015), so we have to infer quite a bit about how ICVT would have performed during 2008, for example. The Calamos fund was down about 26% compared to the S&P 500’s 37% decline that year. Also, the Calamos fund is actively managed, which makes it more expensive to own than ICVT (1.14% per year vs 0.2%). That extra cost is a drag on performance. ICVT is an index fund and comparing the cost of actively managed funds to index funds is a bit unfair but, just as with the bonds versus stocks comparison, we do it anyway.

Given the complexity of convertibles, I would consider a solid manager with a long-term track record like Calamos, but it’s hard to ignore the relative simplicity and cost savings of index funds like ICVT. Either way, hybrids like convertibles can play a role in the fixed income side of your portfolio if you have room for them. Just be prepared for periods of heightened volatility along the way.

Have questions? Ask me. I can help.

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Preferreds and Junk

Before we get to this week’s discussion about bonds, let’s touch on where we are with the stock market right now. It seems like investors can’t buy a positive day lately and that’s quite the harsh entry into 2022 after such great returns last year. That’s one of the things that makes yesterday’s market action so surprising.

The S&P 500 seemed destined to slip into a technical correction as of last Friday, and actually did yesterday before staging a dramatic recovery that saw it and the other major indexes end the trading day positive. (At one point the tech-heavy NASDAQ was down almost 5% but ended up slightly – amazing!) As a reminder, a correction doesn’t start until at least a 10% decline from a recent high. The S&P 500 declines almost 14%, on average, throughout each year in fits and starts, and experiences a technical correction every couple of years, again on average.

Like we discussed before, markets are mostly made up of people, and they’re just as susceptible to mood swings as anyone else. Lately the mood of Mr. Market has been dark and full of foreboding about inflation, whether the Fed can contain it, and what collateral damage might be wrought by the Fed wielding it’s blunt inflation-fighting tool of interest rate increases. There’s even whispers of the dreaded “R” word after some recent economic reports. That, plus any number of other negative headlines in recent days and it’s understandable if investors are feeling glum.

And adding some extra oomph to the gut punch lately is that on many days the stock market was doing fine until the last hour, even the last 15 minutes, of trading. This timeframe is said to be when the so-called smart money makes its decisions. You can tell a lot about institutional investor sentiment by watching what they do during this time. That was when most of the recovery happened yesterday, which was great to see, but it’s tough to watch when it goes the other way.

The bottom line, at least from a purely dollars and cents/market perspective is that corrections are healthy. They shake things up and establish a new price floor from which to keep climbing. That said, it’s very risky to try to “trade” a correction, especially the lightening-fast ones that are typical these days. As of this writing markets are moving lower again, so the mood still seems negative, even after yesterday’s recovery. Lower prices present buying opportunities and there’s a plan in place for that if I’m managing your portfolio. But we want to remain disciplined instead of simply reacting. Reacting is easy so we’ll be content to let others do it.

And, at least in a small way, market volatility like we’re seeing serves to underline points we’re reviewing regarding bonds and the structure of risk in our portfolios. So, with that as a segue, let’s review some alternatives to bonds. This week we’ll look at preferred stocks and junk bonds. We’ll get to others next week.

It’s important to understand where investment options fall on the risk spectrum, pyramid, or ladder (take your pick). Cash is at the bottom (or to one side if it’s a spectrum you’re imaging) and has no immediate risk. It’s followed by short- and then medium-term bonds, and then there’s a giant stride, so to speak, before we get to the options we’ll look at below. Each step up or out adds risk. For this discussion we’re focusing on two main types of risk: default and volatility.

Default risk is exactly what it sounds like (think bankruptcy) and is something to be avoided like the plague. Volatility risk, on the other hand, is more nebulous. It’s the risk of buying the wrong investment (for your situation) at the wrong time, seeing it behave in unanticipated ways, then selling too soon while trying to cut your losses. Time and again this has been a losing strategy accidentally employed by many investors. So we have to pay attention not only to the structure of a fixed income index fund, for example, but also and perhaps most importantly to how it behaves during periods of market turmoil. (As a reminder, bonds are in your portfolio primarily as a longer-term store of value, not exciting growth potential – that’s the job for stocks.)

Here’s a chart looking at year-to-date performance of a typical S&P 500 index fund, ticker symbol SPY, compared to Vanguard’s Total Bond Market fund, ticker symbol BND. Both began the year poorly while the bond market ticked up in recent days as the stock market fell. This “flight to safety” isn’t guaranteed, of course, but is a reasonable expectation over time.

Now let’s look at two popular alternatives. The first is an index fund comprised of preferred stocks, ticker symbol PFF. “Preferreds” are considered hybrids of bonds and stocks because they trade like stocks but are in reality a special type of very long-term bond. Companies that issue preferreds pay higher interest rates than they might on traditional bonds they’ve issued because the holders of preferreds (you) have less of a right to repayment if the company defaults.

I’ve always imagined this as waiting in line to be handed pieces of a bankrupt company. Ideally, you’d be first in line or at least near the front. Holders of common stock are last in line. Holders of preferreds are second to last but there can be a long line of traditional bondholders in front of you. What scraps are left when you get to the front? Is it someone’s desk lamp instead of cold hard cash? I’d rather not find out.

In reality, default risk is relatively low when buying a diversified fund like PFF. It currently owns about 500 preferred stocks of companies from a variety of industries. A majority of the holdings are from financial institutions, but the single largest holding is less than 3% of the portfolio. So my main concern isn’t necessarily default risk, it’s volatility risk.

This next chart layers on PFF and the second option we’ll get to in a moment, JNK. Look at how both responded to the recent leg down in the stock market.

JNK is the ticker symbol for a popular high-yield bond fund from State Street. This category of bonds is also referred to using the outdated but functionally accurate term “junk”, hence the ticker symbol.  

JNK is a diversified portfolio of bonds from companies with sub-standard credit quality that have to pay higher interest rates to investors. The fund owns many of these bonds across a variety of industries. The top holding is less than half a percent of the portfolio, so the risk of any one company blowing up the fund is essentially diversified away. So again, volatility risk is the main concern when adding this to your portfolio.

Here’s another chart, but this time I’ve cherry-picked the dates to show you performance during the worst of the initial market reaction to Covid during 2020.

You’ll note that while core bonds fell briefly, PFF and JNK looked more like the stock market. Preferreds tend to act like stocks when investors want to reduce risk and we see that here. Junk bonds also tend to follow this pattern. But junk bonds are still bonds, and bondholders stand before holders of preferreds in that line we’ve discussed, so JNK held up a little better than PFF.

Okay, so what to make of all this? The bottom line is that both of these funds are viable alternatives for a portion of the core bonds in your portfolio. They pay higher interest and that’s great. But you better understand and be prepared for the volatility risk. Here’s an example of what I mean by being prepared before branching out into more exciting fixed income (think of this as an oxymoron).

Cash in the bank = 1 – 2 years of spending (emergency fund + known, or at least likely, big-ticket expenses).

Core bonds = 3 – 6 years of spending if you’re nearing or living in retirement. Maybe more, but I wouldn’t suggest less. Maybe much less if retirement is, say, more than ten years off.

Exciting fixed income (preferreds, junk, etc) = These could round out the rest of your fixed income allocation. Say your top-down allocation calls for 40% in bonds and cash. Back into how much room you have after covering the first two steps above. Maybe a lot, maybe a little. Whatever it is, don’t dip too far into the safe stuff in a reach for yield. If you do, it’s almost Murphy’s Law that you’ll need money and find yourself having to sell losing investments in a down market.

Have questions? Ask me. I can help.

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Annuities

Before we begin this week’s post I wanted to share this quote that arrived in my inbox this morning from my research partners at Bespoke Investment Group. It just seems fitting with everything going on out there in the world, and in our own households, these days.

“What we know is a drop, what we don't know is an ocean.” - Isaac Newton

We’ve been discussing alternatives to bonds in recent weeks for obvious reasons. Inflation is surging and some of it seems sticky, interest rates are rising, consumer confidence is flagging a bit, and sabers are rattling in the East, although there’s a glimmer of positive news this morning. During times like these it’s natural to wonder about other ways of doing things, if for no other reason than getting some validation that you were doing the right thing all along.

There are lots of potential stand-ins for bonds. I thought of including some, such as commodities or even crypto, but they all touch more on longer-term speculation than a reasonable medium-term store of value. TIPS have been in the news lately, but they’re also a longer-term bet. Solid fixed income investments play a large role in the capital structure of our lives and appreciating that structure is important. Mix too much risky or illiquid stuff with the wrong time horizon and you’re asking for trouble.

In that vein, let’s extend our list of bond alternatives by looking at annuities.

Annuities –

In general there are three types of annuities: variable, fixed, and immediate. I’ll go out on a limb and suggest that you throw out the first type, variable annuities. If you already have one with large, imbedded gains or perhaps fancy add-ons from a bygone era, great, you’ll probably want to keep it going. Otherwise, just toss them out as an investment option, and certainly as a replacement for bonds. The reasons why could easily end up in a rant that’s beyond the scope of this post, but the bottom line is variable annuities are convoluted and expensive, a hybrid claiming the best of everything while usually coming up short. (There’s another variation on this theme, an equity-indexed annuity. Throw those out too.)

The other two types of annuities are different and can be good alternatives for replacing some of your bonds under the right circumstances. Both are insurance contracts based on the interest rate environment but neither has a secondary market, so you won’t see their values fluctuating all over the place. The difference between them is fundamentally about time, how long you can park your money and when you want to spend it.

The mechanics of a fixed annuity are similar to a bank CD. You put cash down for a set period at a guaranteed interest rate. If you break it early there’s a penalty. The important difference is in who’s making the guarantee. With a CD it’s the bank backed by the federal government (up to at least $250,000). With a fixed annuity it’s just the insurance company. In practice, there’s a state fund that could help you recoup some losses if the insurance company goes bust, but that’s only vaguely similar to government insurance and shouldn’t be counted on in the same way. But assuming you’re sticking with a high-quality insurance company (as rated by AM Best, for example – Google makes this information easily available) it’s unlikely you’ll have to deal with bankruptcy in a shorter timeframe, say five years or less.

Looking at this shorter timeframe on annuity.org, you could get 2.65% on over $100K if you were willing to let the money sit for five years. Rates drop to just over 2% for a couple years and periods in between have rates in the middle of that range.

By way of comparison, as of this morning the yield on the 10yr Treasury, a key bond benchmark, is hovering a hair over 2%. The 30-day SEC yield (a standardized way to assess bond fund cash flow) for the Vanguard Total Bond Market Fund is about 2%. Vanguard’s shorter-term bond option has a 30-day SEC Yield of 1.4%. And 1yr CDs on bankrate.com top out at 0.9%. There’s also a 5yr CD at 1.2%.

Say you’re thinking five years. You’d pick the annuity because the yield is higher, right? Maybe. The correct answer depends on your personal liquidity structure and willingness to take risk. The annuity return is fixed, and the bond fund’s isn’t, so that’s one up for the annuity. The annuity also offers tax deferral on the interest if you leave it in the contract, so that’s another bonus. The bond fund has the potential to outperform the annuity, and I would expect it to over five years. But the bond fund can be too volatile for some investors. So maybe bonds are tied with fixed annuities? Let’s add a layer of risk to the annuity and see how it stacks up.

At the end of five years the contract “matures”. You can either take the money and run or reinvest in another annuity. But let’s say you want some access to your cash in the meantime. Typically there’s a percentage maximum the company will let you withdraw early without paying a penalty. Beyond that the penalty could be hefty.

Annuity companies invest your cash, usually in high-quality bonds and work off the spread between what they make on their portfolio and what they’re forced to pay you in interest. Since, at least in our simple example, the company has to sell bonds to generate the cash you’re asking for, they’ll assess a Market Value Adjustment (a penalty) for taking out too much money too soon. The MVA is based on the bond market and bond prices tend to fall as interest rates rise. This potentially makes the MVA painful in a rising rate environment, such as we’re in now.

If you structure things right, however, you shouldn’t have to worry about an MVA. You’d still have ample cash in the bank (as we’ve discussed in prior posts), and you’ll still want to keep some bonds. My suggestion is that a fixed annuity shouldn’t account for more than half of your fixed income allocation and no more than a third of your liquid net worth. Beyond that, the MVA and any other penalties lurking in the contract’s fine print can become larger issues. But again, I would expect the bond fund to outperform the annuity over this five-year timeframe. This makes the annuity a good option for someone who’s super skittish about investing and is willing to risk underperforming for more certainty.

Now let’s look at immediate annuities.

These contracts bake in a small investment return and include a guarantee to pay recurring income for the rest of your life. Although people typically begin taking income immediately, hence the name, you could decide up front to defer income for several months, even years.

What’s interesting about these annuities is that the company is essentially sending you back your own money until you outlive their life expectancy for you. If you die earlier they keep what’s left but you can buy a time guarantee, such as for ten years, to protect your heirs. And the cost can really add up over time. For example, immediateannuities.com shows that a 65-yr-old woman in California could receive about $460 per month for life on a $100,000 purchase, but $420 per month with a “ten-year certain” guarantee.

Some fuzzy math shows us that $460 per month equals $5,520 of annual income, or a 5.52% annual return. Sounds great, right? But recall that this is overwhelmingly the buyer’s own money coming back to her until she lives another 18+ years and breaks even on her original purchase. Then she’s on the company’s dime but still lagging behind having invested in bonds and spending down the principal on her own.

In short, immediate annuities are an appropriate replacement for bonds if someone; 1) has no heirs; 2) needs to stretch their savings to meet their monthly needs; 3) has a recurring bill to pay that isn’t tied to inflation, such as the principal and interest on a fixed mortgage; 4) doesn’t want bond market risk; 5) could check all five of these off their list.

And the same rule applies that no more than half of your bond allocation should go into an immediate annuity because it’s fundamentally illiquid.

Have questions? Ask me. I can help.

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Structured Products and REITs

Recently we’ve been spending time looking at alternatives to bonds in our investment portfolios. Bonds put up a poor showing last year and lagged stocks considerably. It’s unfair to compare bonds to stocks since they’re not the same, and in fact are used to reduce portfolio risk because of this, but we’re drawn to make the comparison anyway.

Stocks rose 20+% last year while core bonds fell almost 2%. It’s reasonable to ask why we own bonds at all. But, as is often the case, we didn’t have to wait long for a real-world example of the market’s risk spectrum and the importance of bonds for more conservative portfolios.

As the stock market made its abrupt turn this year and speedily entered a technical correction last week, bonds generally held their ground, even in the face of expectations for at least a few interest rate increases by the Fed this year. Expected rate increases are a serious headwind for bonds, but investors still flocked to them when the stock market was at its most volatile. This so-called flight to quality is easily underappreciated when stocks are rising and speaks to owning a sufficient amount of high-quality bonds.

That said, you don’t have to hold only core bonds. As we discussed last week, you can add other flavors to juice up return potential within the fixed income side of your portfolio. But before you go exploring the wide world of bond alternatives, you should ensure you have your financial bases covered.

And by that I mean working backward to determine how much, if any, of your portfolio you can dedicate to alternatives. Here’s the rough framework I mentioned last week.

Cash in the bank = 1 – 2 years of spending (short-term emergency fund + known, or at least likely, big-ticket expenses).

Core bonds = 3 – 6 years of spending if you’re nearing or living in retirement. Maybe more, but I would only suggest less if retirement is more than, say, ten years off.

If you do the math you might find you don’t have much room for riskier types of fixed income investments. Or maybe you have a lot of room. In either case it’s important to think about these alternatives as not being a foundational part of your personal short- and medium-term liquidity; they’re longer-term compliments.

With that said let’s add to our list of alternatives. I’m not creating an exhaustive list by any means. There are tons of options and I’m mostly sticking with what’s typical and readily available in public markets. Going into private investments with no active secondary market, for example, adds complexity, cost, increases risk and generally gives me the willies, so I try to avoid it.

By the way, I’m not suggesting you run out and buy any of these. The list below should be taken as a jumping off point for your own research.

Structured Products – I’ll come right out and say that I don’t like these products very much, but they’re popular in certain circles so I want to mention them here. My experience with these products goes back to the Great Financial Crisis when many of them got hammered or went bust. These products are constantly being created and I’m sure many have done just fine since, maybe even surprisingly well. But the GFC illustrates the main issues with structured products: complexity and issuer risk.

Structured products are like a bond with bells and whistles attached to it. Investment banks like Goldman Sachs and Morgan Stanley “structure” these investments to hold your money for a couple to several years or more. Then they invest the money in a stock index fund or maybe even an individual stock like Tesla. If the investment rises over the period the bank pays you the gains, which are often capped at a certain maximum percentage. If the underlying investment value falls during the period you’d typically you’d get your money back without any interest. Often, however, if the index falls too much the contract stipulates that you’ll have the honor and privilege of sharing in the losses, either capped or shared fully.

These products can be extremely complicated, and that’s putting it lightly, especially when tied to options contracts, commodities, and foreign currencies. Additionally, while some products are FDIC-insured, most are backed solely by the issuer (the investment bank). And in my experience these and other risks are glossed over by the salespeople who schlep these products, so caveat emptor.

The bottom line is that there’s no risk-free way to get stock market returns. If you want exposure to a stock index or Tesla, for example, just keep it simple and buy those directly.

That said, there’s a secondary market for some structured products and volatility in the stock market can present buying opportunities. I have open access to these, and I reviewed several yesterday, but the minutia made me want to scream so I moved on.

Publicly-traded Real Estate

Real estate investment trusts (known as REITs) traded on a stock exchange are a more standard, and dare I say simpler, bond alternative. But they are not bonds, they are regulated trusts that trade like stocks. REITs can be made up of commercial or residential real estate, even mortgages. Part of their structure is to pass through most of the income they raise to investors in the form of dividends. This leads to higher cash flow than core bonds provide, which is obviously a huge bonus.

The problem, however, is that a REIT’s income and value are more subject to changes in the broader economy than a bond. The REIT could own shopping malls during a recession (or a pandemic) and see increased vacancy leading to declining rental income and lower payments to shareholders. Then maybe the value of the malls declines for the same reasons. All this and more impacts the REIT’s share price, at times making the category more volatile than the S&P 500, for example.

Because of the size of the REIT space, and the size variation among REITs themselves, I think it pays to be diversified. A good example of this is Vanguard’s REIT fund, ticker symbol VNQ. The fund owns about 170 separate REITs covering an array of industries and property types including healthcare, offices, retail, storage, and residential.

Diving deeper, an investor with conviction in a certain area could buy an individual REIT instead of (or in addition to) a fund. There are tons of options, but one worthy of consideration is Realty Income Corp, ticker symbol O. O is itself a diversified portfolio of around 11,000 properties with high occupancy, and good geographic and industry diversification. Interestingly, VNQ has owned shares of O within its portfolio for years, so buying one also gets you exposure to the other.

That’s it for this week. Next time we’ll round out our list by looking at convertible bonds, floating rate bonds, and fixed annuities.

Have questions? Ask me. I can help.

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Bonds vs Cash

“Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.” - Warren Buffett

This quote from the Oracle of Omaha pretty much sums up my feelings about holding cash for too long. Yes, it’s immediately gettable and doesn’t come with any market risk like stocks and bonds do. That makes us feel better as Mr. Buffett suggests, but over time the insidious nature of inflation will strip away the purchasing power of that cash and leave you behind the eight ball.

On that note let’s look at our first step in reviewing the investment thesis for bonds in our portfolio. As a reminder, I do this sort of thing regulary but am sharing some of my thinking with you because bonds have been going through a tough time lately. Especially when compared with the stock market, which isn’t really fair but we do it anyway, bonds have been vastly underperforming. So we should review why we own them, compare against alternatives, and then consider what other layers we could add to help performance over time.

This week we’ll look at bonds versus holding cash.

As I mentioned last week, the right kinds of bonds act as a store of value, or something you can trust to put money into today that should, if given enough time, allow for easy access in the future while preserving your purchasing power. In other words, the bonds versus cash question is all about your personal liquidity over different periods of time and keeping up with inflation.

Cash isn’t meant to be held long-term. It’s considered safe because there’s no market risk and is federally insured up to $250,000 per person, per institution, with higher limits possible depending on how accounts are structured. Those are great benefits but the problem is that our economic and financial system incentivizes risk taking, not hoarding cash. We need savers to invest and to put their savings at some amount of risk because this helps keep the economy growing. Savers are rewarded if they do and punished if they don’t. Incredibly low interest rates on cash in recent years has made this painfully obvious.

Here’s a chart showing total growth over the last ten years of the Consumer Price Index (CPI) versus the 90-day Treasury bill, a typical proxy for cash. We see that even modest levels of inflation easily degraded cash’s purchasing power. And we all know this has gotten worse lately.

Over longer periods of time cash don’t pay, so to speak. Cash underperformed every other reasonable alternative as well for at least the last 25 years. Again, that’s by design so we should expect this.

That said, having cash at the bank absolutely serves a purpose in the short-term. What’s short-term? Maybe a year or two. My suggestion is to add up what you need for the coming month, add an emergency fund of at least three to six months’ worth of spending, and then add expensive items (appliances, cars, dental work, houses, whatever) you’re pretty sure you’ll want to spend money on in the next year or two. I’d argue that inflation doesn’t matter that much over such a short timeframe. You should willingly pay an opportunity cost to keep this money locked up tight at your local bank or credit union. But beyond that you should do something more productive with your cash.

Now let’s add the Bloomberg Barclays US Aggregate Bond index, the main proxy for core (high quality, medium term) bonds, to the chart above. With some exceptions along the way, bond values have maintained purchasing power by keeping pace with the CPI.

With bonds two issues are paramount, credit quality and time. Credit quality, because bonds are loans that borrowers, such as the US Government, states, or US corporations, have agreed to pay interest on before eventually repaying the lender (you). The entity’s ability to do both is measured by its credit rating (good credit = low risk = low interest rates). And time, because the longer you have to wait for repayment, and the longer you’re stuck with a given interest rate, the greater the risk and the more susceptible the bond’s price is to changes in interest rates in the broad market.

I favor core bonds for client portfolios because, again, these bonds act as a medium-term store of cash. The two I use most are the “total bond market” funds from Vanguard and State Street. Both meet the above criteria nicely and have performed as expected, even though they lost money last year. These funds are also inexpensive with an annual cost of about 0.03% compared to an industry average of around 0.5%. And they’re both very actively traded each day, so buying and selling them is easy.

But that’s for the core of your bond portfolio. How about something shorter-term? As I mentioned, holding cash is a good idea up to maybe two years. You can either jump into core bond funds because they also hold short-term bonds, or you could buy a second fund that only owns bonds with shorter maturities. This can work great for stacking, or bucketing, spending needs in retirement.

Here’s the same chart but including short-term bonds, in this case Vanguard’s popular index fund, ticker symbol BSV (which I also use sometimes). You’ll see that short-term bonds, the purple line, have lagged the CPI but have still handily outperformed cash.

The bottom line is that bonds pass the test as a store of value while cash doesn’t. Again, I don’t see this relationship changing anytime soon because taking even a little risk is required in our system when thinking out beyond a couple of years. But are bonds the be-all and end-all?

Over the next few weeks we’ll look at reasonable alternatives for bonds and how you might implement them in your portfolio. I don’t want to bore you by looking at everything, so we’ll look at preferred stocks and junk bonds, publicly traded real estate, and perhaps fixed annuities and a little crypto for the sake of variety. If there’s another category on your mind, let me know and maybe we’ll look at that too.

Have questions? Ask me. I can help.

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