Investment Themes for 2023

Posted On January 13, 2023 By Scott Stratton, CFP(R), CFA In Portfolio Management / No Comments

At the start of each year, I discuss our investment themes for the year ahead. Today we share our Investment Themes for 2023. 2022 was a lousy year for investors, with a Bear Market in stocks (a loss of more than 20%) and double digit losses in bonds. And to add insult to injury, 9% inflation increased our cost of living even as portfolios shrank. War in Europe, supply chain problems, and political drama added to the uncertainty.

The Federal Reserve is committed to raising interest rates to slow the economy back down to 2% inflation. Economists are predicting a recession in 2023. With all these problems, it is easy to feel pessimistic about 2023 as an investor.

However, there are reasons for optimism. The call for a recession is so clear that it may already be somewhat priced into the market’s expectations for 2023. Many stocks are down 20%, 30% or more from their peaks and more fairly valued today. The large losses in international stocks were driven by a 17-20% increase in the value of the dollar to the Euro and Yen, and that headwind may be turning into a tailwind as the dollar starts to decline.

Today, we have very attractive rates in the bond market, 4.5% on short-term bonds and 5.5% on intermediate investment grade bonds. Bonds look better in 2023 than they have since the Global Financial Crisis in 2008.

My annual investment themes are not a prediction of whether stocks will be up or down this year. We don’t believe anyone can time the market or predict short-term performance. Instead, our process is to tilt towards the areas of relative value, with a diversified, buy and hold portfolio. Here is how we are positioning for the year ahead.

(And if you want to look back, here were our Investment Themes for 2022 and 2021.)

Stocks

In 2022, the Growth / Value reversal became widely acknowledged. For over a decade, growth stocks had crushed value stocks, but that leadership came to an end last year. Now, value stocks are performing better and growth stocks could have further to fall. We are using Value funds across markets caps – large, medium, and small.

International stocks have lagged US stocks, but today offer a better value. These stocks are cheaper than US stocks, have a higher dividend yield, and offer a hedge against a falling dollar. International and Emerging Markets are attractive today, and we are maintaining our international diversification. There are now more low-cost Value funds and ETFs offered in International stocks, and so we have replaced some of our Index Funds with a Value fund.

Overall, we have not made significant changes to the holdings within our stock allocations. What has changed is the expected return of stocks versus bonds. Over the next 10 years, Vanguard has an expected return of 5.7% return on US stocks. Yields have risen in A-rated bonds to where we can get a similar return from bonds. So, we are moving 10% of our stock allocation into individual bonds, 5-7 years with a yield to maturity of at least 5.5%. We are buying AAA government agency bonds (such as Fannie Mae or Freddie Mac), and some A-rated corporate bonds. These are offering a similar return as the expected return from stocks, but with much, much less risk and volatility. We aren’t giving up on stocks, but if bonds are going to offer similar potential, then we are going to add to bonds.

Bonds

Our core approach to bonds is to buy individual A-rated bonds, laddered from 1-5 years. We buy Treasury Bonds, Agency Bonds, CDs, Corporate Bonds, and Municipal Bonds. Yields are up and we want to lock-in today’s yields. For clients who are retired or close to retirement, our laddered bond portfolio will be used to meet their income needs for the next five years.

We use a “Core and Satellite” approach. The 1-5 year ladder represents our Core holdings today. For 2023, we decreased our Satellite holdings in bonds. Last year, we had a large position in Floating Rate Bonds. And these ended up being the best performing, most defensive category within Fixed Income in 2022. They worked exactly as hoped, protecting us during a year of rising interest rates. For the year ahead, though, they are less attractive. These are smaller, more leveraged companies. A year ago, their debt cost them 3%. Today, those companies are facing a recession and their debt now may cost them 7%. Floating Rate bonds have become more risky and more likely to have losses. We have sold Floating Rate and added the proceeds to our core 1-5 year ladder.

At the start of 2022, our focus was to minimize interest rate risk by keeping bonds short-duration. Yields have risen so much that in 2023 we want to extend duration and lock-in higher yields. Unfortunately, with an inverted yield curve, it is more challenging. Still, today, we are looking to add 5-7 year bonds to our ladders when cash is available and we can find attractive bonds.

We continue to own a small position in Emerging Market bonds. These have always been more volatile than other bonds, but history suggests that selling after a down year is a bad idea. The yields going forward are attractive, and many of these emerging countries are actually more fiscally sound than developed nations.

Alternatives

We are always looking for other investments which offer a unique opportunity for the current environment. We want returns better than bonds, but with less risk than stocks. If we can add investments with a low correlation to stocks, it will improve the risk/reward profile of our portfolio.

We purchased commodities early in 2022 with inflation spiking. Although they had a good Q1, commodities fared poorly for the rest of the year. We sold most of our commodities in October, and replaced them with TIPS, Treasury Inflation Protected Securities. The price of TIPS fell dramatically through the year, and by October, we could buy 5-year TIPS which yield 1.7% over inflation. TIPS are now a more direct inflation-hedge than commodities, which are frustratingly inconsistent. (If Gold doesn’t do well when there is 9% inflation, when will it shine?) Today, TIPS also offer a better yield than I-series US Savings Bonds.

Preferred Stocks were down in 2022 and we are trimming those positions to add to our Core 1-5 Year Ladder. Still, there are some good opportunities as many Preferreds are now trading at a 30% discount to their $25 par value. Preferreds with a set maturity date should be held to maturity. Perpetual Preferreds (those without a maturity) now offer 6-7% current yields or higher. While volatile, that is a decent level of income, plus the potential for price appreciation if interest rates fall in the future.

Overall, Alternatives are less attractive in 2023 because we now have such compelling bond yields. When we can buy risk-free T-Bills with a 4.5% yield, there is a higher bar for what will make the cut as an Alternative.

Summary

No one has a crystal ball for the year ahead, and our Investment Themes for 2023 are not based on a 12-month horizon. Instead, we are looking for assets that we think will be good over the next 5-10 years. We remain very well diversified, both in size (large, medium, small) and location (US, International, Emerging), as well as in Bonds and Alternatives. We diversify holdings broadly, with 10-12 ETFs, and each fund holding several hundred to several thousand stocks.

Although 2022 was an ugly year for investors, I wouldn’t bet against the stock market after a 20% drop. Historically, the market is usually up 12 months later. The expectations for 2023 are low and I would certainly caution investors to assume a volatile year ahead. Still, in these difficult periods, the best thing for investors is to stick to a good plan: diversify, keep costs and taxes low, and don’t try to time the market.

We take a patient approach and tilt towards the attractive areas, including Value stocks and International. Bonds finally offer a decent yield today and we have increased our core bond holdings and are looking to extend duration. We are making more changes in the bonds and alternatives than to our stock holdings. In 2022, we added more value on the bond side of portfolios, relative to benchmarks, than we did in stocks. So, as boring as bonds may seem, we focus a lot on bonds because we think there is an opportunity to add value for our investors.

Investing isn’t easy, but thankfully, it can be simple. We don’t need a lot of complexity to accomplish our goals over time. Years like 2022 are an unfortunate reality of being an investor. For 2023, we are making small adjustments but focused on staying the course.

Secure Act 2.0 Retirement Changes

Posted On December 29, 2022 By Scott Stratton, CFP(R), CFA In Retirement Planning / No Comments

The SECURE Act 2.0 passed this week after being discussed in Washington for nearly two years. The Act could not make it through Congress on its own, but it was stuffed into the Omnibus Spending Bill that was required to avoid an imminent government shutdown. I’ll save that rant for another day and focus on some of the dozens and dozens of changes to retirement planning in the Secure Act 2.0 which will affect you.

First, some background: The original SECURE Act was passed in December 2019. This legislation was the largest change to retirement planning in recent decades. It included increasing the age of RMDs from 70 to 72 and eliminating the Stretch IRA for beneficiaries.

The SECURE Act 2.0 goes even further and has a large number of changes to help improve retirement readiness for Americans. We are not going to cover all of these changes, but focus on a few key areas that are likely to apply to my clients.

Required Minimum Distributions

The SECURE Act 2.0 will gradually increase the age of RMDs from 72 to 75. Next year, the age to start RMDs will be 73, and then this will increase to age 75 in 2033. So, if you were born before 1950, your RMD age will remain 72 and you have already started RMDs. If you were born between 1951-1959, your RMD age is 73. And if you were born in 1960 or later, RMDs will begin in the year you turn 75.

I’m happy to see RMDs pushed out further to allow people to grow their IRAs for longer. For investors, this will extend the window of years when it makes most sense to do Roth Conversions. People are living longer and we should be pushing out the age of RMDs and starting retirement.

Roth Changes

Washington loves Roth IRAs. Anyone who thinks Washington doesn’t like Roths should consider the incredible expansion to Roths in SECURE Act 2.0. Roths are here to stay.

First, SEP IRAs and SIMPLE IRA plans will be amended to include Roth Accounts. This brings them up to par with 401(k) plans which have offered a Roth option for several years now. What does this mean? Roth contributions are after-tax and grow tax-free for retirement. You will be able to now open a Roth SEP or a Roth SIMPLE. Do you have a W-2 job and also self-employment income? You can do a 401(k) at work and also a Roth SEP for your self-employment.

2.0 also eliminates the RMD requirement from Roth 401(k)s. This was an odd requirement, and could easily be avoided by rolling a Roth 401(k) to a Roth IRA. But it still caught some people by surprise, so I am glad they eliminated this.

Starting in 2023, Employers may now make matching contributions into Roth 401(k) sub-accounts for employees. These additional contributions will be added to the employee’s taxable income. So, this may not make sense for everyone.

Forced Roth for Catch-Up Contributions

In 2024, high wage earners will be forced into using a Roth sub-account for catch-up contributions. If you are over age 50, you can make catch-up contributions. If you made over $145,000 in the previous year, your catch-up contributions must go into a Roth 401(k) starting in 2024. You will no longer be able to make Traditional (“deductible”) contributions with catch-up amounts. Oh, and if your company does not currently offer a Roth option, everyone over 50 will be prohibited from making any catch-up contributions.

This one will be a mess and is one of the only negative impacts we will see from SECURE Act 2.0. It will take many months for 401(k) providers and employers to update their systems and figure out how to implement these new changes.

Lots of Roth changes, but what isn’t here? The SECURE Act 2.0 didn’t eliminate the Backdoor Roth IRA. Many in Congress have been wanting to kill the Backdoor Roth, but it lives on. There are no new restrictions on Roth Conversions of any sort. Why so much love for Roths? Washington wants your tax money now, not in 30 years.

529 Plan to Roth

What if you fund a 529 College Savings plan for your child and they don’t use all the money? Currently, you can change the 529 plan to another beneficiary. But if you don’t have another beneficiary, withdrawing the money could result in taxable gains and a 10% penalty. The SECURE Act 2.0 is creating a third option: you can rollover $35,000 from a 529 plan to a Roth IRA for the beneficiary.

Here are the requirements. You must have had the 529 plan open for at least 15 years. You cannot rollover any contributions made in the preceding five years. Each year, the amount rolled from the 529 to the Roth is included towards the annual Roth contribution limit. For example, this year the limit is $6,500. The maximum you could roll from a 529 would be $6,500. But if the beneficiary already contributed $3,000 to an IRA (Roth or Traditional), you could only roll $3,500 from the 529 to the Roth. Thankfully, there are no income limitations to make this rollover. The lifetime limit on rolling over a 529 to a Roth will be $35,000, so this may take 5-6 years assuming the beneficiary makes no other IRA contributions.

You can change the beneficiary of a 529 plan to yourself. So, could you take an old 529, change the beneficiary to yourself and then roll it into your own Roth IRA? It is unclear in the legislation if a change in beneficiary will start a new 15-year waiting period. We will have to wait for additional rules to find out.

Other SECURE Act 2.0 Retirement Changes

So many changes! (Here is the most detailed summary I have seen so far.) These won’t impact everyone but I am studying all of these to see who might benefit:

IRA catch-up amounts will be indexed to inflation and increase in $100 increments.
401(k) Catch-up contributions will be increased for ages 60-63. The amount will be $10,000 or 150% of the annual amount, whichever is higher.
QCD (Qualified Charitable Distributions) limit of $100,000 will be indexed to inflation.
New exceptions to the 10% premature distribution penalty.
Emergency Savings Accounts, allowing people to access their 401(k)s without penalty. (Bad idea, but so many people in distress do this and then have to pay penalties and taxes, hurting them even further.)
QLAC limit increased to $200,000.
Allowing matching 401(k) contributions for payments towards student loans.
Tax credits for small employers who start a retirement plan.
New Starter 401(k) plans.
Lower penalties for missed RMDs.

I appreciate that Washington wants to make it easier for Americans to save for retirement. The SECURE Act 2.0 has a vast amount of retirement changes to incentivize the behavior the government wants to see. For those who are able to save for retirement, they are making it easier to save and accumulate assets. Your retirement is your responsibility! And retirement planning is my job. I’m here to help with your questions, preparation, and implementing your retirement goals.

Callable Bonds versus Discount Bonds

Posted On December 3, 2022 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Bond yields are up this year and we are seeing newly issued bonds with 5 to 6 percent coupons. Which is better – to buy a new issue or an older one with lower coupon? Here is what we are looking at as we buy individual bonds.

Yield To Maturity

The return of a bond from the date of purchase to its maturity is its Yield to Maturity or YTM. We calculate YTM with three things: the bond’s interest payments, the price of the bond, and the number of years to maturity. While bonds are generally issued and redeemed at a Par value of $1000, they inevitably trade at a premium or a discount to Par.

The bonds of any issuer tend to have the roughly the same YTM, but the price can differ. For example, a newly issued 5-year bond could have a 6% coupon (interest payment) and a price of $1000. This bond has a YTM of 6%. But an older bond with 5-years remaining might have a 3% coupon. Today, that bond would likely trade for $872, and have the same 6% YTM. In the first one, the 6% coupon, all of your YTM is solely from the coupon. In the second bond, the 3% coupon, part of your return is coupon and part is from the price increasing from $872 to $1000 over five years.

I think most investors would prefer the first bond, the 6% coupon, and get the same steady income each year. They’d rather have the current income rather than the capital gains of the second bond. However, the annual return on both, held to maturity, is the same 6%.

Callable Bonds

Unfortunately, there is one problem. Most corporate and municipal bonds are callable. That means the issuer has the right to refinance their debt and buy back your bonds early, before the five years are up. So, if interest rates drop from today’s 6% to 4% two years from now, they can buy back your 6% coupon bonds at 1000. And now you have to replace those 6% bonds at a time when interest rates are only 4%. This is called Reinvestment Risk.

However, the discount bond (the 3% coupon) won’t get called in this scenario. The issuer will not refinance a debt that costs them 3% for the new rate of 4%. You hold it for the full five years and receive your expected YTM of 6%. It’s better to buy the discount bond with a 6% YTM than a 6% coupon bond at par because of the Call Risk of the 6% coupon.

I’m sharing this because clients may hear me talking about bonds at 6% but then see a bond listed as a 3% bond on their statement. No one really knows what interest rates will do over the next five years, but they will probably move around quite a bit, like they have over the last five years. And that Call Risk is a real problem for bonds with a high coupon. If you really want to lock in your return from a bond, you have to understand its call features.

Callable Bonds Don’t Appreciate

One other consideration – callable bonds don’t have the ability to appreciate much. If the issuer can redeem anytime for $1000, that bond is not ever going to trade at a significant premium. However, if interest rates fall, our discount bond (the 3% coupon) can increase in price in a hurry. It can move up from $872 quickly. We can have a bigger return in the short run, and even sell that bond if we want.

In managing our bond ladders, I focus primarily on Yield To Maturity, not the current coupon. We prefer to buy discount bonds, which have lower call risk, when possible. Non-callable bonds are even better, but harder to find in all categories. Today, interest in bonds is high (pun intended), and so we have been writing a lot about how we manage this important piece of your portfolio.