Long Bonds Beating Stocks in 2019

Through August 31, the S&P 500 Index is up 18.34%, including dividends. Would it surprise you to learn that bonds did even better? The Morningstar US Long Government Bond Index was up 18.40% in the same period. Even with this remarkable stock market performance, you would have done slightly better by buying a 30-year Treasury Bond in January!

How do bonds yielding under 3% give an 18% gain in eight months? Bond prices move inversely to yields, so as yields fall, prices rise. The longer the duration of the bond, the greater impact a change of interest rates has on its price. This year’s unexpected decrease in rates has sent the prices of long bonds soaring. While bonds have made a nice contribution to portfolios this year because of their price increases, today’s yields are not very attractive. And longer dated bonds – those which enjoyed the biggest price increases in 2019 – could eventually suffer equivalent losses if interest rates were to swing the other direction. We find bonds going up 18% to be scary and not something to try to chase. 

Today’s low interest rates are a conundrum for investors. The yields on Treasury bonds, from the shortest T-Bills to 10-year bonds are all below 2%. CDs, Municipal bonds, and investment grade corporate bonds have all seen their yields plummet this year. In some countries, there are bonds with zero or even negative yields.

What can investors do? I am going to give you three considerations before you make any changes and then three ideas for investors who want to aim for higher returns.

1. Don’t bet on interest rates. Don’t try to guess which direction interest rates are going to go next. We prefer short (0-2 year) and intermediate (3-7 year) bonds to minimize the impact that interest rates will have on the price of bonds. With a flat or inverted yield curve today, you are not getting paid any additional yield to take on this interest rate risk. Instead, we take a laddered approach. If you own long bonds which have shot up this year, consider taking some of your profits off the table.

2. Bonds are for safety. The reason why we have a 60/40 portfolio is because a portfolio of 100% stocks would be too risky and volatile for many investors. Bonds provide a way to offset the risk of stocks and provide a smoother trajectory for the portfolio. If this is why you own bonds, then a decrease in yield from 3% to 2% isn’t important. The bonds are there to protect that portion of your money from the next time stocks go down 20 or 30 percent.

3. Real Yields. Many of my clients remember CDs yielding 10 percent or more. But if inflation is running 8%, your purchasing power is actually only growing at 2%. Similarly, if inflation is zero and you are getting a 2% yield, you have the same 2% real rate of return. While yields today are low on any measure, when we consider the impact of inflation, historical yields are a lot less volatile than they may appear. 

Still want to aim for higher returns? We can help. Here are three ideas, depending on how aggressive you want to go.

1. Fixed Annuities. We have 5-year fixed annuities with yields over 3.5%. These are guaranteed for principal and interest. We suggest building a 5-year ladder. These will give you a higher return than Treasuries or CDs, although with a trade-off of limited or no liquidity. If you don’t need 100% of your bonds to be liquid, these can make a lot of sense. Some investors think annuity is a dirty word, and it’s not a magic bullet. But more investors should be using this tool; it is a very effective way to invest in fixed income today. 
Read more: 5-year Annuity Ladder

2. High Yield is getting attractive. Back in 2017, we sold our position in high yield bonds as rising prices created very narrow spreads over investment grade bonds.  Those spreads have widened this year and yields are over 5%. That’s not high by historical standards, but is attractive for today. Don’t trade all your high quality bonds for junk, but adding a small percentage of a diversified high-yield fund to a portfolio can increase yields with a relatively small increase in portfolio volatility.

3. Dividend stocks on sale. While the overall stock market is only down a couple of percent from its all time high in July, I am seeing some US and international blue chip stocks which are down 20 percent or more from their 2018 highs. Some of these companies are selling for a genuinely low price, when we consider profitability, book value, and future earnings potential. And many yield 3-5%, which is double the 1.5% you get on the US 10-year Treasury bond, as of Friday. 

While we don’t have a crystal ball on what the stock market will do next, if I had to choose between owning a 10-year bond to maturity or a basket of companies with a long record of paying dividends, I’d pick the stocks. For investors who want a higher yield and can accept the additional volatility, they may want to shift some money from bonds into quality, dividend stocks. For example, a 60/40 portfolio could be moved to a 70/30 target, using 10% of the bonds to buy value stocks today. 

When central banks cut rates, they want to make bonds unattractive so that investors will buy riskier assets and support those prices. When rates are really low, and being cut, don’t fight the Fed.

Long bonds have had a great performance in 2019 and I know the market is looking for an additional rate cut. But don’t buy long bonds looking for capital appreciation. Trying to bet on the direction of interest rates is an attempt at market timing and investors ability to profit from timing bonds is no better than stocks. If you are concerned how today’s low yields are going to negatively impact your portfolio going forward, then let’s talk through your options and see which might make the most sense for your goals.  

Source of data: Morningstar.com on September 2, 2019.

10 Rules for Playing Defense in Investing

Stocks take the stairs up and the elevator down. When they rise, it is slow and steady, but when they go down it feels like a free-fall. Given the recent market tumult, I wanted to share my top ten rules for defensive investing.
Defense doesn’t mean that you won’t have losses on days when the market goes down. It means that you avoid unnecessary risks that could really blow up your portfolio, so you can have the confidence to stay with the plan.

1. Diversification is the only free lunch in investing. You should be diversified by company, as well as by sector and country. If your employer issues you stock options or has an Employee Stock Purchase Plan, take every opportunity to sell and diversify elsewhere. Most disaster stories I hear are from people who failed to diversify.

2. Index Funds are the antidote to performance chasing. When you pick a concentrated fund, such as a sector fund or single country fund because of its recent track record, you risk buying at the top and experiencing a painful (and much larger than necessary) drop when the winds change direction. While it’s so easy to find actively managed funds that beat the index over the past year, there is a better than 80% chance that those funds will lag the index over the next five or more years. The Index fund is also likely a fraction of the cost and is also more tax-efficient than an actively managed fund.

Read More: Manager Risk: Avoidable and Unnecessary

3. Asset Allocation is the most important decision you make. Start with a carefully measured recipe so you don’t end up with a random collection of funds and stocks you’ve acquired over the years. If you’ve decided that a 60/40 portfolio is the right mix for your needs, that should be for all market environments, not just while stocks are going up.

4. You are going to be tempted to adjust your Asset Allocation. It is very tough to get this right, because humans are wired to make terrible investing decisions. We want to sell a down market and we want to buy when the market is at all-time highs. Obviously, in hindsight, we should buy when things are really ugly and sell at the peaks. Invest with your brain and not your gut-feeling.

Read More: Are You Making These 6 Market Timing Mistakes

5. Rebalance. When you have a target asset allocation, then the process of rebalancing back to your target levels creates a built-in process of selling assets which have shot up in value and buying assets which have temporarily gone out of favor. This works great with Funds, but don’t try this will individual stocks.

6. We buy stocks for growth and bonds for income and safety. When you try to switch those objectives, things seldom go as planned or hoped. Buying stocks for their yield and safety can easily lead to long-term under performance. Many times you will be better off in a plain vanilla index fund than a basket of super-high dividend stocks or supposedly safe stocks. Many high-yielding stocks are very low quality companies with no growth. When they do eventually cut their dividends, the shares plummet.

Similarly, you can find bonds that as quoted, should yield stock-like returns. Stay away. These could be future bankruptcies.

Read More: Bonds for Safety in 2019

7. Don’t use margin. Keep cash on hand. If you don’t thoroughly understand options, avoid them. Don’t buy penny stocks or stocks on the pink sheets.

8. Dollar Cost Average in every account you can. 401(k) accounts are ideal. You will often make most of your gains on the shares you purchased in a down market, you just won’t know it until later. 

9. Take your losses. Don’t play the imaginary game of “I will sell it when it gets back to even”. If you are in a crummy fund, replace it with a more appropriate fund. We tax-loss harvest in taxable accounts annually and immediately replace each sale with a different fund in the same category (large cap value, emerging markets, etc.). 

Read More: Why You Should Harvest Losses Annually

10. Stick to the Plan. Don’t make abrupt, knee-jerk changes. Investing adjustments should not be all in/all out decisions. Keep opening your statements, but recognize that a bad day, month, quarter, or year doesn’t mean that anything is wrong with your plan. Of course, if you didn’t start with a plan, that’s another story.

We genuinely believe that no one can repeatedly time the market and that the attempts to do create significant risk to your long-term returns. I try to convey this message consistently. Last week, a friend asked if all my clients were panicking about that day’s drop. And I said that I hadn’t gotten a single call that day, because they know we are in it for the long haul and have already positioned their portfolio with their goals in mind. 

It will not surprise you that I think you are more likely to be a successful investor if you work with an advisor who can make sure you start with a plan, stick to an asset allocation, and implement your plan with sensible investments. Along the way, we will rebalance, make adjustments, and monitor your progress. We are looking to help more investors in 2019 and would welcome an opportunity to discuss how our approach could work for you. 

Bonds for Safety in 2019

2018 saw rising interest rates, which hurt the prices of bonds. Most bond funds were flat to slightly down for the year. Rising interest rates also means higher yields, and we now see sufficient yields to justify buying short-term bonds. We have been reducing our equity exposure over the last few weeks, and have been using those proceeds to buy individual investment grade short-term bonds and Exchange Traded Funds (ETFs). 

I wanted to share a couple of themes which will guide our investment process for fixed income in the year ahead. In general, this is not a great time to be taking a lot of risk with your bond allocation. We want to use bonds to offset the risk of stocks to dampen overall portfolio volatility. Thankfully, bonds can now also make a positive contribution to your return albeit in a very modest 2-4% range, and with low or very low risk.

1. Credit doesn’t pay. A credit spread measures the difference in yield between a high quality bond, such as a US Treasury bond, versus say a bond issued by a company which has lower credit. That spread remains very tight today, meaning that you are not getting much additional yield for accepting the credit risk of a lower quality issuer.

This has led us to be selective about which corporate bonds we buy, only buying issues which have enough spread to justify their purchase. In today’s market, this primarily leads us to financial companies, especially the large banks, and to municipal bonds, including the rarely-discussed taxable municipal bonds which are a good choice for IRAs or other non-taxable accounts.

Both Treasury and US Government Agency bonds still have lower yields than CDs. This month, we bought some one-year CDs at 2.70% to 2.75% while the one-year Treasury was around 2.50%. That spread widens as we look to two and three year maturities.

I should explain that we offer “Brokerage CDs”, which are a little different than your typical bank CDs. Brokerage CDs are FDIC-insured against loss and we can shop for the best rates available, from both top banks like Wells Fargo or JP Morgan Chase and from smaller local banks who want to compete for the best yield. 

While you can typically redeem a bank CD early, albeit with an interest penalty of a few months, with a Brokerage CD, you would have to sell the CD in the bond market. If interest rates continue to rise, you would likely have to sell at less than full value. While these CDs offer the excellent rates, they are best used when you can hold to maturity.

We use CD rates as the basis of our spread comparison, rather than the traditional Treasury bonds. If we can’t find an improvement of at least 0.35% to 0.50% for an A-rated bond, then it’s not worth taking even the small risk over the CD. We will still use Treasury Bills for maturities of 6 months or less.

2. 5-year Ladder. In larger accounts, our goal is to create a ladder of bonds and CDs that mature over the following five years (2019, 2020, 2021, 2022, and 2023). This gives us a nice diversification of maturities while still maintaining a low overall duration. When the 2019 bonds mature, we purchase 2024 bonds to maintain a 5-year structure. In a rising rate environment, we are likely to be able buy new bonds at a higher rate. 

Besides being a sensible way to build a bond portfolio, a ladder also can be used to meet future needs for withdrawals or Required Minimum Distributions. Then instead of needing to sell equities or bond funds which could be down, we have a bond that is maturing to meet those cash needs. As a result, an investor might not need to touch their equities for the next five years. If or when their equities do grow, we can rebalance by selling stocks and buying new bonds at the top of the ladder.

While bond prices may go down if interest rates continue to rise in 2019, when you have an individual bond or CD, you know that it will mature at its full face value. So even if prices fluctuate, you will realize your stated Yield to Maturity when you do hold to maturity, which should be very possible with a 5-year ladder.

(Two notes: 1. While we can say that CDs and Treasury Bonds are guaranteed, other types of bonds do have some risk of default and cannot be described as guaranteed. 2. Investors who try to predict interest rates have as little success as investors who try to predict stock markets. We do not want to make bets on the direction of interest rates.)

3. Fixed Annuities. Annuities get a bad rap, but a Fixed Annuity is a third type of guaranteed fixed income investment. They deserve a closer look by investors as a bond substitute and work well with a 5-year laddered approach.

The current rate for a 5-year fixed annuity is 3.80% from one carrier I use. That compares to a 5-year CD at 3.35% to 3.60%. That’s not much of an improvement, however, the Fixed Annuity is an insurance product outside of our managed portfolio, so there are no investment management fees. Your net return is 3.80%. The insurance company will pay me a small commission directly, which does not impact your principal or your rate of return.

I think laddering fixed annuities can make sense for some, as a bond replacement, and more investors should learn about this before dismissing it as soon as they hear the word annuity. A 3.80% percent return on an annuity would be the equivalent of a 4.80% bond if you include a 1% annual management fee.

We wrote about doing a 5-year ladder of Fixed Annuities back in February 2016 in this blog, and I think it still makes sense for some investors. We would count this as part of your fixed income target for your overall portfolio allocation (60/40, etc.).

The stock market gets a lot of attention, but we don’t neglect fixed income in our portfolios. I do think there are benefits to managing your bond portfolio, and we spend as much time sweating the details of our fixed income selections as we do our stock market exposures.

Four Investment Themes for 2017

Each November and December, I undertake a complete review of our Premier Wealth Management Portfolio Models and make tactical adjustments for the year ahead. We have five risk levels: Conservative (roughly 35% equities / 65% fixed income), Balanced (50/50), Moderate (60/40), Growth (70/30), and Aggressive (85/15).

Our investment process is tactical and contrarian. Each year we look for those market opportunities which have attractive and low valuations, and increase our weighting to those segments, while decreasing those categories which appear more expensive. We include Core positions, which offer broad diversification and are the essential and permanent foundation of our portfolios. And we purchase Satellite positions which we feel offer a compelling current opportunity in a more narrow or niche investment category. Typically, there are 12-15 positions in total, consisting of Exchange Traded Funds (ETFs) and Mutual Funds.

While we are not afraid to make changes to our models, we believe that when it comes to trading, less is more. We want to minimize taxable sales and especially to avoid short-term capital gains. That’s why we only change the models once a year, although we also believe that more frequent trading would be likely to be detrimental rather than return enhancing.

For 2017, our portfolio changes will be based on three considerations:
1) Relative valuations (reducing expensive stocks and adding to the inexpensive segments).
2) Replacing our holdings in a few categories, where another fund appears to offers a better risk/return profile.
3) Our world view of the markets in 2017, which is more focused on identifying risk than trying to predict the top performing investments. No matter what, diversification remains more valuable than our opinions about investment opportunities.

Here then are our four investment themes for 2017:

1) Low for Longer
Although interest rates may have bottomed in 2016, it does not appear that there will be a V-shaped recovery. We think interest rates, inflation, Domestic and Global GDP will all remain quite low for 2017.

2) Full Valuations
US Equities are no longer cheap. Years of central banks holding interest rates near zero (or actually negative in some countries this year) has forced investors into risk assets. This has driven up PE multiples. And while I would not call this a bubble, you can’t say that the US market is cheap today. That means that equity growth going forward is likely to be tepid.

Low bond yields pushed investors into dividend stocks, specifically to consumer staples and utilities, which are perhaps the most “bond-like”. These categories seem to be especially bloated and could underperform.

Turning to bonds, the yield on the 10-Year Treasury has increased from 1.6% to 2% in the past three months. Time will tell, but could this summer have been the peak of the 30-year bull market in bonds? I don’t know, but when yields are this low, prices on long-term bonds can move dramatically. We invest in bonds for income and stability and to balance out the equity risk in our portfolios. We’re not interested in using bonds to speculate on the direction of interest rates.

While there may not be an equity level of risk in bonds, it is safe to say that the price of bonds globally is higher in 2016 than it has ever been before. Bonds are much less attractive than five years ago, although we find some pockets that interest us and may at least give us a chance of exceeding inflation and earning a positive real return on our money.

3) Leadership Rotation
I believe we are going to see a very gradual shift in three areas:

A) From Growth to Value. Since 2009, growth stocks have dominated value stocks. This tends to be cyclical, but over the long-term, value has outperformed. We see a widening valuation gap between popular growth stocks, some of which are trading at PEs of 100 or higher, and out of favor value companies. Value is showing signs of life in 2016, and we think that there will be mean reversion at some point that favors value.

B) From Domestic to Emerging. Over the past 5 years, US stocks have reigned. Boosted by a strong dollar and a global flight to quality, US stocks have outperformed others and become more expensive than international stocks. Emerging markets have languished and are now trading at a big discount to developed markets. But emerging economies have higher growth rates and overall, have less debt and more favorable demographics than developed markets. While volatility will be higher, Emerging markets could greatly outperform if you are looking out 10 or 20 years from now.

C) From Bonds to Commodities. In 2016 we have already seen a rebound in oil, gold, and other commodity prices. After years of commodity prices falling, have we put in a bottom? We don’t have commodities in our models currently, but when inflation and interest rates start to pick up, I expect to see commodities gain and bonds suffer. That’s why the bull market in bonds may well end at the same time as the bear market in commodities. 2017 may be a good year to start diversifying for long-term investors.

4) High Risk, Low Return
With full valuations in equities and very low interest rates in bonds, expected returns for a Balanced or Moderate allocation are likely to be noticeably lower than historical returns. While volatility has been actually very mild for the past several years, investors should not be lulled into thinking that their portfolios will continue to grind higher without the possibility of a 10% or 20% correction.

Unfortunately, in today’s global economy, it seems less likely that a traditional diversification, for example, adding small cap and international stocks, will provide any sort of defense in the next bear market. We are expanding our investment universe to look for alternative strategies which can offer a true low correlation to equities. When the market is booming or even just recovering (like 2009), equities are often the top performers. But in a high risk, low return environment, we want some positions that offer the potential for positive returns with lower, different, or uncorrelated risks. If you want to explore these in greater detail, see our new Defensive Managers Select portfolio model.

These four investment themes are important considerations for how we position for 2017. You can get investments anywhere and they are becoming a low-cost commodity. However, what you cannot get anywhere is insight, personal service, and a custom-tailored individual financial plan. Investments are interesting, but we view them as a means to an end. Investments should accomplish your financial goals with the absolute least amount of risk necessary. The more interesting angle is how we can use investments to fulfill your plan just for you.