interest rates Archives - Good Life Wealth Management

How are Bonds and Interest Rates correlated? Bonds move inversely from Interest Rates. When rates rise, the price of bonds fall. This simple fact led to the downfall of Silicon Valley Bank and Signature Bank this month. Banks invest your deposits in bonds and earn a spread on the difference between what they pay you and the bonds they buy. Banks are not vaults with piles of cash – they are bond investors. That is their business model.

In 2020, these banks bought long-term bonds with yields of 1-2 percent. Fast forward to 2023, and yields are now 4-5 percent on the same bonds, and some of those bonds are now trading at 90 cents on the dollar. A bank with $10 Billion in these bonds now has a paper loss of $1 Billion.

If they can hold to maturity, these bonds will return back to their full value. But if a large number of depositors all want their money out today, the banks have to sell their bonds for a huge loss. And if that loss is large enough, the bank becomes insolvent and doesn’t have enough assets to cover their deposits.

Bank Failures

When a bank fails, the FDIC steps in and seizes the bank. What is remarkable about these two bank failures in March is the size of the losses. These two banks represent $319 Billion in assets, which makes 2023 the second worst year ever for the FDIC, and it’s only March. In 2008, bank failures totaled $373 Billion in assets. So it is easy to see how bad things could get in 2023, if two bank failures in March almost reached the losses of the Global Financial Crisis of 2008.

These banks are collateral damage from rising interest rates, thanks to the Federal Reserve. The Fed held rates for too low for too long after the start of the pandemic, and helped create the accelerating inflation. Now they are raising rates to slow the economy.

While the Federal Reserve did set this in motion, the poor risk management at the Banks should bear the brunt of the blame. We have been talking for several years about reducing the duration of our bond holdings and lowering our interest rate risk. And I thought everyone else was doing the same, it seemed pretty obvious to me. But no, there were banks buying these long bonds which were just waiting to get crushed. When customers realized the size of bank losses, they pulled their deposits and there was a run on the bank. Could other banks follow? Maybe. If customers pull out their deposits en mass, it is possible.

I am not terribly concerned about this spreading to other banks, because the Fed has launched a new program. The Bank Term Funding Program will provide loans to banks so that they can hold on to their longer dated Treasury bonds and not have to sell for a loss. It will provide liquidity so that the banks can hold these bonds for longer. And like other government programs, I can see this program being expanded and made permanent.

It is remarkable to me how much of our news today has its roots in bonds and interest rates. The bank crisis, inflation, recession, unemployment, retirement programs, real estate and mortgages, etc. These are all linked. What should the individual investor do? Here are our thoughts:

FDIC Coverage

I would never have more than $250,000 at any bank and exceed the FDIC coverage limits. I heard about a corporate subsidiary that had tens of millions at SVB, which failed last month. Luckily, it looks like the FDIC has arranged for all of those large account holders of SVB to be made whole. But I would not just assume that FDIC coverage is now unlimited. Instead of exceeding FDIC limits:

You could use more than one bank and stay under FDIC limits.
We can buy brokerage CDs from multiple banks in your Ameritrade account. Each issuer will carry $250,000 of FDIC coverage. Today we have 6-month CDs at 5%. Investors are often surprised that I can show them much better yields from Chase or Wells Fargo than they can get at their local branch.
Ladder Treasury Bills. There are maturities every week. Treasury bonds are high quality and the most liquid market in the world.

Bond Strategies

Our core holdings for bonds consist of owning individual bonds laddered from 1-5 years. We buy investment grade bonds including Agency Bonds, Treasuries, Corporate, Municipal, and CDs. Today, the yield on Agency bonds is very competitive with Corporates. And CDs are yielding higher than Treasuries.

With today’s yields, I would avoid taking on significant credit risk. We are not buying any junk bonds, and have sold our Floating Rate bonds. In addition to rising interest rates, we are seeing liquidity problems in some areas of the bond market. It may become difficult or impossible for some low credit quality companies to refinance their debt in 2023 and 2024. It is probable that defaults will rise, another casualty of the Federal Reserve heading the economy towards a likely recession.

Inverted Yield Curve

While the Fed raised the Fed Funds rate 0.25% at their March meeting, the bond market moved the opposite direction. Over the past month, the 2-year Treasury has actually fallen from 4.89% on March 1, to as low as 3.76% on March 23rd. The bond market remains inverted, with the 2-year yields higher than the 10-year yields. This is a strong historical predictor of recession. The bond market is priced as if the Federal Reserve will begin cutting interest rates in 2023, which is not what Jerome Powell is saying at all. The Fed’s commentary shows that they anticipate raising rates to 5.10% (from the current 4.75-5.00%) by year end. The movement in the bond market is bearish for the economy and stocks.

So now there is the potential for the opposite movement of the bond see-saw. If rates do go down this year or next, bond prices will rise. If we enter a recession, investors will want to shift towards safety and the Fed will lower rates. This would be a good time to have longer duration bonds with higher credit quality. And so we have begun buying longer bonds, 7-15 years. And if nothing happens and we just hold these bonds, we have yields to maturity of 6%. That is also a good outcome, an alternative to stocks, which have a similar expected return today.

In spite of seeing losses in bonds in 2022, looking forward, bond returns look strong. Still, it is crucial to be mindful of the risks and to take steps to mitigate them. Here are some additional ways to improve safety in a bond portfolio:

Diversify Across Different Types of Bonds

It’s important to diversify across different types of bonds, such as corporate, municipal, and government bonds, as well as across different industries and sectors. This can help reduce the impact of any one bond issuer or industry experiencing difficulties.

Consider Active Bond Management

Active bond management can help adjust the portfolio to changing market conditions and credit risks. It may be worth considering investing in low-cost actively managed bond funds or working with an investment advisor who specializes in bond management.

Monitor Interest Rate Risks

Investors should keep a close eye on interest rate risks and how they may impact their bond portfolio. The longer the duration of the bond, the greater the impact of interest rate fluctuations. Investors may want to consider laddering their bonds to manage interest rate risks.

Use Credit Ratings as a Guide

Credit ratings can provide a guide to the creditworthiness of a bond issuer. Investors should be wary of bonds with lower credit ratings, as they may carry higher risks of default. However, it’s important to remember that credit ratings are not infallible and can sometimes be inaccurate.

In conclusion, while bonds can offer attractive yields and provide diversification to a high net worth investor’s portfolio, it’s important to be mindful of the risks and take steps to mitigate them. By diversifying across different types of bonds, actively managing the portfolio, monitoring interest rate risks, and using credit ratings as a guide, investors can help reduce their exposure to potential losses. Keeping cash in a bank may not be as safe as you might assume, especially if you exceed FDIC coverage. And why have cash earning next to nothing when you could be making 4-5% in short term CDs or Treasury Bills?

Within our strategic asset allocation models, we actually spend more time on managing our bond holdings than our stock holdings. Why? Because it’s that important, and it is an area where we believe we can add more value with our time. Interest Rates are in the news and there are a lot of risks today. Risk is often defined as a danger, but risk can also mean opportunity. We are seeing both dangers and opportunities in 2023, and you can bet there will continue to be a lot of headlines about Bonds and Interest Rates.

With interest rates crushed around the world, how do you create retirement income at zero percent? Fifteen years ago, conservative investors could buy a portfolio of A-rated municipal bonds with 5 percent yields. Invest a million dollars and they used to get $50,000 a year in tax-free income.

Not so today! Treasury bonds set the risk-free rate which influences all other interest rates. Currently, the rate on a 10-year Treasury is at 0.618 percent. One million dollars in 10-year Treasuries will generate only $6,180 in interest a year. You can’t live off that.

You can do a little better with municipal bonds today, maybe 2-3 percent. Unfortunately, the credit quality of municipal bonds is much worse today than it was 15 years ago. A lot of bonds are tied to revenue from toll roads, arenas, or other facilities and are seeing their revenue fall to zero this quarter due to the Coronavirus. How are they going to repay their lenders?

Debt levels have risen in many states and municipalities. Pension obligations are a huge problem. The budget issues in Detroit, Puerto Rico, Illinois, and elsewhere are well known. Shockingly, Senator McConnell last week suggested that states maybe should be allowed to go bankrupt. That would break the promise to Municipal Bond holders to repay their debts. This is an appalling option because it would cause all states to have to pay much higher interest rates to offset the possibility of default. And unlike Treasury bonds which are owned by institutions and foreign governments, Municipal Bonds are primarily owned by American families.

With Treasuries yielding so little and Municipal Bonds’ elevated risks, how do you plan for retirement income today? We can help you create a customized retirement income plan. Here are three parts of our philosophy.

1. Don’t Invest For Income

We invest for Total Return. In Modern Portfolio Theory, we want a broadly diversified portfolio which has an efficient risk-return profile, the least amount of risk for the best level of return. We focus on taking withdrawals from a diversified portfolio, even if it means selling shares.

Why not seek out high dividend yields and then you don’t have to touch your principal? Wouldn’t this be safer? No, research suggests that a heavy focus on high yields can create additional risks and reduce long-term returns. Think of it this way: Company A pays a 5% yield and the stock grows at zero percent; Company B pays no yield but grows at 8%. Clearly you’d be better off with the higher growth rate.

When you try to create a portfolio of high yield stocks, you end up with a less diversified portfolio. The portfolio may be heavily concentrated in just a few sectors. Those sectors are often low growth (think telecom or utilities), or in distressed areas such as oil stocks today. The distressed names have both a higher possibility of dividend cuts, as well as significant business challenges and high debt.

The poster child for not paying dividends is Warren Buffett and his company, Berkshire Hathaway. He’s never paid a dividend to shareholders in over fifty years. Instead, he invests cash flow into new acquisitions of well-run businesses or he buys stocks of other companies. Over the years, the share price of BRK.A has soared to $273,975 a share today. If investors need money, they can sell their shares. This is more tax-efficient, because dividend income is double taxed. The corporation has to pay income taxes on the earnings and then the investor has to pay taxes again on the dividend. When a company grows, the investor only pays long-term capital gains when they decide to sell. And the company can write off the money it reinvests into its businesses.

2. Create a Cash Buffer

Where a total return approach can get you into trouble is when you have to sell stocks in a down market. If you need $2,000 a month and the price of your mutual fund is $10/share, you sell 200 shares. But in a Bear Market when it’s down 20%, you’d have to sell 250 shares (at $8/share) to produce the same $2,000 distribution. When you sell more shares, you have fewer shares left to participate in any subsequent recovery.

This is most problematic in the early years of retirement, a fact which is called the Sequence of Returns Risk. If you have a Bear Market in the first couple of years of retirement, it is more likely to be devastating than if you have the same Bear Market in your 20th year of retirement.

To help avoid the need to sell into a temporary drop, I suggest keeping 6-12 months in cash or short-term bonds so you do not have to sell shares. Additionally, I prefer to set dividends to pay out in cash. If we are receiving 2% stock dividends and 2% bond interest, and need 4% a year, we would have to sell just two percent of holdings. This just gives us more flexibility to not sell.

Also, I like to buy individual bonds and ladder the maturities to meet cash flow needs. If your RMD is $10,000 a year, owning bonds that mature at $10,000 for each of the next five years means that we will not have to touch stocks for at least five years. This approach of selling bonds first is known as a Rising Equity Glidepath and appears to be a promising addition to the 4% Rule.

3. Guaranteed Income

The best retirement income is guaranteed income, a payment for life. This could be Social Security, a government or company Pension, or an Annuity. The more you have guaranteed income, the less you will need in withdrawals from your investment portfolio. We have to be fairly conservative in withdrawal rates from a portfolio, because we don’t know future returns or longevity. With guaranteed income, you don’t have to fear either.

We know that Guaranteed Income improves Retirement Satisfaction, yet most investors prefer to retain control of their assets. But if having control of your assets and the ability to leave an inheritance means lower lifetime income and higher risk of failure, is it really worth it?

I think that investors make a mistake by thinking of this as a binary decision of 100% for or against guaranteed income. The more sophisticated approach is to examine the intersection of all your retirement income options, including when to start Social Security, comparing lump sum versus pension options, and even annuitizing a portion of your nest egg.

Consider, for example, if you need an additional $1,000 a month above your Social Security. For a 66-year old male, we could purchase a Single Premium Immediate Annuity for $176,678 that would pay you $1,000 a month for life. If you instead wanted to set up an investment portfolio and take 4% withdrawals to equal $1,000 a month, you would need to start with $300,000. So what if instead of investing the $300,000, you took $176,678 and put that into the annuity? Now you have guaranteed yourself the $1,000 a month in income you need, and you still have $123,322 that you could invest for growth. And maybe you can even invest that money aggressively, because you have the guaranteed annuity income.

Conclusion

It’s a challenge to create retirement income at zero percent interest rates. Unless you have an incredibly vast amount of money, you aren’t going to get enough income from AAA bonds or CDs today to replace your income. We want to focus on a total return approach and not think that high dividend stocks or high yield bonds are an easy fix. High Yield introduces additional risks and could make long-term returns worse than a diversified portfolio.

Instead, we want to create a cash buffer to avoid selling in months like March 2020. We own bonds with maturities over five years to cover our distribution or RMD needs. Beyond portfolio management, a holistic approach to retirement income evaluates all your potential sources of income. Guaranteed income through Social Security, Pensions, or Annuities, can both reduce market risk and reduce your stress and fear of running out of money. The key is that these decisions should be made rationally with an open mind, based on a well-educated understanding and actual testing and analysis of outcomes.

These are challenging times. If you are recently retired, or have plans to retire in the next five years, you need a retirement income plan. We had quite a drop in March, but recovered substantially in April. The economy is not out of the woods from Coronavirus. I think global interest rates are likely to remain low for years. If you are not well positioned for retirement income, make changes soon, using the strength in today’s market to reposition.

Bonds and Interest Rates