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.

Stocks Versus Bonds Today

Posted On November 14, 2022 By Admin In Portfolio Management /

Where is the best opportunity – in stocks or bonds? I’ve been enthusiastic about the rising interest rates in 2022 and this has impacted the relative attractiveness of stocks versus bonds today. What do we expect from stocks going forward?

Vanguard’s Investment Strategy Group publishes their projected return for stocks for the next 10 years. And while no one has a crystal ball to know exactly how stocks will perform, this is still valuable information. They look at expected economic growth, dividend yield, and whether stock values (P/E ratios for example) might expand or contract.

Their median 10-year expected return for US stocks is 5.7%, with a plus or minus 1% range, for a range of 4.7% to 6.7%. This is actually up from the beginning of the year. As stocks have fallen by 20%, we are now starting from a less expensive valuation. But a projected return of 5.7% for the next decade would be well below historical averages, and most investors are hoping for better.

Is Vanguard being too pessimistic? No, many other analysts have similar projections which are well below historical returns. For example, Northern Trust forecasts a 6% return on US stocks over the next five years. And of course, these are just projections. Returns could be better. Or worse!

Bonds Are An Alternative

Last week, I bought some investment grade corporate bonds with a yield to maturity of 6% over three to five years. Bonds have much less risk than stocks and have only a fraction of the volatility of stocks. As long as the company stays in business, you should be getting your 6% return and then your principal back at maturity.

If we can buy a good bond with a return of 5.5% to 6.0%, that completely matches the projected stock returns that Vanguard expects. Why bother with stocks, then? Why take the risk that we fall short of 6% in stocks, if we can get a 6% return in bonds? Today, bonds are really attractive, even potentially an alternative to stocks.

For many of our clients, bonds look better than stocks now. And so we may be trimming stocks by year end and buying bonds, under two conditions: 1. The stocks market remains up. We are not going to sell stocks if they fall from here. 2. We can buy investment grade bonds, 3-7 years, with yields of at least 5.5% and preferably 6%. And we have to find different bonds, because we aim to keep any one company to no more than 1-2% of the portfolio.

We won’t be giving up on stocks – not at all. But we may look to shift 10-20% of that US stock exposure to bonds.

Three Paths for the Market

I think there are three scenarios, all of which are okay.

Stocks do way better than 6%. The risk here is that stocks could perform much better than the 5.7% estimate from Vanguard. Maybe they return 8% over the next five years. Well, this is our worst scenario: we make “only” 6% and are kicking ourselves because we could have made a little bit more if we had stayed in stocks.
Stocks return 6% or less. In this case, it is possible we will get the same return from bonds as the expected return from stocks. And if stocks do worse than expected, our bonds might even outperform the stocks. That’s also a win for bonds.
Stocks decline. What if the economy goes into recession, and stocks drop? If stocks are down 10% and we are up 6% a year on bonds, we will be really happy. In a recession, it’s likely that yields will drop and the price of bonds will increase. The 6% bond we bought might have gone up in value from 100 to 104. Then, our total return on the bond might be 10%, and we could be 20% ahead relative to stocks’ 10% drop. And in this scenario, we don’t have to hold the bonds to maturity. We could sell the bonds and buy stocks while they are down.

Smoother is Better

I’m happy with any of those three scenarios. Many investors are feeling some PTSD from the market performance since 2020. Many will be happy to “settle” for 5.5% to 6% from bonds, versus the 5.7% expected return from stocks. And of course, stocks won’t be steady. They may be up 20% one year and down 20% the next. It is often a roller coaster, and so increasing bonds may offer a smoother ride while not changing our expected return by much at all.

Should everyone do this? No, I think if you are a young investor who is contributing every month to a 401(k) or IRA, don’t give up on stocks. Even if the return ends up being the same 6%, you will actually benefit from the volatility of stocks through Dollar Cost Averaging. When stocks are down, you are buying more shares. So, if you are in accumulation, many years from retirement (say 10+), I wouldn’t make any change.

But for investors with a large portfolio, or those in or near retirement, I think they will prefer the steady, more predictable return of bonds. When the yield on bonds is the same as the 5-10 year expected return on stocks, bonds make a lot of sense. The risk/reward comparison of stocks versus bonds today is clear: bonds offer the same expected return for less risk. We will be adding to bonds and adjusting our portfolio models going into 2023.

Q3 Portfolio Results

Posted On October 2, 2022 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Q3 Portfolio Results are in and no surprise, it’s ugly. Today we are going to dive into the numbers and give a realistic overview of the situation. More importantly, we are going to share some reasons for optimism, or at least patience. And we will discuss the remarkable situation being created from currencies and interest rates.

Market Returns YTD

We use two benchmarks to design and evaluate our portfolios. For stocks, we look at the MSCI World Index, using the ETF ticker ACWI. For bonds, we use the Barclays US Aggregate Bond Index, or AGG. Year to date through September 30, the total return of ACWI was -25.72% and the total return of AGG was -14.38. (Source: Morningstar.com)

Our portfolios are a blend of stocks and bonds. For example Moderate is 60/40, which has a benchmark of 60% stocks in ACWI and 40% bonds in AGG. Your hypothetical, benchmark returns YTD are as follows:

Conservative 35/65: -18.35%
Balanced 50/50: -20.05%
Moderate 60/40: -21.18%
Growth 70/30: -22.32%
Aggressive 85/15: -24.02%
Ultra Equity 100/00: -25.72%

Category Performance

This has been a difficult environment. We are doing a couple of points better than our benchmarks across our portfolios, net of fees. Our move to shorter duration bonds and floating rate at the beginning of the year was a positive. And our Value funds have lost less than the overall market. No doubt, it has been a tough year for investors and I am not happy with our results.

Q3 deepened the Bear Market in stocks and extended losses in bonds with rising interest rates. Commodities, which were up dramatically in Q1, reversed in Q3. Thankfully, we have been well positioned in our bonds which has been our primary area of defense.

International stocks are down more than US Stocks and this has detracted from our returns. A large component of the loss in International stocks is due to the currency exchange. The dollar is up 16% to the Euro, and the dollar is up 25% to the Japanese Yen. So, even if a European stock was flat on its price in Euros, it would be a 16% loss in dollars.

Don’t Time The Market

When the market is up, and I say that we don’t time the market, everyone nods in agreement. But when stocks are down 25%, even the steeliest investor may want to throw in the towel. It’s natural and it’s human nature. It’s also the worst thing an investor can do.

But Scott, this time is different!

The economic outlook is terrible. The Federal Reserve is determined to crush inflation regardless of the short-term pain it inflicts on the economy. The 30-year mortgage hit 7% this week. Corporate earnings are starting to decline and consumer confidence is plunging.

Yes, all this is true. But, the stock market is a leading indicator. Stocks move ahead of economic data and investors aim to predict what will happen. Even if markets are not perfectly efficient, it is possible that a lot of the future economic woes are already priced into stocks. Stocks typically rebound before we fully exit a recession.

I am not making light of the severity of the current market impact or the economic situation which faces the world. But when we see the historic graphs of when the stock market was down 25% and where it was a few years later, it is pretty obvious that we should to stay on course.

In fact, I have spent a lot of time kicking myself for not being more aggressive in March of 2020, when we had such an amazing buying opportunity. But these opportunities are only obvious in hindsight. In real time, these feel like horrible, painful times to be an investor. Selling didn’t work in 2002, 2008, or 2020. Those were years to stay invested, so you could recover in 2003, 2009, or the second half of 2020.

International Stocks Improving

Q3 has been especially tough for international stocks and they’ve fared even worse than US stocks. Shouldn’t we focus more on the high-quality US companies then? After all, the dollar continues to go up. Why fight that trend?

There are going to be future ramifications of the strong dollar. Besides that it’s a great time to go visit Europe or Japan, let’s think through the implications of a strong dollar. For US companies, a strong dollar hurts us. It makes our exports more expensive to the rest of the world. And it makes the foreign profits of US companies look smaller. (Almost half of the profits from the S&P 500 index comes from foreign sales.) Over time, a strong dollar will hurt the US stock market.

On the other hand, the strong dollar can benefit foreign companies. As US imports become more expensive, they can gain local market share. Their products are now cheaper to US consumers and we buy more imported goods. They sell more and have higher profits.

This creates a leveling mechanism where currencies may tend to pull back towards each other rather than continue to widen apart. A stronger dollar will help Europeans (including through our increased tourism), and those international companies will see their profits grow. When the dollar eventually weakens, that currency headwind will become a tailwind, pushing foreign stocks higher. I don’t know when the dollar will reverse, but based on their improving fundamentals, I don’t think now is the time to give up on international stocks.

No More ZIRP, Bye Bye TINA

In 2008, central banks reduced interest rates to zero to save the global economy. For the next 11 or so years, we had a Zero Interest Rate Policy, nicknamed ZIRP. The US had just begun to test the waters of moving up from 0%, when COVID-19 hit. And we went right back to 0% and piled on unprecedented stimulus to the economy.

The stimulus worked. It worked so well, in fact, that we created 8-10% inflation around the world this year. And so now, central banks are raising rates around the world. Last week, I wrote about being able to buy a 5% US government agency bond for the first time in over a decade. It’s a game changer.

For the past 14 years, 0% interest rates meant that There Is No Alternative to stocks. You simply could not invest in bonds. It became such a reality, that it became its own acronym. Like FOMO or LOL, every advisor knew TINA meant There Is No Alternative. Well, bye bye TINA, because bonds are back.

Bond yields are up and we can now buy high quality bonds with 4-6% yields. At those rates, we have a very real alternative to stocks. While we patiently wait for an eventual stock market recovery, we can buy attractive bonds right now. We are laddering our bonds from 1 through 5 years and will hold bonds to maturity. For clients with established withdrawals or Required Minimum Distributions, we are buying bonds to meet those needs over the next five years.

Discouraging but not Discouraged

Q3 has been rough, especially September. All the expectations about weak Septembers and mid-cycle election years certainly came true in 2022. I know the markets are incredibly disappointing right now, looking back over the last nine months. Both the stock and bond markets have double digit losses for 2022. I don’t think that has ever happened before and it means diversification hasn’t been much help.

We did make a few beneficial choices at the beginning of the year, with short-term bonds and Value stocks. Looking forward, there are reasons to be optimistic. Historically, after a 25% drop, stocks are usually higher 12 months later, and often see a double digit gain. Our international stocks have been hammered by the strong dollar. But that may ultimately be beneficial for foreign companies and the dollar may even reverse. Bonds yields are up and now there is a real alternative to stocks. (Can I coin TIARA, there is a real alternative? You heard it here first…)

No doubt these are frustrating times. I feel your pain and I am in the same boat, personally invested in our Aggressive Model. We’ve seen this before – Bear Markets in 2020, 2008, and 2000, and many before that. In fact, before 2000, Bear Markets were about once every four years. And one of three years in the market is down, historically. Every one of these drops feels unique and like the sky is falling. And in time, they work out eventually. I am looking at the markets daily and am ready to make adjustments. But sometimes, the sailor has to sail through the storm to reach their destination and it’s all part of the journey. We need patience, but also to keep asking questions and thinking long-term.

Inflation Investment Ideas

Posted On July 15, 2022 By Admin In Portfolio Management /

Inflation continues to shock the Global economy and has become a major concern when we discuss investment ideas. This week’s data showed the Consumer Price Index up 9.1% over last year, and the Producer Price Index is up over 11%. These are numbers not seen since 1981.

Today, I’m going to share some thoughts on inflation and get into how we want to respond to this situation. But first, here is an inside look at the government response to inflation.

Federal Reserve Hitting the Brakes

Last week, I attended a breakfast meeting for the Arkansas CFA Society at the Federal Reserve office in Little Rock. Our guest speaker was James Bullard, president of the St. Louis Federal Reserve Bank and voting member of the Open Market Committee which sets interest rates.

Bullard said that we were at a profound regime switching moment today, and that this is not just a blip in inflation but a “stunning amount of inflation”. He stated that the Fed would move aggressively to reduce inflation and that they were committed to their inflation target of 2%. He thinks the Fed will continue to raise rates until policy rates are greater than the inflation rate and may need to hold those high rates for years to come to bring inflation down.

Bullard felt that the current inflation levels are not simply a temporary supply shock from the Ukraine War. Output is actually up. In March 2020, the Fed responded very quickly to support an economy crashing from COVID-19 shutdowns. 60 days later, markets recovered and housing boomed. He wishes that they had reduced their asset purchases sooner. Instead, the Fed is only now ceasing to buy bonds and is allowing their holdings to run-off as they mature. The global stimulus response was correct, but has overheated.

He was less concerned about the possibility of a recession. Bullard said that recessions are difficult to predict and that the Fed is going to focus on getting inflation under control first. Inflation remains a global problem, but the US Federal Reserve will lead the way on fighting inflation, as the European Central Bank has other issues making them slower to respond.

Inflation, Rising Rates, Recession

It’s important to understand that even if inflation remains elevated for a couple of years, the impact of inflation may only be part of the story. Our investment ideas cannot simply assume high inflation as the only factor. We have to also consider the likelihood of rising interest rates and a recession. We’d love it if the Federal Reserve can orchestrate a soft landing as they apply brakes to this runaway economy. But they have not been very good at soft landings in the past.

The Fed policies are starting to work. Since the June inflation numbers, we’ve already seen the price of oil down by 20%. Mortgage applications are down and we should start to see housing inventories normalize and home prices stop their double digit increases. Interest rates have doubled compared to last year – 5.5% versus 2.75% for a 30-year mortgage – and this will impact how much home buyers can afford to pay. The Bloomberg Commodity Index was at 130 on June 16th and is now at 113, a drop of 13% in one month.

It is hard to imagine additional inflation shocks or surprises at this point. Despite the headlines, markets already know we have inflation. Inflation remains high, but may have peaked and should be starting to come down. The question is what is next? How will the markets respond to the Fed actions? Here are five thoughts about where to go from here.

Five Inflation Investment Ideas

Rising Rates. Bond investors beware. The Fed is going to continue to raise interest rates for an extended period. Keep your duration short on bonds. Consider floating rate bonds, if you don’t have any. Stay high quality – rising rates may cause defaults in weaker credits.
I-Bonds. These are inflation linked US savings bonds. They’ve been in the news this year, but I’ve been writing about them since 2016. Limited to $10,000 in purchases a year. These could do great for a couple of years.
Recession and Stocks. We might already be in a recession today, but won’t know it until later economic data shows a negative GDP for two quarters. Please resist the temptation to try to time the stock market. Recessions are a lagging indicator; stocks are a leading indicator and stocks will bounce back sooner. If you try to get out of stocks, it will be very difficult to get back in successfully. Instead, focus on diversification, with Value and Quality stocks. Avoid the high-flying growth names, we are already seeing those stocks get pummelled.
Roth Conversions. We are in a Bear Market, with the S&P 500 Index down 20%. This could be a good time to look at Roth Conversions, if you believe as I do that stocks will come back at some point in the future. An index fund that used to be $50,000 is now trading for $40,000. Do the Roth Conversion, pay taxes on the $40,000 and then it will grow tax-free from here. This works best if you anticipate being in a similar tax bracket in retirement as today.
Cash is Trash. Inflation is reducing your purchasing power. Thankfully, rising interest rates means we can now earn some money on Bonds and CDs. We can build laddered bond portfolios from 1-5 years with yields of 3-5%. And we have CDs at 3% as short as 13 months. Those are a lot better than earning 0% on cash. If you don’t need 100% liquidity, short-term bonds, CDs, and T-Bills are back.

Perseverance and Planning

I believe in long-term investing. Times like these will challenge investors to have the perseverance to stay the course. Rising rates and a possible recession in the months ahead may pose additional losses to our investment portfolios. If I thought we could successfully avoid the losses and step away from the market, I’d do that in a heartbeat. But all the evidence I have seen on market timing suggest it is unlikely to add any value, and would probably make things worse. We will stay invested, continue to rebalance, tax loss harvest, and carefully consider our options and best course of action.

With higher inflation, the cost of living in retirement increases, and so we have to aim for equity-like returns to make plans work. For our clients who are in retirement or close to retirement, we typically have a bucket with 5-years of expenses set aside in short-term bonds. And that bucket is still there and we won’t need to touch their equities for five years. In many cases, we have bonds which will mature in 2023, 2024, etc. in place to fund your spending or RMD needs. So, I am happy we have the bucket strategy in place, it is working as we had planned.

We have shared some inflation investment ideas, but I think the risks to investors may be greater from the Fed. Rising rates and recession are likely in the cards as they look to slow the economy. In spite of the headlines, this will undoubtedly be different than 1981, so I’m not sure we have an exact road map of what will happen. But, I will be your guide to continue to monitor, evaluate, and recommend what steps we want to take with our investments.

Bear Market Has Arrived

Posted On May 22, 2022 By Admin In Portfolio Management /

Stocks continued their slide for an eighth week. Friday’s drop now brings the S&P 500 Index down 20% from its recent peak. We are officially in a Bear Market. Tech stocks, in the Nasdaq Index, are down over 30% and have already been in a Bear Market.

Investors have questions and want to know what to do next. I’m going to share five thoughts.

One. Predictions are a waste of time. I’ve spent too much time this past week, reading, listening, and watching “experts” suggest what will happen next. No one knows. Some say the bottom is in, others call for another 20% drop. Some say inflation is here to stay, some say we are already in a recession, other say stagflation. The challenge is Confirmation Bias. Are we really evaluating evidence with an open mind? Or are we only looking for evidence which confirms our point of view? Unfortunately, certainty is one thing which we do not get to have as investors. Luckily, we don’t need a crystal ball to be successful. We know what has worked over time: diversification, index strategies, and focusing on keeping costs and taxes low.

Two. Our Investment Themes for 2022 have been helpful. Year to Date: Value stocks are doing better than growth stocks. International stocks are doing better than US Stocks. Short-Term bonds and Floating Rate bonds have held up better than the Aggregate Bond Index. We are still down an uncomfortable amount, and that is to be expected. However, we are down less than our benchmarks across all our portfolio models. I am not ever happy about Bear Markets, but our asset allocation has been a positive factor.

Three. We are at a 52-week low in many stocks and indices. Look back over the last 10, 20, or 30 years of stock market history and find those 52-week low points. Going forward, were you better off selling those lows or buying those lows? Obviously, you would have done very well by buying historic 52-week lows and selling would have been a mistake eventually. Could the market go lower from here? Of course. We don’t know what will happen next, but market timing via selling 52-week lows has been a poor strategy historically.

Read more: Are We Headed For a Bear Market? (2015)

Four. We have made a few moves in our portfolio that I wanted to share. We sold some of our convertible bonds and replaced them with a Vanguard Commodities fund. This should help us reduce equity-like exposure and add an inflation hedge. We sold one emerging markets bond fund and replaced it with a newer fund (also from Vanguard) with a much lower expense ratio. We sold bond funds and replaced them with individual bonds, laddered from 1-5 years. Although interest rates may rise, we can hold bonds to maturity and receive back our par value. Overall, these trades do not drastically change our asset allocation. But we are always looking for ways to improve our holdings, even in modest, incremental ways. We are not ignoring the market, portfolios, or clients at this time.

Five. Patience. If you are a ways off from retirement, this is a great time to dollar cost average and be buying shares in your IRA, 401(k), or brokerage account. You make money in Bear Markets, you just don’t realize it until later. For those who are close to retirement, or in retirement, we are already diversified and have a withdrawal strategy that anticipates market volatility such as this. We are planning for the next 20-30 years. There will be multiple Bear Markets over your retirement. Although each Bear Market feels like a surprise, they are bound to happen. And like in 2020, we are using the current drop as an opportunity to rebalance portfolios and do tax loss harvesting.

Read more: Stock Crash Pattern (March 2020)

We’ve seen this before. We’ve been here before. Bear Markets are an unfortunate reality of being an investor. They stink and we would all prefer if markets only went up. When times are good, we need to invest with the knowledge that Bear Markets are inevitable. And then when Bear Markets do arrive, like Winter, we need to wait out the storms knowing that Spring will eventually return.

Ignore predictions. Our investment themes are on the right track. Don’t sell a 52-week low. Look for opportunities to make small improvements. Be patient and persevere. That is how we are responding to the Bear.

5 Ways to Buy The Dip

Posted On March 15, 2022 By Scott Stratton, CFP(R), CFA In Behavioral Finance, Portfolio Management /

Right now, we are talking to investors about ways to buy the dip. From the highs of December, it is pretty remarkable how quickly markets have reversed. Stocks were already down in January as fears of inflation and rising interest rates took hold. The war in Ukraine has shocked the world and we are seeing tragic consequences of this inexcusable aggression. Inflation was reported at 7.9% for February and that was before we saw gas prices surge in March following the Russia sanctions.

This past Tuesday, we saw 52-week lows in international stock funds, such as the Vanguard Developed Markets Index (VEA) and the Vanguard Emerging Markets Index (VWO). Here at home, the tech-heavy NASDAQ is down 20%, the threshold used to describe a Bear Market. It’s ugly and there’s not a lot of good news to report.

Ah, but volatility is the fundamental reality of investing. Volatility is inevitable and profits are never guaranteed. In December, when the market was at or near all-time highs, everyone was piling into stocks. And now that many ETFs are near their 52-week lows, investors are wondering if they should sell.

Market timing doesn’t work

Unfortunately, our natural instinct is to do what is wrong and want sell the 52-week low rather than buy. Back in December, there were a lot of people hoping for a correction to make purchases. Now that a correction is here, it’s not so easy to pull the trigger on making purchases. The risks seem heightened today and nobody wants to try to catch a falling knife. Unfortunately, the market isn’t going to tell us when the bottom is in place and it is “safe” to invest.

Last week was the 13-year anniversary of the 2009 Lows. Most reporters say that the low was on March 9, 2009, because that was the lowest close. But I remember being at my desk when we saw the Intraday low of 666 on the S&P 500 Index on 3/06/09. Today, the S&P 500 is at 4,200 (down from a recent 4,800). Even with the 2022 drop, we have had a tremendous run for 13 years, up 530%.

A prospective client asked me this week what I had learned from being an Advisor back in 2008-2009. And I told her: First, you can’t time the market. Clients who decided to ride out the bear market did better than those who changed course. Second, individual companies can go out of business. You are better off in diversified funds or ETFs rather than trying to pick stocks.

Buying The Dip

While you shouldn’t try to time the market, we do know that “buying the dip” has worked well in the past. Since 1960, if you had bought the S&P 500 Index each time it had a 10% dip, you would have been up 12 months later 81% of the time. And you would have had an average gain of 12%. That’s a pretty good track record.

I feel especially confident about buying index funds on a dip. While some companies will inevitably become smaller or go out of business, an index like the S&P 500 holds hundreds of stocks. Over time, an index adds emerging leaders and drops companies on their way down. That turnover and diversification are an important part of managing an investment portfolio.

So with the caveat of buying funds, what are ways to buy the dip today? What if you don’t have a lot of cash on the sidelines? After all, if we don’t time the market, we are likely fully invested at all times already.

5 Purchase Strategies

Continue to Dollar Cost Average. If you participate in a 401(k), keep making your contributions and buying shares of high quality, low cost funds. If you are a young investor, you should love these market drops. You can accumulate shares while they are on sale!
Make your IRA contributions now. If you make annual contributions to an Traditional IRA, Roth IRA, 529 Plan, or other investment account, I would not hesitate to proceed. Make your contribution when the market is down.
Rebalance your portfolio. Do you have a target allocation, such as 70% stocks and 30% bonds? With the recent volatility, you may have shifted away from your desired allocation. If your stocks are down from 70% to 65%, sell some bonds and bring your stock level back to 70%. Rebalancing is a process of buying low and selling high.
Limit orders. If you do have cash, you could dollar cost average. Or, with your ETFs you can use limit orders to buy at specific prices.
Sell Puts. Rather than just use limit orders, I prefer to sell Puts for my clients. This is an options strategy where you get paid for your willingness to buy an ETF at a lower price. We have been doing this for larger accounts with cash to deploy, but this not something most investors would want to try on their own.

Uncertainty, Risk, and Sticking to the Plan

There is always risk as an investor. Whenever you buy, there is a possibility that you will be down and have a loss in a week, a month, or a year from now. Luckily, history has shown us that the longer we wait, the better chance of a positive return in a market allocation. We have to learn to accept volatility and be okay with holding during drops.

We can go one step further and seek ways to buy the dip. To me, Risk means opportunity, not just danger. So, which is riskier, buying at a 52-week high or at a 52-week low? Well, neither is a guarantee of success, but given a choice, I would rather buy at a low. And that is where we are today.

I think back to March of 2020, when the market crashed from the COVID shut-downs. And I recall the horrible markets in March of 2009. In both cases, we stuck to the plan. We held our funds and didn’t sell. We rebalanced and made new purchases with available funds. That is what I have been doing with my own portfolio this month and it’s what I have been recommending to clients. We don’t have a crystal ball to predict the future. But we do know what behavior was beneficial in the past. And that is the playbook I think we should follow.

Amazingly, I have had only a couple of calls and emails from clients concerned about the market. None have bailed. We are in it for the long-haul. Market dips are inevitable. It is smarter to ignore them than to panic and sell. And if we can make additional purchases during market dips, even better.

Past performance is no guarantee of future results. Investing includes risk of loss of principal and Dollar Cost Averaging may not protect you from declining prices or risk of loss.

Bonds in 2022

Posted On December 12, 2021 By Admin In Portfolio Management /

Resuming last week’s Investment Themes, today we consider Bonds in 2022. It is a challenging environment for bond investors. We are coming off record low yields and the yield on the 10-year Treasury is still only 1.5%. At the same time, yields are starting to move up. And since prices move inversely to yields, the US Aggregate Bond index ETF (AGG) is actually down 1.74% year to date. Even including the yield, you’ve lost money in bonds this year. With stocks having a great year in 2021, it is frustrating to see bonds dragging down the returns of a diversified portfolio.

Inflation Hurts Bonds

Inflation is picking up in the US and globally. Supply chain issues, strong demand for goods, and rising labor costs are increasing prices. The Federal Reserve this week said they would be removing the word “transitory” from their description of inflation. And now that it appears that Jay Powell will remain the Chair, it is believed that the Fed will focus on lowering inflation in 2022. They will reduce their bond buying program which has suppressed interest rates. And they are expected to gradually start increasing the Fed Funds rate in 2022.

It is difficult to make accurate predictions about interest rates, but the consensus is that rates will continue to rise in 2022. So, on the one hand, bonds have very little yield to offer. And on the other hand, you will lose money if interest rates continue to climb. Then, to add insult to injury, most bonds are not maintaining your purchasing power with inflation at 6%.

Bond Themes for 2022

There aren’t a lot of great options for bond investors today. But here are the bond investment themes we believe will benefit your portfolio for the year ahead. This is how we are positioning portfolios

We will be increasing our allocation to Floating Rate bonds (“Bank Loans”). These are bonds with adjustable interest rates. As rates rise, the interest charged goes up. These are a good Satellite for rising rate environments.
Within core bonds, we want to reduce duration to shorter term bonds. This can reduce interest rate risk.
We continue to hold Preferred Stocks for their yield. While their prices will come under pressure if rates rise, they offer a continuous cash flow.
Ladder 5-year fixed annuities. I have been beating this drum for years. Still, multi-year guaranteed annuities (MYGA) have higher yields than CDs, Treasuries, or A-rated corporate and municipal bonds. If you don’t need the liquidity, MYGAs offer a guaranteed yield and principal.
I previously suggested I-Series Savings Bonds rather than TIPS. These are linked to inflation and presently are paying 7.12%. Purchases are limited to $10,000 a year per person, and unfortunately cannot be held in a brokerage account or an IRA. Read my recent article for more details. I personally bought $10,000 of I-Bonds this week.

Purpose of Bonds

Even with a negative environment for bonds, they still have a role in most portfolios. Unless you have the risk capacity to be 100% in stocks, bonds offer crucial diversification. When we have a portfolio with 60% stocks and 40% bonds, we have an opportunity to rebalance. When stocks are down, like in March of 2020, we can use bonds to buy more stocks while they are on sale. And of course, a portfolio with 40% in bonds has much less volatility than one which has 100% stocks.

Yields may eventually go back up to more normal levels. While it would be nice to have higher yields, the process of yields going up will be painful for bond investors. Our themes are trying to reduce this “interest rate risk”. We hope to reset to higher rates in the future, while reducing a potential loss in bond prices in 2022.

Inflation Investments

Posted On September 10, 2021 By Scott Stratton, CFP(R), CFA In Financial Planning, Portfolio Management /

With the cost of living on the rise in 2021, many investors are asking about inflation investments. What is a good way to position your portfolio to grow and maintain its purchasing power? Where should we be positioned for 2022 if higher inflation is going to stick around?

Inflation was 5.4% for the 12 months ending in July. I share these concerns and we are going to discuss several inflation investments below. Before we do, I have to begin with a caveat. We should be cautious about placing a lot of weight in forecasts. Whether we look at predictions of stock market returns, interest rates, or inflation, these are often quite inaccurate. Market timing decisions based on these forecasts seldom add any value in hindsight.

What we do know for sure is that cash will lose its purchasing power. With interest rates near zero on most money market funds and bank accounts, it is a frustrating time to be a conservative investor. We like to consider the Real Yield – the yield minus inflation. It would be good if bonds were giving us a positive Real Yield. Today, however, the Real Yield on a 10-year Treasury bond is negative 4%. This may be the most unattractive Real Yield we have ever seen in US fixed income.

Let’s look at inflation’s impact on stocks and bonds and then discuss three alternatives: TIPs, Commodities, and Real Estate.

Inflation and Stocks

You may hear that inflation is bad for stocks. That is partially true. Rising inflation hurts companies’ profitability and consumers’ wallets. In the short-term, unexpected spikes in inflation seem correlated to below average performance in stocks.

However, when we look longer, stocks have done the better job of staying ahead of inflation than other assets. Over five or ten years, stocks have generally outpaced inflation by a wide margin. That’s true even in periods of higher inflation. There are always some down periods for stocks, but as an asset class, stocks typically have the best chance of beating inflation over a 20-30 year horizon as an investor or as a retiree.

We can’t discuss stocks and inflation without considering two important points.

First, if there is high inflation in the US, we expect that the Dollar will decline in value as a currency. If the Dollar weakens, this would be positive for foreign stocks or emerging market stocks. Because foreign stocks trade in other currencies, a falling dollar would boost their values for US investors. Our international holdings provide a hedge against a falling dollar.

Second, the Federal Reserve may act soon to slow inflation by raising interest rates. This would help slow the economy. However, if the Fed presses too hard on the brake pedal, they could crash the economy, the stock market, and send bond prices falling, too. In this scenario, cash at 0% could still outperform stocks and bonds for a year or longer! That’s why Wall Street has long said “Don’t fight the Fed.” The Fed’s mandate is to manage inflation and they are now having to figure out how to keep the economy growing. But not growing too much to cause inflation! This will prove more difficult as government spending and debt grows to walk this tightrope.

Inflation and Bonds

With Real Yields negative today, it may seem an unappealing time to own bonds, especially high quality bonds. Earning one percent while inflation is 5% is frustrating. The challenge is to maintain an appropriate risk tolerance across the whole portfolio.

If you have a 60/40 portfolio with 60% in stocks and 40% in bonds, should you sell your bonds? The stock market is at an all-time high right now and US growth stocks could be overvalued. So it is not a great buying opportunity to replace all your bonds with stocks today. Instead, consider your reason for owning bonds. We own bonds to offset the risk of stocks. This gives us an opportunity to have some stability and survive the next bear market. Bonds give us a chance to rebalance. So, I doubt that anyone who is 60/40 or 70/30 will want to go to 100% stocks in this environment today.

Still, I think we can add some value to fixed income holdings. Here are a couple of ways we have been addressing fixed income holdings for our clients:

Ladder 5-year Fixed Annuities. Today’s rate is 2.75%, which is below inflation, but more than double what we can find in Treasury bonds, Municipal bonds, or CDs.
Emerging Market Bonds. As a long-term investment, we see attractive relative yields and improving fundamentals.
Preferred Stocks, offering an attractive yield.

TIPS

Treasury Inflation Protected Securities are US government bonds which adjust to the CPI. These should be the perfect inflation investment. TIPS were designed to offer a return of inflation plus some small amount. In the past, these may have offered CPI plus say one percent. Then if CPI is 5.4%, you would earn 6.4% for the year.

Unfortunately, in today’s low yield environment, TIPS sell at a negative yield. For example, the yield on the Vanguard short-term TIPS ETF (VTIP) is presently negative 2.24%. That means you will earn inflation minus 2.24%. Today, TIPS are guaranteed to not keep up with inflation! I suppose if you think inflation is staying higher than 5%, TIPS could still be attractive relative to owning regular short-term Treasury Bonds. But TIPS today will not actually keep up with inflation.

Instead of TIPS, individual investors should look at I-Bonds. I-Bonds are a cousin of the old-school EE US Savings Bonds. The I-series savings bonds, however, are inflation linked. I-bonds bought today will pay CPI plus 0%. Then your investment is guaranteed to keep up with inflation, unlike TIPS. A couple of things to know about I-bonds:

You can only buy I-bonds directly from the US Treasury. We cannot hold I-Bonds in a brokerage account. There is no secondary market for I-bonds, you can only redeem at a bank or electronically.
I-Bond purchases are limited to a maximum of $10,000 a year in electronic form and $5,000 a year as paper bonds, per person. You can buy I-bonds as a gift for minors, and the annual limits are based on the recipient, not the purchaser.
I-bonds pay interest for 30 years. You can redeem an I-bond after 12 months. If you sell between 1 and 5 years, you lose the last three months of interest.

Commodities

Because inflation means that the cost of materials is rising, owning commodities as part of a portfolio may offer a hedge on inflation. Long-term, commodities have not performed as well as stocks, but they do have periods when they do well. While bonds are relatively stable and consistent, commodities can have a lot of volatility and risk. So, I don’t like commodities as a permanent holding in a portfolio.

The Bloomberg Commodities Index was up 22% this year through August 31. Having already had a strong performance, I don’t think that anyone buying commodities today is early to the party. That is a risk – even if we are correct about above average inflation, that does not mean we are guaranteed success by buying commodities.

Consider Gold. Gold is often thought of as a great inflation hedge and a store of value. Unfortunately, Gold has not performed well in 2021. Gold is down 4.7% year to date, even as inflation has spiked. It has underperformed broad commodities by 27%! It’s difficult to try to pick individual commodities with consistent accuracy. They are highly speculative. That’s why if you are going to invest in commodities, I would suggest a broad index fund rather than betting on a single commodity.

Real Estate

With home prices up 20% in many markets, Real Estate is certainly a popular inflation investment. And with mortgage rates at all-time lows, borrowers tend to do well when inflation ticks up. Home values grow and could even outstrip the interest rate on your mortgage, potentially. I’ve written at length about real estate and want to share a couple of my best pieces:

While I like real estate as an inflation hedge, I’d like to remind investors that the home price changes reported by the Case-Schiller Home Price Index do not reflect the return to investors. Read: Inflation and Real Estate.

Thinking about buying a rental property? Read: Should You Invest In Real Estate?

With cash at zero percent, should you pay off your mortgage? Read: Your Home Is Like A Bond

Looking at commercial Real Estate Investment Trusts, US REITs have had a strong year. The iShares US REIT ETF (IYR) is up 27% year to date, beating even the S&P 500 Index. I am concerned about the present valuations and low yields in the space. Additionally, retail, office, apartments, and senior living all face extreme challenges from the Pandemic. Many are seeing vacancies, bankrupt tenants, and people relocating away from urban development. Many businesses are rethinking their office needs as work-from-home seems here to stay. Even if we do see higher inflation moving forward, I’m not sure I want to chase REITs at these elevated levels.

Inflation Portfolio

Even with the possibility of higher inflation, I would caution investors against making radical changes to their portfolio. Stocks will continue to be the inflation investment that should offer the best chance at crushing inflation over the long-term. Include foreign stocks to add a hedge because US inflation suggests the Dollar will fall over time. Bonds are primarily to offset the risk of stocks and provide portfolio defense. We will make a few tweaks to try to reduce the impact of inflation on fixed income, but I would remind investors to avoid chasing high yield.

As satellite positions to core stock and bond holdings, we’ve looked at TIPS, Commodities, and Real Estate. Each has Pros and Cons as inflation investments. At this point, the simple fear of inflation has caused some of these investments to already have significant moves. We will continue to evaluate the inflation situation and analyze how we position our investment holdings. Our focus remains fixed on helping clients achieve their goals through prudent investment strategies and smart financial planning.

Preferred Stock Dividends

Posted On September 2, 2021 By Scott Stratton, CFP(R), CFA In Portfolio Management /

As part of our Core and Satellite portfolio models, our investors have received Preferred Stock Dividends for several years. Preferred Stocks are different from Common Stock as they are a hybrid security which combines the features of a stock and a bond. Like a stock, preferreds trade on an exchange and pay a quarterly dividend. Like a bond, preferreds are issued at a Par Value ($25) and can be called or redeemed by the issuer in the future for $25.

If you’d like a primer on Preferred Stocks, check out my previous article, Preferred Stocks Belong In Your Portfolio. Or check out Forbes, What is Preferred Stock?

The Role of Preferreds

The preferreds we own have yields from 4-6% or more. Today, with the yield on 10-year Treasury Bonds around 1.25%, preferred stock dividends offer a nice rate of return compared to bonds but without all of the volatility of common stocks. And with the current high valuations on US Stocks, Preferred Stocks offer us an alternative that complements our stock and bond holdings. It’s a nice way to diversify our holdings, but preferreds remain a small, niche investment that most people have never owned.

Presently, our Premiere Wealth Portfolios have between 7-11.5% in Preferred Stocks. In our Defensive Managers Select portfolio, we have a 20% position in Preferred Stocks. Those are significant weights for a satellite position, but it remains a small piece of our overall allocation.

We buy a basket of individual Preferred Stocks. For each client, we will own a minimum of 5 and as many as 15 individual Preferred Stocks. As of today, our largest holdings include Capital One, Wells Fargo, Regions Financial, JP Morgan, and Brookfield Finance. Most preferreds are issues by financial companies, although there are some issued by real estate and utilities, too.

I prefer to own individual preferreds to have better control over the portfolio and keep costs down. Generally, I like to buy Exchange Traded Funds. And there is an ETF for preferreds: PFF from iShares. Two problems. First, the ETF owns many preferreds trading at a very large premium to Par. That means you would be buying a preferred at $27 that could be redeemed at $25 within 5 years. We have to look at the Yield to Call to understand this. Second, the ETF has an expense ratio of almost half a percent (0.46%), and that would reduce investors’ return. In a sector where the expected return is only 4-5%, that expense ratio would be a big drag on returns.

Managing Preferreds

Within our baskets of preferreds, we’ve had quite a few trades this summer. Generally, for most of my clients, we own preferreds in IRAs, since they create taxable income. In an IRA, we can trade without any capital gains impact. With yields falling this year, there has been a high demand for Preferred Stock Dividends. And this has pushed up the price of many Preferred Stocks. This is not a good time to just blindly buy any Preferred Stocks – many are very expensive.

So, we have been rotating from preferreds with higher prices to those with lower prices. In some cases, a Preferred with a high dividend payment actually has a low Yield to Call. If you are paying $27 for a preferred that is callable for $25, you are paying an 8% premium. And that premium will decline to the call date, creating a loss of capital that will eat into your total return. I am finding opportunities to improve our preferred stock dividends with some careful trades.

Trading and Upgrading

There are a couple of scenarios where we have placed trades to replace one preferred with another.

Price comparison. Here are two preferreds with the same coupon of 4.45% and similar credit ratings and call dates. The Schwab (series J) is trading at $26.57, while Regions Financial (series E) is at $25.60. This is an opportunity to sell an expensive share and use the proceeds to buy more shares of the lower priced preferred.
Same company, different series. Capital One’s series L has a coupon of 4.375% and the series N is at 4.25%. Both have the same call date of September 2026. There is a one-eighth of a percent difference in coupon. So, when the L’s were trading for 2.5% more than the N’s, that is too big of a difference. We sold the L’s and bought the N’s. Then this week, the prices swapped and we were able to sell the N’s and buy back the higher yield L’s for less. Many companies have multiple series of preferred stocks. Sometimes one is more expensive and the other is less expensive, for no logical reason. We’ve also swapped between the Goldman Sachs series C and D, which both have a 4% coupon.
New issues. We can buy IPOs of Preferred Stocks. We’ve bought a new JP Morgan preferred at $25 this summer and it is now up to $25.56. Other times, we have been able to buy preferreds for below $25 for a few days after the IPO, when the issue was undersubscribed. We’ve bought shares of Regions Financial and Texas Capital Bancshares at a discount this way. Over a few weeks, new issues usually move to where similar preferreds are priced.

Long-Term Outlook

I’ve been looking at all types of income securities for the last 17 years. Not just Preferred Stocks, but Closed End Funds, MLPs, REITs, and individual corporate and municipal bonds. It’s a lot of time to manage individual securities correctly, and it takes skill and knowledge that takes years to develop.

I like the idea of Preferred Stock Dividends to add income to our portfolio models. And that’s the purpose behind our Alternatives sleeve to the portfolio: to seek investments with a better return than bonds, and lower correlation and volatility compared to stocks.

For now it’s working as I had hoped. What might change this? If we see the Federal Reserve start to raise interest rates and see the long-end of the yield curve move up, this would be negative for preferreds. That’s why this is a Satellite holding and not a Core. There may well come a day that we liquidate the preferreds for another asset class with better prospects. Even though we are buy and hold, long-term investors, by no means is the approach a purely passive portfolio. Rather than looking in the rear view mirror, we construct portfolios looking forward at the challenges we see facing markets today.

Have a question about Preferred Stock Dividends? Curious about your Retirement Income? Let’s talk about our portfolios and how they might work for you. Click Contact on the top of this page to get in touch!

10 Year Expected Returns

Posted On March 3, 2021 By Scott Stratton, CFP(R), CFA In Portfolio Management /

With the market rising so fast in the past year, investors are wondering if the 10 year expected returns are still attractive. Are we in a speculative bubble? Other investors see certain stocks soaring and are driving prices even higher. Will recent returns continue? While it’s natural to fret about the future of the stock market, we suggest investors resist the temptation to try to time the market.

It may be helpful, however, to evaluate current valuations and consider how to weight a diversified, buy and hold portfolio. Based on present levels and projected growth, the Vanguard Capital Markets Model calculates the 10 year expected returns for various asset classes. We use this information both in our portfolio construction as well as in our financial planning calculations.

Expected returns today are lower than historical returns. The stock market has risen much faster than corporate earnings. Now, companies need to catch up with their stock valuations. Dividend Yields are lower than historical, as well as economic growth and inflation. All of these are components of projected future Equity returns.

Vanguard recently updated their 10 year expected returns, based on market levels on December 31, 2020. You can compare these figures to six months ago, when I last wrote about Vanguard’s estimates.

Vanguard’s 10 Year Expected Returns

US Stocks: 3.0% to 5.0%
International Stocks: 6.1% to 8.1%
US Growth: -0.1% to 1.9%
Value: 4.4% to 6.4%
Large Cap: 2.9% to 4.9%
Small Cap: 3.2% to 5.2%
US REITs: 3.0% to 5.0%
US Aggregate Bonds: 0.8% to 1.8%
International Bonds: 0.6% to 1.6%
Emerging Markets Bonds: 1.5% to 2.5%

These estimates are 10 year annualized projections and are not guaranteed. There will undoubtedly be down years and this is not meant to suggest returns over the next year or in the short-term. Investing involves risk of loss of capital. Source: Vanguard Market Perspectives, March 2021.

Key Takeaways

10 year expected returns are lower than historical returns. I have cautioned in the past about using historical returns in financial planning projections. We use projected returns. Based on the midpoint of Vanguard’s figures, a 60/40 portfolio with 30% US Stocks, 30% International Stocks, and 40% US Aggregate Bonds has a projected return of 3.85% a year. This may cause some investors to rethink their allocations.
US Growth Stocks are overvalued. US Value is more attractive for a long-term investor today. Be careful of chasing 2020’s hot stocks! We have already built a sizeable position in Value stocks in our models.
International Stocks are more attractive than US Stocks. Be diversified and don’t invest in just US companies. Presently, International Stocks make up 43% of the World Index. If you don’t have at least 43% of your equities in International, you have a Home Bias. This may have worked well in the past decade, but appears less likely to be the case for the next 10 years.
US Small Cap may offer a diversification benefit to Large Cap. REITs on the other hand, have the same return profile as US Stocks, but are riskier (higher volatility). So, we are avoiding REITs in our models.
Bonds and Cash serve primarily as portfolio defense today. They offer little return potential. Vanguard projects inflation will be 1.1% to 2.1% over the next 10 years. Bond and cash returns may be less than inflation, which means you are losing purchasing power. Still, fixed income offers some benefits to rebalance when things are volatile. On their own, bonds are not making much of a positive contribution to portfolio returns.
Preferred Stocks, Convertible Bonds, and Emerging Markets Bonds offer an attractive return potential compared to expected returns on core categories like US Stocks or US Aggregate Bonds. We have expanded our Alternative holdings in 2020 and again in 2021. Read more: Investment Themes for 2021.

Stay Diversified, Don’t Speculate

While we do tilt portfolios towards areas of relative value, it is important to remain diversified. Don’t put all your eggs in the one basket with the highest expected return. There’s no guarantee that Vanguard’s projected returns will become reality. Regardless of short-term market movements, our investment strength comes from keeping costs low, using Index strategies, staying diversified, and tax-efficiency.

The stock volatility over the past 12 months has been remarkable. But, it’s not unprecedented, though. I remember the Tech Bubble in 1999 and the rebound 12 years ago, from March of 2009. Both of those created rampant speculation, which we see today in certain growth stocks, cryptocurrency, and in the options market. Have we not learned the painful lessons of previous day-traders and those who gambled on stocks? Recently, individual investors have been asking me about trading options, Penny Stocks, and day trading stocks with the money they have set aside for a house down payment in one year.

Even as Vanguard is lowering its 10 year expected returns, people are getting greedy, with the fear of missing out on their chance to get rich. They know someone who got lucky over the past year and made a great trade. The lesson from the past is that everyone is a genius in a Bull Market. You could do no wrong in the past year, as long as you did something. Things won’t always be that easy, and that’s why you need a plan. Please make your investment choices about the next 10 years, and not the next 10 hours or 10 days.