Regular readers know that I am or have become a bigger proponent of income investing lately and if you don’t know what I am talking about you should be reading my material more. However, there seems to be preconceived disconnect with my philosophy and what you believe to be true about interest rates moving forward. Some people see my bullishness on bonds in the face of rising interest rates as purely insane, especially given what treasuries are doing, but I can assure you it is not.
Keep in mind I am talking about investment grade corporate bonds and high yield bonds, my favorites are ‘BB’ and ‘BBB’ rate paper in an ETF format, I do not like mutual funds because of the once a day pricing. As an aside I do like selective sovereign debt as well, but don’t go out and buy Eastern European government debt or anything, be selective as the risk return is there, but supply is going to be an issue moving forward so it will pay to be extremely selective in 2010. Anyhow, back to corporate debt and why I like it.
Treasuries are entering a bear market for the first time in my memory and I expect there to be a bear market until the next crisis hits, so for only a few months. The reason there is a bear market is simple, supply, end of story. You cannot issue an endless amount of paper and expect the market to eagerly accept it without paying more for it because people, foreign central banks in this case, know they will never fully be repaid for the US debt they buy now, it is mathematically impossible for the US to repay its debt so don’t shoot the messenger hate the calculator. Because of that mathematical probability interest rates on treasuries are going higher and, according to those wonderfully bullish, and misguided, government data figures investors are pricing in interest rate hikes which kill treasuries and other high grade corporate debt, high grade being the operative word, so remember that please.
High grade corporate debt is technically, and in my opinion, anything rated higher than ‘A’ and issues interest rates slightly above treasury yields. We are talking about your really safe corporate paper issued by IBM and similar firms. Essentially, those are a riskless investment which is why your yield is so close to treasuries and why those bonds will get crushed when/if interest rates go higher. For those who do not understand how bonds work think of bonds and interest rates like a teeter-totter with interest rates on one side and bond prices on the other side, when one goes up the other side goes down. Therefore rising interest rates are bad for bonds because new bond issues will have higher yields so your existing bond will have less appeal in the marketplace and if rates go down new issue bonds will have lower rates which means your existing bond will be more attractive because it has a higher interest rate. Make sense, good.
All of that is important because we are at zero interest, technically we are in the negative interest rate area because of quantitative easing and deflation which is bond friendly. However, this red hot economy we are in, sarcasm is my trademark, many people are expecting an interest rate hike to happen at some time this year and they are right. The Fed will raise interest rates in 2010 from 0-.25% to .25-.50%, wow. There is an outside chance that rates may go to 1% by the end of the year, but that is pure speculation right now because the economic data or ‘recovery’ is spotty at best. Even if rates go up it is relatively meaningless to lower grade corporate bonds because it does not hurt the spread as badly as it does for higher grade corporate bonds.
What I mean is newer higher grade corporate debt and treasury debt will have higher yields than current issues so existing paper will get slammed. However, existing lower quality corporate paper will do OK as we would need rates to go up substantially in order to really hurt the spread. I am not saying that there is no risk in lower quality corporate debt, defaults will be a huge issue moving forward, but I am also betting that the Fed’s liquidity programs end up not going away either. In fact, I would speculate that the Fed’s balance sheet will continue to expand over the next 12 months, perhaps double again if the FASB gets its way and the SIV’s have to be added to banks balance sheets right away, but again that is speculation right now.
If the Fed does actually raise interest rates this would be a bullish signal to the markets because it means we have real growth in the economy as well. This means lower grade paper would perform better, even if that growth is only at lower levels. However, higher interest rates will not be good for stocks, in my opinion, which is why I shifted focus to lower quality corporate bonds and to companies like Alteria. I would not expect, even if the economy is cruising, to see rates go much higher than 1-1.5% though because the Fed is stuck and it cannot move rates higher or to a meaningful level ever again. Regardless, corporate bonds of ‘BBB’ or ‘BB’ and selective ‘junk’ should do OK moving forward in the face of higher interest rates because of what I said previously. We will not see huge returns like that of 2009, but I think they will do better than stocks moving forward, plus you are first in line when the company folds, something to think about.
Why the Fed is stuck
What do I mean by that, a meaningful level? You see, the US is in a debt trap that we cannot escape from, it is simple mathematics. The Fed will not be raising rates to protect the dollar, they want a weak dollar that is for another post, they do not really care about inflation as they really want massive inflation but we cannot create it. The Fed will raise interest rates to keep politicians off of its back and that is about it, but raising rates higher than 1.5% presents problems that the US cannot handle.
Congress just had to raise the debt ceiling by a few hundred billion to fund the government for the next 6-8 weeks, unbelievable, and a more ‘permanent’ fix of raising the debt ceiling to about $14T will be coming soon.
I know this is no big deal to liberal democrats because, after all, under Bush we had to raise the debt ceiling 7 times and to them 8 or 9 wrongs make a right, but this is a major, major problem. Considering that raising the debt ceiling to $14T moves the total US debt to just about 100% of GDP marks a new low for the US and is the greatest amount of debt any country has ever attempted. What I am saying is that our current debt servicing costs with the Fed holding rates at 0% and using QE is about $500B+ a year and our average maturity of our debt is less than 10 years, again this is a first in all of the world’s history.
If the Fed moves rates up past 1.5% then that debt servicing cost will go up, dramatically, and there will be major consequences that the American people are not ready to face. Forget the debt ceiling, we will repeal that silly little rule, especially since we have to raise it almost every year anyhow. Within 7 years out debt servicing costs will begin to take its toll on the national budget squeezing out typically paid for items, like earmarks. Defense spending will have to decline immensely which is why the US remains a superpower even though we have a relatively small manned military compared to say a China, India or North Korea. The dollar will decline much further, it will anyhow as the latest rally, which I anticipated, is a head fake and was driven by Dubai, Greece, Fear, short covering and the selling will comeback harder and faster than you could ever imagine.
All of the senseless spending is coming home to roost, now. China is telling us where to stick it as there is not enough dollars to buy our debt, which is kind of funny in a sick way, and they said no to strengthening their Yuan which makes sense for them and smells of protectionism to me. When we demand a foreign country make their products more expensive in the US just so we can shrink out trade deficit thereby boosting our GDP and sell more products to them that is protectionism, straight up. I do not like to be so grime, but many of the things I foresaw and have been keeping to myself are coming out in the open. Things are not good, but hey as long as the market keeps going up, who cares right? Well, you will when it comes crashing down around you. Fixed income never looked so attractive right now.
Nope, they have not and they will not understand the benefits of variable annuities. This market which has devastated retirement savings has had nothing that has gone up. Even gold has now declined in value, bonds are a no go, especially corporate bonds and stocks have been horrible.
However, a variable annuity with a living benefit has done something that no other investment has done, guaranteed retirement income without annuitization. All the financial writers in the world tell you to buy index funds and to stay away from those bad variable annuities. If you listened to them you would be sucking wind in the S&P 500 with 24% or more exposure to financial stocks – pre-market meltdown – and another 20% or so in technology which as also suffered badly.
Even with reality hitting them right in the face they still deny variable annuities their rightful place as a good investment alternative. They, the financial guru’s, just don’t get it. They do not understand that the Democrats will more than likely take the Whitehouse and Congress which will ultimately raise taxes, specifically the capital gains tax.
A complete Republican controlled government did not do well, spending went through the roof along with other questionable behavior, what makes them think that Democrats will do any better when they have a much stronger history of raising taxes. Actually Obama is the only political candidate that we have ever known to be, possibly, elected on the premise that he is actually going to raise taxes.
Your political affiliation does not matter, all you need to know is what we have been saying about the 15% capital gains tax is correct, it’s going higher. Regardless of who would have been elected taxes would need to be increased given the massive debt the US has, we just never had such stark honesty from a politician who is advocating higher taxes.
So, income taxes will go up for those “wealthy” Americans, we will see what the term wealthy means after the election, and capital gains taxes will go up. This means that all distributions from mutual funds will be taxed higher and it blows the argument right out of the water for the Suze’s, Liz Pullman’s and Scott Burn’s of the world.
Oh, did we mention your retirement income is also guaranteed?
While there are some good fee-based planners in the world we find it rather odd that everyone just assumes that they are the best choice for everyone. The selling point of the fee-based planner is the fact that they do not collect commissions from product sales and therefore they must be unbiased. While this seems reasonable enough to the average person are these advisors really the way to go?
The idea that a person can be unbiased just because they do not collect a commission from product sales, but collect a fee no matter what you buy, is ridiculous. Every time you read an article and the author was asked a question they tend to always recommend that you speak to a fee-based planner before you make that investment. Now, here is the problem, fee-based advisors are still earning commissions, sorry, I mean fee, for the amount of money that is invested, or my favorite, they get paid $200 an hour for their time.
By the time the average person gets done with a fee-based planner they end up paying way more than any sales load or CDSC on a regular broker sold mutual fund.
Here’s an example:
A client wishes to invest $100,000 and a commissioned broker recommends an A share mutual fund with a load of 4.25%, or $4,250 in commissions. That is all the client pays, besides annual expenses, in commissions. Now if the same client went to a fee-based planner they would recommend index funds and then slap on a 1.5% annual fee for their services. Assuming the investor holds the mutual fund for 5 years, not an unreasonable assumption, then the fee based planner would have made $7,500 in fees as compared to the $4,250 the commissioned broker would have made. What is worse is the fact that the planner probably did recommend index funds and they still have the stones to charge a fee, seriously, a trained monkey can pick an index fund. Based on this assumption, which is very fair and reasonable, it is pretty clear that at the end of the day everyone gets paid.
By the way, even if the commissioned broker sold the investor an annuity they would have only made a 6.5% commission or $6,500 from the investment which is still far less than the fees the planner charged. It is really odd that all of these magazines talk about high commissioned annuities and mutual funds while the fee-based planners get a free ride because they do not collect a commission, but charge a fee. The average fee-based planner client is paying the same amount of money per year as the variable annuity client, roughly, with no guarantees or tax deferral.
Just because someone charges a fee instead of a commission it does not make them smarter or any less human. Well, may be they are smarter as they know by chargeing fees they will make more money over the long-term, but none the less they are still sales people. We do not care how people choose to make a living, but just be honest about it and the media should be ashamed of themselves for not recognizing the obvious.
One last note, I recently read an article by Humberto Cruz who quoted a fee-based planner who said that any variable annuity that guarantees the client their money back sounds “fishy” to him. This is the other problem with both the media and the fee-based planners, they have no idea how variable annuities work and what the living benefits ultimately do. If that planner who Mr. Cruz quoted did not understand what a guaranteed minimum accumulation benefit was then he should not have even commented on it.
The hottest trend for investment firms is planning for income distribution for the Baby Boomers. As the Boomers age they are seeking investments that will provide income for their retirement needs. The insurance industry has had a lock on the guaranteed income angle for the better part of 200 years through annuities.
Now, mutual fund firms are trying to get in on the action. The hottest trend, besides ETF’s, are income replacement funds which will allocate the investors money and then start to pay a stream of income after a set number of years. The income is derived from income paying securities, dividends and good old fashion withdrawals. The big question is will these products work?
Well the jury is out because all of these products are brand new and have zero track record. With the existing strategies it seems feasible that they will work if the market only goes up and interest rates increase, but then again all investments look good in that scenario. The truth is only time will tell.
They can as part of a diversified portfolio, but not as a stand alone solution. Like investing at any point in a persons life diversification is key and having guaranteed income mixed in with mutual funds can make perfect sense. In a recent article a person from Morningstar was even quoted as saying that for guaranteed income the variable annuity, with living benefits, makes much more sense than just income replacement funds.
While some annuities are less than appealing, EIA’s for example…huh, hum, Steve, a variable annuity with a living benefit can provide guaranteed income along with inflation protection by keeping money invested in equities. As with any type of investment a variable annuity should be considered an asset class and not as a stand alone solution. By using mutual funds and an Annuity the investor will reduce their risk and improve long term returns, Ibbotson has proven this.
The only thing is how do you know what variable annuity is good and which ones are below par? Sign-up for Annuity IQ to find out.
Today is the last day to mail your taxes and as many people now know their investments also come with tax liabilities. Many people will tell you that investing in mutual funds is a better idea than using a variable annuity because of the long-term capital gains treatment. The irony is that the long-term tax treatment is only relevent to sales of your mutual funds that are more than 12 months old and only on a portion of your total mutual fund distributions.
The vast majority of your distributions from your mutual fund account was probably short term income distributions. That means that the gains from this account will be taxable at your ordinary income tax bracket, not the famed 15% long-term capital gains rate that many claim you will be taxed at.
With turnover rates of mutual funds hovering around 100% annually it is highly unlikely that you will pay long-term capital gains on your investments in the future, unless you sell your fund. To add insult to injury the sub-prime meltdown has handed investors hefty losses on their mutual funds and now they owe taxes on a fund that lost them money.
With a variable annuity you would have circumvented both of these situations. The tax deferral would have shielded the investor from taxes and a living benefit would have preserved the investors income or principal, depending on what type of benefit they bought. To find out what type of benefit is right for you go to Annuity IQ to find out more.
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