Retirees (or near retirees) heavily invested in bonds are likely in for a roller coaster ride that basic financial theory says may not end too well. With interest rates at historic lows due to the Federal Reserve’s $85 billion per month stimulus package, which is designed to keep rates low, bonds may be getting to a crisis point.
Made worse by the understanding that as interest rates rise, bond prices fall, investors are confronted with hard decisions. Facing the combination of falling bond prices and basement low yields, retirees especially need to evaluate their income generating strategies.
One solution is to purchase individual bonds and hold to maturity. Unlike many bond mutual funds which typically turnover bonds as they reach certain criteria, thereby potentially creating capital losses in a rising rate environment, individual bonds can be held till maturity at which time they should be redeemed for par value, barring any company liquidity issues. By doing this, investors lock in a specified rate of return for the portfolio that shouldn’t change regardless of interest rates. The key would be to utilize a yield to maturity calculation as opposed to a simple yield calculation. A yield calculation gives the amount of income the bond is paying out based on the price purchased now. The problem with a simple yield calculation, and the fix that yield to maturity provides, is many bonds are currently trading at a premium to par value (meaning you may pay more now than you will receive at expiration). While purchasing bonds at a premium sounds like a definitive negative, it is not necessarily the case as the increased interest you receive may offset this downside. Yield to maturity allows a fair comparison among bonds and represents the total return to the investor.
Another option is floating rate loans. Mostly used with financial firms or with small and midsize private companies, floating rate loans adjust to rising interest rates and typically also hold their principal much better than fixed rate bonds. While these bonds many times pay lower up front interest rates or are hard to access (in regards to private companies) these ma y provide an adequate hedge to rising interest rates.
Lastly, there have been numerous articles showing dividend yields on specific stocks or the general market and how they compare to bond interest rates. While moving assets destined for bonds towards stocks may increase current income, it almost certainly will increase the risk and volatility of your portfolio. If this is the chosen option, proceed cautiously as some basic hedging strategies may be appropriate to limit potential drops.
According to MetLife Mature Market Institute, the average cost of a private room in a nursing home is up to $248/day, or about $90,000 a year. Even with the best retirement planning, many investors would still find themselves short if a long term care stay extended past a few years for either themselves or their spouse.
Because of this, many Americans look towards Long Term Care Insurance (LTCI) to protect against running out of money. While LTCI is a fairly new insurance product compared to life or health insurance, it has had enough years to establish a less than stellar reputation. Unlike basic term life insurance, and much more like health insurance, LTCI premiums are not guaranteed and allow the insurance company to raise rates if needed. This has happened on a consistent basis with annual increases topping double digits, making previously affordable policies now unaffordable.
However, there have also been new advances in preparing for long term care that give some hedging against the risk of losing money, while costing less over the life of the coverage.
First, shared benefit policies potentially reduce the cost as only one policy is needed for each couple instead of one for each individual. Since the only Federal program that covers long-term care is Medicaid, which is on a need basis and requires a certain spending down of assets, the highest risk for couples is when one spouse enters long-term care for several years while the other spouse remains healthy. A shared benefit policy allows whichever spouse enters first to utilize the policy. Then if benefits are still available for the other spouse, they can utilized when that spouse enters care. Effectively, the policy protects the healthy spouse from running out of money due to long term care needed by the first.
The second advance in LTCI is through “asset based” policies. These typically consist of permanent life insurance with a feature allowing access to a reduced death benefit early for paying long-term care expenses. The benefit of this feature is whether you need to utilize long-term care or not, a small return is being earned on the money deposited. If long term care is needed benefits are available. If not needed, then a tax free life insurance benefit is passed along.
Lastly, additional features have been added to some annuity products that allow a doubling of the monthly payment if an investor enters long term care. For example, if Bob was receiving $1,500 a month from his guaranteed annuity payment, an additional feature to that annuity may double the payment to $3,000 a month while he is in long-term care.
With more options available for funding long-term care than ever before, it is worth some research and understanding the different methods and what fits your financial situation the best.
December’s Kiplinger’s Magazine featured an article entitled “How the Fed Blew It,” by Jeremy Sigel. Mr. Siegel is a highly respected journalist and economist that has appeared regularly on TV and in respected print magazines.
While in the past Mr. Siegel has been supportive of the Federal Reserve and the numerous stimulus packages they utilized to stabilize the economy, he turned against them with the recent decision to delay “tapering” the bond purchasing designed to control low interest rates. He argued the Federal Reserve did something so unexpected by market standards, and possibly even the standards they had set for themselves, that any forward guidance given by the Federal Reserve from now on would have a muted effect.
I completely concur. One of the Federal Reserve’s primary tools for controlling economic (and market) bubbles and recessions is forward guidance, or statements by the Fed foreshadowing actions they might take if certain economic indicators reach important levels. Many times historically, forward guidance (if done early enough) was able to curb market inefficiencies, with very little long term damage or cost to the taxpayer.
However, by setting a general set of guidelines for economic and market recovery which many believed were achieved, then still delaying the reduction of stimulus, the Federal Reserve lost credibility in their forward looking statements.
This loss of credibility could easily magnify future economic hardships or bubbles as more extreme measures will needed to be taken to solve inefficiencies. With already extreme measures taken by any historical standard, and now a loss of credibility to follow through on guidance given, the Federal Reserve will likely be forced to take action when previously no action was needed, and likely more extreme action than previously needed.
Similar to a drug addict who continually increases his dependency and many times moves into more dangerous stimulants, the Federal Reserve has increased the dependency of the market on its extreme stimulus measures and now foreshadowing future measures may not have any effect either.
For investors over the age of 70 1/2, distributions are required from their pre-tax IRAs and 401(k)s*. For investors who have already been forced to make this withdrawal at least once, their distributions are due by December 31st of each year.
The purpose of the IRS requiring RMDs each year is to ensure the government receives the taxes “due to them.” For pre-tax contributions to IRAs and 401(k)s, the IRS gave investors a temporary exemption from paying taxes on contributions, with the expectation that the money will be withdrawn and taxed later on.
Astonishingly, many investors forget to take their RMDs each year. Between 2006 and 2007 over 250,000 investors forgot to take their RMDs, for a total missed distribution of $348 million according to the Treasury Inspector General.
RMDs are vitally important as the penalty associated with missing distributions or receiving them late remains one of the harshest in the tax code, a 50% penalty on any missed distributions. So if an investor was required to take distributions out of their IRA totaling $50,000, the penalty assessed for this year would be a whopping $25,000!
One of the benefits allowed again this year is the ability to donate the RMD directly to charity. Without this special exemption that began to appear just a few years ago, investors were required to take the RMD, include it in income, then deduct it as a charitable contribution. While many investors had no problem with this, for some who are charitably inclined, giving 100% of the RMD amount to charity exceeded the allowable deductible amount for charitable giving. However, with the ability to give it directly from your IRA to charity, the RMD does not show up as taxable income and a charitable deducted is then unneeded, freeing up even the most charitably inclined investors to give additional money and still be able to receive a deduction.
Many reports have the IRS cracking down on missed RMDs, so don’t let you or your family’s account fall victim to the increased scrutiny.
*An exemption may apply on 401(k)s for investors still working at the company where the 401(k) is located.
Since the last post about a month ago, our government entered a prolonged shutdown, almost defaulted on the US Treasury debt, but reached a compromise at the last second that temporarily funded the government and the debt, as well as created a bipartisan commission to study the budget issues. The last time a similiar committee was created, what became known as the Simpson-Boyles Commission, a series of balanced recommendations were produced that many economists and reasonable people liked, only for it to get caught up in partisan politics and the recommendations to fall through the cracks. Hopefully this time will be different, however slim that hope may be.
Also in the last month, the roll-out of “Obamacare” hit the individual market, with many seeing sticker shock on their policies unless they qualified for heavy subsidies by the federal government. However, the news item that is getting much more play in the press is the website troubles that led to only 6 (yes 6 in the whole country) to sign up on the main healthcare website. A month later, the website still sees frequent crashes and poor response times. At some point the website will become an old story and then the increased premiums for many Americans may take center stage.
Lastly, and more directly related to finance, was the appointing of Janet Yellen to replace Ben Bernake as the Federal Reserve chair(wo)man. Bond interest rates reacted over the last several months to the rumors of her possible nomination as she has said she is likely to keep the foot on the gas for monetary easing until unemployment gets down to a favorable level. Some of the other nomination possibilities were much more concerned with the inflation portion of the Feds dual mandate, and were more likely to slow down the printing of money. Certainly the nomination of Yellen calmed the interest rate climbs we had seen over the past month but also increased the likelihood for higher inflation several years down the road.
Last Tuesday morning, Congress reached an impasse and shut down the Federal Government. Ironically, the stock market increased Tuesday morning, only to give back its gains later in the week. As a byproduct of the shutdown, there will be no government economic data released which puts the market and economic pundits in a position of limbo.
Overall, I believe the shutdown will not have substantial long-term effects on the economy. Of far more consequence is the debt ceiling debate that may immediately follow this clash of political parties. A debt ceiling debate could cause the government to default on their outstanding debt, causing a major hurdle for the economy to continue to recover.
August of 2011 was the closest the United States has ever come to defaulting on their debt and this caused bond yields and mortgage rates to spike and the United States to receive a downgrade on their debt rating.
Many political pundits have suggested that the current government shutdown may actual reduce the chances of the government defaulting as a deal to end the shutdown could include a debt ceiling increase. If this becomes true, I believe most economic watchers will gladly trade a short term government shutdown for avoiding a debt default scenario.
Last week was 5 days of “shock and awe” in the financial markets. The Federal Reserve announced that instead of starting the process of scaling back their $85billion a month in interest rate reduction stimulus, they are going to stay on pace until the economy improves. This sent shock-waves through the market as this was polar opposite to the general consensus by economists and Federal Reserve watchers.
Gold immediately jumped intraday by almost 4% (the jump was likely due to the concern that continued printing of American dollars will lead to lower valuation and higher inflation), the stock market instantly shot up, and the 10yr Treasury yield dropped 0.16% (a huge move as this was over a 5% reduction intraday). However, over the last couple days of the week, logical thinking prevailed and the moves retracted a little.
While the headline of continued stimulus seemed shocking, in reality it is probably just going to delay the inevitable for about 2-3 months, surely not reason enough for bond yields or gold to swing that wildly. In fact, I think this was a perfect example of a market over reaction, leading to possible opportunities across the board. For bond traders, there was a brief couple hours where bonds prices jumped, and holders of gold were also rejoicing for a couple hours. However, once the dust settled, normalcy returned.
These are situations that we look to exploit. While this illogical move was briefer than some in the past, these market “inaccuracies” are what can make a portfolio achieve extra returns. However, many times this means acting against the crowd and following Warren Buffett’s golden quote “be fearful when others are greedy, and greedy when others are fearful.”
Last week was a tale of two halves, as the first 3 days posted gains in line with the best of 2013, while the last two days saw some sell-offs in the market. As the threat of a Syrian attack started to dissipate, markets were focused on a more positive long-term outlook. Treasury yields actually decreased slightly in the week, further paring gains made in haste over the month of August.
However, despite the recent quietness of big economic news over the last couple weeks, this week is sure to hold a little more excitement. This week the Federal Reserve meets and is expected to make interest rate target announcements on Wednesday. While an increase in the target interest rates is highly, highly unlikely (although Akron did almost beat University of Michigan on Saturday), the press release should give more insight into the Federal Reserve’s plans for the near future.
Also, today marked a large turning point in the future direction of the Federal Reserve. The favorite to replace current head Ben Bernanke, Larry Summers, removed himself from consideration. This clears the way for Janet Yellen to be the next Federal Reserve Chairman (or chairwomen). As opposed to Summers, who had expressed concern over possible inflation and was likely to cut down on both government stimulus and abnormally low interest rates, Yellen has expressed concern that the economy is growing too slowly and is likely to keep her foot on the stimulus petal for the near future.
As the stock market has become almost addicted to cheap (or free) money, the increasing likelihood of Yellen as the next Federal Reserve head greatly excited markets, which opened up on Monday. We will be keeping a close eye as her nomination could me a further retraction or stabilizing of interest rates, as well as a temporary stock market boost.
Last week was a light week of economic news and one that did not provide clarity to the overall economic situation and on our main focus of the Federal Reserve tapering off their stimulus.
On a positive note, a general measure of the manufacturing sector (ISM Manufacturing index) rose last month and is now hovering at a much higher rate than expected by economists. Because the manufacturing sector is considered vital to a recovering economy, the ISM index rising is seen as a very positive sign for the economy.
However, the biggest economic news from last week was the payroll numbers. While the headline number by itself looked strong (payrolls rose by 169,000), it actually missed analyst and economists predictions of 180,000. In addition to the disappointing headline number, they also revised the previous two month’s reports down by 74,000. This lower than expected growth may cause the Federal Reserve to give a lighter touch on tapering off their stimulus as they want to ensure the job market is growing at a fast pace.
Overall, we still see the Federal Reserve partially reducing their $85 billion/month stimulus by the end of the year. Realistically, the specific timing makes little difference in our investment strategy going forward, so we are not concerned whether it may be October or November, Instead, our concern is with the long-term implications on both the bond and stock market.
Also, Syria once again played a part in market returns. But as the country waited on Congress to return, it seemed slightly less likely action would be taken which reassured the markets slightly. As stated previously, we believe that in our long-term strategies, any market drop due to Syria will be relatively short and could present a time where companies are trading at a better valuation.
Markets worldwide closed lower last week and the VIX (a measure of market volatility) increased greatly as the Syrian conflict looked like it could potentially escalate. This weekend we found a little more clarity on the situation as President Obama announced he does desire some form of military action but he will allow Congress to decide.
Yields on US Government bonds reversed recent trends and actually decreased (bond prices increased) after a lengthy and substantial increase over the last few months. This was probably due to the focus on Syria and the skittishness of investors as they waited out outcomes for the Syrian conflict.
We believe any large negative market moves due to a Syrian conflict or engagement are likely to be short term and could bring about more attractive valuations on some of the stocks we are tracking for potential in our portfolios. Unless the United States finds itself in a very active military role for long periods of time, we see the impact on actual valuations of the companies we track to be very limited.
In economic news, the data was somewhat mixed. Jobless claims decreased by 6,000, following a trend of lower claims on a somewhat consistent basis. The GDP headline number also looked encouraging as we saw 2.5% growth in quarter two, about .8% higher than originally thought. However, some economists argue the detailed numbers are less than stellar and the trend may not be sustainable. This is due to the gains being largely attributable to revisions of import and export numbers, and to inventory and non residential structures, which could play a lesser role in Q3 GDP reports.
Also slightly worrying, was the snag hit by home sales in July. As an increased focus on “tapering” of stimulus takes hold, mortgage rates have started to rise and pending home sales in July dropped.
Overall, the economic news was not overly exciting nor overly worrisome as there was information available for both bulls and bears in defending their positions. We are watching to see if there will be a couple more days of pullbacks due to the Syrian conflict and if so, we will be looking for good companies selling at cheaper than should be prices.