The Safest Way to Beat Inflation


With interest rates so low today, investors wonder where they can keep their money safe both in terms of their principal and purchasing power. We recently discussed Fixed Annuities as one substitute for CDs or bonds, with the conclusion that Annuities are best for investors over 59 1/2 who don’t need liquidity for at least five years. For others, one often overlooked option is Inflation-linked Savings bonds, officially known as Series I Bonds.

What Do Low Interest Rates Mean For Your Retirement?


A 2013 study from Prudential considered whether a hypothetical 65-year old female retiree would have enough retirement income to last her lifetime. In their scenario, they calculated a 21% possibility of failure, given market volatility and longevity risk. When they added in a third factor of “an extended period of low interest rates”, the failure rate rose to 54%.

What To Do With Your CD Money


If you’ve had CDs mature over the past several years, you’ve faced the unfortunate reality of having to choose between reinvesting into a new CD that pays a miniscule rate, or moving your money into riskier assets and giving up your guaranteed rate of return and safety. Although you can earn a higher coupon with corporate bonds than CDs, those investments are volatile and definitely not guaranteed. I understand the desire for many investors to keep a portion of their money invested very conservatively in ultra-safe choices. So, I checked this week for current CD rates on a 5-year Jumbo CD and here is what is offered by the largest banks in our area:

Bank of America 0.15%
JPMorgan Chase 0.25%
Wells Fargo 0.35%
Citibank 0.50%
BBVA Compass 0.50%

While there are higher rates available from some local and internet banks, it is surprising how many investors automatically renew and do not search for a better return. Others have parked their CD money in short-term products or cash, hoping that the Fed’s intention of raising rates in 2016 will soon bring the return of higher CD rates.

Unfortunately, it’s not a given that the economic conditions will be strong enough for the Fed to continue to raise rates in 2016 as planned. This week, the 10-year Treasury yield dropped below 2%, which is not strong endorsement of the likelihood of CD rates having a major rebound in 2016.

This is the new normal of low interest rates and slow growth. While rates could be nominally higher in 12 months, it seems very unlikely that we will see 4% or 5% yields on CDs anytime in the immediate future. Waiting out in cash is a sure-fire way to not keep up with inflation and lose purchasing power.

What do I suggest? You can keep your money safe – and earn a guaranteed rate of return – with a Fixed Annuity. I only recommend Fixed Annuities with a multi-year guaranteed rate. Like a CD, these have a fixed interest rate and set term. At the end of the term, you can take your investment and walk away.

Today, we can purchase a 5-year annuity with a rate of 2.9% to 3.1%, depending on your needs. I know that’s not a huge return, but it’s better than CDs, savings accounts, Treasury bonds, or any other guaranteed investment that I have found. Since an annuity is illiquid, I suggest investors set up a five year ladder, where each year 20% (one-fifth) of their money matures. When each annuity matures, you can keep out whatever money you need, and then reinvest the remainder into a new 5-year annuity.

The beauty of a laddered approach is that it gives you access to some of your money each year and it will allow your portfolio to reset to new interest rates gradually as annuities mature and are reinvested at hopefully higher rates. In the mean time, we can earn a better return to keep up with inflation and keep your principal guaranteed.

Issued by insurance companies, Annuities have a number of differences from CDs. Here are the main points to know:

  • Annuities typically have steep penalties if you withdraw your money early. It’s important to always have other sources of cash reserves for emergencies. Consider an annuity as illiquid, and only invest long-term holdings.
  • If you take money out of an annuity before age 59 1/2, there is a 10% premature distribution penalty, just like a retirement account. A 5-year annuity may be best for someone 55 or older.
  • Money in annuity grows tax-deferred until withdrawn. If you rollover one annuity to another, the money remains tax-deferred. Most annuities will allow you to withdraw earnings without penalty and take Required Minimum Distributions (RMDs) from IRAs. Always confirm these features on an annuity before purchase.
  • While CDs are insured by the FDIC, annuities are guaranteed at the state level. In Texas, every annuity company pays into the Texas Guaranty Association, which protects investors up to $250,000. If you have more than this amount to invest, I would spread it to multiple issuers, to stay under the limit with each company.

If you have CDs maturing and would like to learn more about Fixed Annuities, please contact me for more information.

The Year Ahead in Fixed Income


At the end of each year, we review the landscape for fixed income and equities, looking for opportunities and themes to use in our model investment portfolios. With this information, we adjust the weight of asset categories based on their relative risk/reward, and also decide which satellite categories offer the most interesting ways to enhance and complement our core holdings. This week, we start with a look at fixed income.

With today’s low interest rates, it should come as no surprise that the Aggregate Bond Index is only up 1.17% through December 11 this year. This small number belies the potential risks to the bond market in 2016, including the possibility for rising rates to crush long-term bond prices, falling credit quality and increased defaults in the energy sector, and the many unknowns about the rising US dollar and future inflation. And perhaps the only thing worse than seeing inflation tick up in 2016 would be seeing no inflation, a sign that the global economy could be moving back into recession.

The Federal Reserve is meeting on Tuesday and Wednesday this week, and many on Wall Street are watching to see if the committee is finally ready to raise the Fed Funds rate. This will likely be a major focus of the business news of the week, but in spite of all the attention paid to deciphering the Fed’s actions and comments, this is not a reason to be making knee-jerk reactions to Fixed Income holdings.

We see four major themes which will shape how we allocate to Fixed Income in 2016:

1) An emphasis on shorter duration. Whether or not the Fed raises rates this week, we are at a point in time at which the rates on 20-30 year bonds are artificially low. If we consider the yield to maturity as the potential reward for buying these bonds, then the risk we face in terms of a significant decline in price, as well as the opportunity cost to have purchased binds at a higher yield, is too great.

Within all our portfolios, we will look to reduce risk in our Fixed Income holdings, emphasizing shorter duration while maintaining or improving credit quality. We’re not interested in speculating on bonds, which is precisely what many investors are doing today with long-term bonds.

2) Sticking with high yield. We already have positioned our high yield holdings into a short duration fund, the SPDR Short-Term High Yield ETF (SJNK). SJNK has taken a beating this year, down 6.49% as of 12/11. While it’s easy to see the challenges facing high yield, the lower prices present a more attractive value than we’ve had in several years in the category. Today, the fund has an average maturity of only 3.12 years, an average bond price of $95.03, and a yield to maturity of 9.42%. In small portions, this short-term high yield position may help enhance our returns.

3) Municipal Bonds. Municipal Bonds have been held back by concerns about over-leveraged entities such as Detroit and Puerto Rico. At the start of 2015, munis were trading at a discount to other bonds, and that discount gave way to a strong performance in 2015. Even though they have come up in price somewhat, for investors in a higher tax bracket, municipal bonds remain very attractive compared to corporate or treasury bonds. For clients with large taxable holdings, we will likely add to municipal bonds in 2016.

4) Fixed Annuities. I’ve always admired the simplicity of a laddered portfolio of high quality bonds or CDs. In recent years, investors have gotten away from this approach, as they searched for higher yields elsewhere. Unfortunately, there is no free lunch – higher yields come with higher risks – and investors who always seek the highest yielding investments sometimes end up with losses rather than the high returns they had hoped for.

For investors who are 55 or older, who do not need liquidity from their holdings, consider creating a ladder of 5-year fixed annuities, buying one-fifth a year over 5 years. Today, we can buy a 5-year annuity at 3.10%, which is not bad for an investment with a guaranteed return. To get the same yield to maturity on a 5-year bond, we’d have to go a BBB-rated issuer or lower. The annuity may also be a good replacement for a CD, if you are disappointed with today’s rates when your CDs mature.

A laddered 5-year annuity portfolio could make sense for conservative investors because it offer a guaranteed rate of return, preservation of capital, and income, none of which are guaranteed with most other types of bonds. The main trade-off would be liquidity, but if you have a 5-year ladder, you’d have access to 20% of your principal each year. I’ve looked at other annuity durations, but feel that the 5-year is the sweet spot today. Shorter terms have a much lower interest rate, while longer terms do not see much of an increase over the 5-year product.

We will use these four themes to help customize each of our client’s fixed income holdings, even though changes to the model portfolios are likely to be relatively small. We have low expectations from fixed income for 2016 and the next several years. Our focus is not “how can we make as much as possible from bonds”. Rather, we view fixed income as a counter-weight to the risk we take in equities; its main purpose is to reduce the volatility of the overall portfolio. That’s why we want to be very careful about taking risks in fixed income at a time which might be the end of the falling interest rates which have boosted bond prices over the past 35 years.

Today, equities are near a high, even as the global economy struggles to sustain a recovery. Prices in fixed income are also at a high. This is a dangerous time for investors who have become greedy with yield in the recent period of rock-bottom rates. Once rates do begin to rise, fixed income will face a tough road, and that could become a very ugly situation if the stock market is also impacted by rising interest rates, decreased liquidity for corporations, and increased defaults.

Real Estate prices, fueled by cheap mortgages today, will also struggle to rise if homeowners cannot afford higher payments, and commercial Real Estate prices won’t be attractive to investors if cap rates are lower than bonds. I point this out not because I expect a crisis, but only because investors need to understand the potential impacts of higher interest rates in 2016 and ahead.

Next week: the outlook for Equities in 2016.

Source of data: Morningstar as of 12/14/2015

Why You Should Not Hold Bonds to Maturity


If you own individual bonds, as opposed to bond funds, you have the option to sell your bonds rather than holding them to maturity. There are a number of reasons why you might sell a bond before it matures, but we’re going to focus on an important opportunity bond investors have today to enhance returns through roll yield. 

In recent years, short-term interest rates have been very low, which causes a steep yield curve. A corporate bond might have a yield to maturity of 3-5% when it has 5-10 years to maturity, but a similar bond with only one year before maturity may yield only 1-2%. Bond yields and prices have an inverse relationship, so as bonds near maturity, their yields shrink and the prices of those bonds increase.

Here’s an example: Let’s say we purchase a 5-year bond with a 5% coupon at par ($1000). One year later, the bond has four years remaining, and let’s say that similar bonds have a yield to maturity of 4%. The price of our 5% bond is now $1036. If we sell the bond after one year, we will have received $50 in interest, and we will made $36 in capital gains, for a total increase of $86, or 8.6%. The $36 gain is the roll yield, and it nicely enhanced our return from 5% to 8.6% for just one year.

When you buy most bonds, it’s not likely that the price of the bond will stay the same until maturity. Because of the steepness of today’s yield curve (low short-term rates), bond investors can benefit from selling bonds above par before maturity.  If we go back to our example of a 5% coupon bond, let’s fast forward a couple of years to when the bond has just one year left to maturity. If the yield on 1-year bonds is 1.5%, our bond would be worth $1034. We could sell for $1034 today versus waiting a year to get back $1000. And while we’d miss out on the final $50 in interest payments, we could use our $1034 to buy other bonds further out on the yield curve. Also, given that the $34 gain would be treated as a capital gain (at a 15% tax rate for many investors), whereas the $50 bond interest would be treated as ordinary income (25%, 28%, 33%, 39.6% or higher), the after-tax return of selling a year early is almost the same as holding until maturity.

Generally, we advocate a laddered approach to individual bonds, but for the last several years, low interest rates have made it possible to sell bonds a couple of years before maturity to take advantage of roll yield. If your bonds are priced with a yield to maturity of 2% or less, it is definitely worth a look to see if you might benefit from selling rather than holding to maturity. This type of active management takes a bit of work, and frankly, we don’t see a lot of other advisors providing this level of service.

We typically suggest using bond funds for portfolios under $1 million dollars, because it is difficult to achieve a satisfactory level of diversification on smaller portfolios. The managers of your bond fund are likely looking closely at roll yield as well as other reasons to buy or sell bonds, to take advantage of the current interest rate environment. This is one of the reasons that it may be easier for fixed income managers to have a better chance of outperforming their benchmark than equity managers. While 65-80% of equity managers typically underperform their benchmark over five years, according to S&P,  only 41.09% of intermediate investment grade bond funds were beaten by their benchmark from 2010 through 2014.

Equities tend to get all the attention, but many of our clients have 30 to 50 percent of their portfolio in fixed income. It’s important that investors do a good job selecting and managing both their equity and fixed income holdings. If you currently have a portfolio of individual bonds, bring me a statement for a complementary portfolio review. I’ll analyze your portfolio and suggest which bonds to keep and which ones to sell and replace. Or if you’re trying to decide between individual bonds or bond funds, please give me a call.

Fixed Annuities in Place of Bonds?

Beach Pier

Today’s low interest rate environment is challenging for investors. Cash is paying virtually nothing, and even the 10-year Treasury has a yield of only 2.3% to 2.4%. If you do invest in longer-dated bonds, you have the risk of falling prices if interest rates begin to rise.

Low interest rates have pushed many investors to seek out higher yielding securities. But, there is no free lunch, as higher bond yields come with lower credit quality, heightened risk of default, and increased volatility.

Treasury bonds are a good tool for portfolio construction, because they have a very low correlation to equities. However, if investors replace those very safe (but low yielding) Treasuries with high yield bonds, they are increasing the probability that both their equity and fixed income positions will be down at the same time.

In 2008, for example, as equities tumbled, the iShares High Yield ETF (HYG) was down more than 17% for the year. Although high yield bonds have a place, investors need to understand that junk bonds may not provide much defense when the stock market takes a dive.

Cautious investors have been hiding out in short-term bonds, which might be yielding 1% or less. And while that will limit losses if rates rise, no one knows how long we will be stuck with today’s low rates. If low rates persist for years, short-term bonds aren’t providing much return to help you achieve your investment goals.

As an alternative to taking the risks of chasing yield, or the opportunity cost of hiding in short-term bonds or cash, some investors might want to consider a Fixed Annuity. These come in a variety of formats, but I am only suggesting annuities with a fixed, multi-year guaranteed rate. These are sometimes compared to CDs, but it is very important that investors understand how annuities differ.

Here’s the attraction: we can offer up to 3.25%, principal and interest guaranteed, on a 5-year Fixed Annuity today. And that’s the net figure to investors, which is fairly compelling for a safe yield. It’s more than 1% higher than the SEC yield on a US Aggregate Bond Index fund, like AGG.

Here are five key points to help you understand how annuities work and determine if an annuity is a good choice for you.

  1. Tax-deferral. Annuities are a tax-sheltered account. While you don’t get an upfront tax deduction, an Annuity will grow tax-deferred until you withdraw your money. When withdrawn, gains are taxed as ordinary income, and do not receive capital gains treatment.
  2. Like an IRA, withdrawals from an Annuity prior to age 59 1/2 are considered a pre-mature distribution and subject to a 10% penalty. This is an important consideration: only invest in an Annuity money that you won’t need until after age 59 1/2. This is obviously easier for someone who is in their 50’s or 60’s compared to younger investors.
  3. Limited liquidity. Annuity companies want investors who can commit to the full-term and not need to access their principal. They may impose very high surrender charges on investors who withdraw money before the term is completed.
  4. At the end of the term, investors have several options. You can take your money and walk away. You can leave the money in the annuity at the current interest rate (often a floor of 1%). You can roll the annuity into a new annuity and keep it tax deferred. If the annuity is an IRA already, you can roll it back into your regular IRA brokerage account. Or lastly, you can annuitize the contract, which means you can exchange your principal for a series of monthly payments, guaranteed for a fixed period, or for life. I don’t think very many investors annuitize – most will walk away or reinvest into another annuity.
  5. Annuities are guaranteed by the issuing insurance company, and that guarantee is only as good as the financial strength of the company. Similar to how CDs are insured the by the FDIC, investors in Annuities are protected by your state Guaranty Association (Texas Guaranty Association). Since coverage for annuities in Texas is only up to $250,000, I would never invest more than this amount with any one company.

What I like about the annuity is that it can provide a guaranteed rate of return and price stability, unlike a bond fund. An annuity also can reduce a number of types of portfolio risks, such as interest rate risk, default risk, and will have no correlation to equity returns.

Is an annuity right for you? You should be able to invest the funds for at least 3-7 years and have ample money elsewhere you can access in case of an emergency. You can invest money from an IRA or a regular account, but either way, should not plan on withdrawing money from an annuity until after age 59 1/2. And we’re only using money that would have otherwise been allocated to bonds, CDs, or cash in your investment portfolio. If this describes you, please give me a call at 214-478-3398 and we can discuss Fixed Annuities and their role in your portfolio in greater detail.


Please note that as an insurance product, an annuity will pay the issuing agent a commission. Clients are not charged an AUM fee on monies invested in Annuities. We aim to disclose all conflicts of interest and provide transparency on how we are paid.

Fixed Income: Four Ways to Invest


Fixed Income is an essential piece of our portfolio construction, a component which can provide cash flow, stability, and diversification to balance out the risk on the equity side of the portfolio. Although fixed income investing might seem dull compared to the excitement of the stock market, there are actually many different categories of fixed income and ways to invest. As an overview, we’re going to briefly introduce the various tools we use in our fixed income allocations.

1) Mutual Funds. Funds provide diversification, which is vitally important in categories with elevated risks such as high yield bonds, emerging market debt, or floating rate loans. In those riskier areas, we want to avoid individual securities and will instead choose a fund which offers investors access to hundreds of different bonds. A good manager may be able to add value through security selection or yield curve positioning.

While we largely prefer index investing in equities, the evidence for indexing is not as conclusive in fixed income. According to the Standard & Poor’s Index Versus Active (SPIVA) Scorecard, only 41% of Intermediate Investment Grade bond funds failed to beat their index over the five years through 12/31/2014. Compare that to the 81% of domestic equity funds which lagged their benchmark over the same five year period, and you can see there may still be an argument for active management in fixed income.

2) Individual Bonds. We can buy individual bonds for select portfolios, but restrict our purchases to investment grade bonds from government, corporate, and municipal issuers. The advantage of an individual bond is that we have a set coupon and a known yield, if held to maturity. While there will still be price fluctuation in a bond, investors take comfort in knowing that even if the price drops to 90 today, the bond will still mature at 100. It’s difficult for a fund manager to outperform individual bonds today if their fund has a high expense ratio. You cannot have a 1% expense ratio, invest in 3% and 4% bonds, and not have a drag on performance.

Those are the advantages of individual bonds, but there are disadvantages compared to funds, including liquidity, poor pricing for individual investors, and the inability to easily reinvest your interest payments. Most importantly, an investor in individual bonds will have default risk if we should happen to own the next Lehman Brothers, Enron, or Detroit. Bankruptcies can occur, and that’s why we only use individual bonds in larger portfolios where we can keep position sizes small.

3) Exchange Traded Funds (ETFs). ETFs offer diversified exposure to a fixed income category, but often with a much lower expense ratio than actively managed funds. ETFs can allow us to track a broad benchmark or to pinpoint our exposure to a more narrow category, with strict consistency. Fixed income ETFs  have lagged behind equity ETFs in terms of development and adoption, but there is no doubt that bond ETFs are gaining in popularity and use each year.

4) Closed End Funds (CEFs). CEFs have been around for decades, but are not well known to many investors. Closed End Funds have a manager, like a mutual fund, but issue a fixed number of shares which trade on a stock exchange. The result is a pool of assets which the fund can manage without worry about inflows or redemptions, giving them a more beneficial long-term approach. With this structure, however, CEFs can trade at a premium or a discount to their Net Asset Value (NAV). When we can find a quality fund trading at a steep discount, it can be a good opportunity for an investor to make a purchase. Unfortunately, CEFs tend to have higher volatility than other fixed income vehicles, which can be disconcerting. We don’t currently have any CEF holdings as core positions in our portfolio models, but do make purchases for some clients who have a higher risk tolerance.

Where fixed income investing can become complicated is that within each category (such as municipal bond, high yield, international bond, etc), you also have to compare these four very different ways of investing: mutual funds, individual bonds, ETFs, or CEFs. They each have advantages and risks, so it’s not as easy as simply choosing the one with the highest yield or the strongest past performance. And that’s where we dive in to each option to examine holdings, concentrations, duration, pricing and costs.

There are other ways to invest in fixed income, such as CDs, or annuities, and we can help with those, too. But most of our fixed income investing will be done with mutual funds and ETFs. In larger portfolios, we may have some individual bonds, but will always have funds or ETFs for riskier categories.

Investors want three things from fixed income: high yield, safety, and liquidity. Unfortunately, no investment offers all three; you only get to pick two. Where we aim to create value is through a highly diversified allocation that is tactical in looking for the best risk/reward categories within fixed income.

The Dangers Facing Fixed Income in 2015


Although returns were largely positive, 2014 did little to ease the risks in Fixed Income, and in some categories, made the situation decidedly more precarious.  Looking at the funds and ETFs I follow, municipal bonds, foreign bonds, and long-term treasuries saw their yields fall, with prices markedly higher.  Bonds with the longest duration experienced the greatest change in price.

We are now several years into a low interest rate environment which central banks, like the Federal Reserve, manufactured through their interest rate policies and quantitative easing (bond buying) mechanisms.  The market consensus was that these depressed interest rates were like a coiled spring, ready to shoot higher and eventually cause bond investors to endure painful losses.  The flip side of some bonds gaining 10-20% in value this year is that if interest rates were to increase by 1-2% in 2015, those same investors could potentially see 20% or higher losses in their positions.

A strong return in 2014 creates a challenging situation – if those categories were overvalued before, they’re even more expensive now.  Although the potential for interest rate risk is now higher than ever, the market is beginning to recognize that without increased signs of inflation, we might be stuck with these low rates for an unprecedented number of years. While the yield on the US 10-year Treasury is around 2.2% today, the equivalent 10-year government bond yields less than 1% in Germany, Japan, and a number of other countries. To accept such a low rate suggests that deflation remains a greater concern than inflation for investors in some locations.

Investors positioned defensively in short-term bonds, floating rate, high yield bonds, or TIPS, all lagged the Barclays Aggregate Bond Index in 2014.  How should we position for 2015 then?  In our Good Life Wealth model portfolios, we are taking a three-prong approach.

1) We don’t try to predict interest rates or speculate on bonds. The role of Fixed Income in our portfolios is to mitigate the risk of our Equity positions.  We are looking to have lower interest rate risk (“duration”) than the overall bond market. This means we will make less if interest rates continue to fall, but we will also lose less if or when rates eventually rise.

2) We will underweight areas where yields are too low to compensate for the potential risks.  For now, this means we avoid foreign and US treasuries and TIPS.  We keep cash to a minimum, to 1% or the amount required for 12 months of withdrawals.

3) We consider each Fixed Income category in terms of its potential rewards and risks.  For example, a fund with an SEC yield of 3 and a duration of 3, would have a ratio of 1; a fund with a yield of 2 and a duration of 4, would have a ratio of 0.5, which is less desirable.  That’s not to say that we can simplify our selection process to a single step, but it does help inform how quickly we would recover from potential losses, so we can be better positioned if interest rates were to rise.

Although bond prices can be volatile in the short-term, the beauty of bonds is that their Yield to Maturity is a very strong predictor of how the bonds will behave over their lifetime.  Our primary focus then is on the opportunity each bond category will provide over time rather than what might occur in the short-term.

With US Stocks sitting at or near all-time highs, bonds may be an after-thought for some investors.  And with today’s paltry yields, it’s no wonder.  However, bonds have an important role in protecting our portfolios and creating income to contribute to our total return.  We’re not going to ignore the risks in bonds, so you can count on our Fixed Income allocation to continue to be tactical in the years ahead.