Sunday, March 26, 2017

Bonds Can Hurt Retirement Capital


Running out of money is the single biggest fear of all investors and should be of their portfolio managers and other fiduciaries. Unfortunately far too many focus on a perceived capital amount to meet their long-term funding needs. Unfortunate because they do not include allowances for taxes, inflation, and mistakes both in terms of investments and unplanned expenses. Thus their retirement or legacy needs are often understated. Because of these understatements/reasonable errors I believe payout of accumulated capital over 3% annually may lead eventually to the depletion of capital  in part or completely.

Universal Problem

There are apparently a number of perceived missing elements in every country's constitution. The global rise in populism is based on the belief that our society, in other words our government, owes each able bodied person gainful employment, and for the others some form of support. To the best of my knowledge the economic structure of no country is set up deliver on these perceived, unwritten promises. Thus this is the first big problem facing us.

Retirement Capital

However there is a second and perhaps even bigger problem that is accelerating ahead of us. Any quick review of national statistics will show that the need for retirement capital is actually growing faster than the need for jobs. To some degree the need for jobs is being addressed in the much reduced growth in population around the world, except in Africa and some parts of the Middle East. The existing unemployment and under-employment is creating a growing class of people that have little to nothing in the way of retirement capital even if they qualify for the under-funded social security.

Demographically there will be others such as the disabled and currently incarcerated who will enter the retirement stage with little or no capital. Add to these a much larger group of people entering their senior stage when they have not built sufficient retirement capital. All of these people (unlike some of the unemployed) can vote and are more likely to do so than in the past.

The risk to those who believe that they have sufficient retirement capital may be  a gross miscalculation. Eventually our societies will react to these needs. While hopefully they may make investing more profitable by lowering expenses and taxes, the odds are that governments will spend money. In some combination the money will impact taxes on (a) those that have money, (b) inflation for all, and (c) deficits which will drive interest rates up and the value of currencies down. It is these prospects plus the current low real interest rates, after inflation, which makes investing in high quality bonds risky if they have to be sold to make payments. 

Currently the Proper and Improper Use of Bonds

After a long struggle to build sufficient retirement capital with due consideration to the growing needs of present and future beneficiaries, an individual or institutional investor may wish to reduce the risk of losing meaningful amounts of retirement capital, one could properly invest in high quality bonds. This assumes that the current interest rates are above the after-tax inflation rate. Such an investor is both extremely rare and lucky. All other bond owners are speculating as to the future. 

At current interest rates adjusted for inflation and taxes it is difficult to see how bonds can be used to actually build retirement capital as distinct from maintaining it. Many if not most bond holders do so in the belief that there is less price risk in owning bonds than owning stocks or other forms of equity. Historically they are right in that most market declines bonds decline less than the stocks. Thus, I believe the proper way to look at the allocation of assets to bonds is a longer term index of fears of stocks than the VIX or other measures of short-term volatility.

Bonds Could be Worthwhile

As with all investment strategies there is a time that they are correct and other times when they are wrong. Unfortunately, I can perceive that once again interest rates will be driven so low that they can make bonds attractive to new purchasers. For those who have owned bonds for sometime, the offset is that during such a period if they have to sell their bonds the odds are the prices will be below (and perhaps significantly below) their purchase prices. There have been periods in history when purchasing high quality bonds with highly elevated yields produce in time big price appreciation benefits. My only problem with this strategy is that most of the time by the end of these market recoveries, one would have been better buying equities.

Equity Risk in Some Bonds

High yield bonds and to some extent high interest loans have been called stocks with coupons. This means while these credit instruments are called bonds and loans they have imbedded in them risk of late and/or incomplete repayment as scheduled. Unfortunately many individual and institutional investors have focused on the bond-like attributes of this kind of paper and have enjoyed the performance comparisons of high yield paper out-performing high quality bonds. Perhaps they didn't notice that in most of these periods stocks in general out-performed both high yield and high quality bonds, but they could claim that they were more conservative because they owned bonds and loans and not those risky stocks.

Spending Too Much of the Income

One of the real disadvantages of high yield paper is that most investors spend all of the interest payments as if they were from a high quality source. Note that in many periods the price performance of these assets is below the total return performance results by more than the paid interest . The missing difference is the impact of the defaults on a minority of these bonds. The major credit rating groups regularly publish their estimates of the forthcoming default rates of this asset  To the extent that investors want to spend the payments off of high yield paper, I would recommend that they put into some reserve account at least the current default estimates on the category. Often when defaults rise all of these types of paper fall to some degree in sympathy to the defaulting issues.

Bond Market Liquidity is Illusive

The liquidity in the bond market is considerably less than in the stock market which makes it difficult to sell during periods of unrest. This is particularly true in the high yield market. In one recently recorded instance that is part of a law case, the nominal bid for a bond was 65 ($0.65 per dollar of face value.) A large professional seller encountered the following situation: 60 to sell $1 million, 50 to sell $2-5 million and 31 for more. What is the worth of this account's net asset value with a nominal quote of 65?

The Problem with Bonds are the Bond Buyers

As with most things the problem with various instruments; e.g., guns or fast cars, are not inherent in the instruments themselves, but the people who use them. Utilizing Schroders* Global Investors Study 2016 one can see individual and institutional investors bring the wrong attitudes to investing in securities and funds. The desired income broken down by location was instructive. Europeans wanted 7.9%, Asians 9.7% and those in the Americas 10.4%. One should not be surprised to learn that the Europeans in aggregate hold a higher allocation to bonds than those in America, but with an older population and more proportion of  debt than those on this side of the pond. Thus they are growing their retirement capital deficit faster as well as having higher unemployment and underemployment which helps to explain their more socialist oriented government. What is most interesting is that those surveyed thought they would live a long time in retirement. In addition, 74% thought they would live sixteen to thirty years in retirement. Contrast that image with their practice of owning particular securities 3.2 years and their advisors recommending holding for on average 4.3 years. In effect what the study is showing is that investors with a long-term need for retirement income plan to trade around five times during their retirement years. While not a perfect comparison, long-term studies of US Mutual Funds suggest those that on average trade less, perform better.
*Held personally

Bear all of this in mind with the surge of global money going into bond funds at the same time that they are significantly under-performing the average equity fund.

US Investors May Do Better

According to the trade association for mutual funds, ICI, 60% of defined contribution assets are invested in equity funds.  With a significantly older weighted population, 54% of Individual Retirement Accounts are in equities. Roughly half of the money in these two main retirement accounts are in mutual funds. Typically defined contribution and IRA accounts don't trade much. To the extent that they don't trade and invest for longer periods of time they will build retirement capital sums. They could be augmented if the tax people allow these accounts to grow without mandatory redemptions way beyond the current 70 ½ years old.  

If the current US Administration and Congress really want to increase employment, perhaps they will focus on small companies being the largest contributors of new jobs - despite the fact that the number of publicly traded companies has dropped by 3000 over the last twenty or so years. We are down about 1/3 from our previous total.

Investment Conclusions 

At the current time, high quality bonds don't make a lot of sense for most retirement accounts. Also the average US investor, excluding currency, is likely to perform better than their European counterparts. This is particularly true if smart job generating tax programs are put into place.
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