Introduction
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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A. Michael
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