Folks, the following is really important! It's worth investing some time to process the points below.
In my last blog, I examined the metaphor of dividends as a sluice diverting some of the broader river of money a company generates. As long as the river is swelling, the sluice can grow too. Earnings growth can be problematic though, and so too can the growth of dividends.
There are many demands made on a company's income stream. Surprisingly, perhaps, one of the greatest threats is the very thing that companies try to generate: cash. As it swells, so too do the temptations to "do" something with it. Some of these things are perfectly fine, even critical. Research and development, infrastructure investments, employee development ... all these might have a big payoff down the line. However, a whole bunch of things are far more questionable. Outsize salaries and bonuses to top management are astonishingly effective in draining money from the income stream. Trophy investments of all kinds can vaporize huge sums of money. Helpful hint: if your hot start-up buys a sports arena or builds a name-brand highrise, run, don't walk, for the exits!
This brings me to one of my biggest gripes: stock buybacks. These are a terrific way to vaporize money. Here's the shill. Take "excess" cash, and use it to buy the company's stock on the open market, thus shrinking the number of shares outstanding. If a company buys up 10% of its stock over a couple of years time, then, in theory, its income will accrue to fewer shareholders. So, their stock will be worth more, and the price will go up! Great idea, right? Actually, it's terrible.
Let's do the math, vastly simplified. Assume a company with $1 million net worth, with $200,000 in cash, and $800,000 in other assets (plant, inventory, patents, etc.). Say it has 100,000 outstanding shares. Say it earns $100,000 a year. How would the this stock be valued? Well, the simplest would be the breakup value: sell off everything and distribute the proceeds to the stockholders. In this case, that would be $10 per share.
In real life, though, those earnings of $100,000 would be the starting point. A company is, after all, usually worth more than its physical assets. It's an earnings machine. Based on opinions about whether the earnings will grow over time, a price/earnings multiple will usually be assigned: say 10 to 1 for a company with average prospects. To that, the cash ($2 per share) would be added, resulting in a price of $12 per share, higher than the breakup value. Note here that cash is a special category. It's not locked up; you can do anything you want with it. You can use it to build the business or protect the business from hard times. You can give it to the investors as a dividend. You can lend it out to others, thus turning it into an income stream. That's why you would add cash in, dollar for dollar, to the per share value of the company.
Now assume a Carl Icahn vulture buys in, and then demands a buyback to "enhance shareholder value," citing the magic of enhanced per-share earnings. There is a HUGE intellectual gap in his presentation, however. Here's a startling
idea: if you spend money, then you don't have it. It's like cake. You
can look at it, luscious and tantalizing, or you can eat it. You can't
do both (at the same time, of course, of course). Yes, earnings per
share will rise if you purchase back a portion of the outstanding
shares, but the company itself is now worth less, dollar for dollar, than before.
In this example, using the $200,000 in cash to buy 16,666 shares at $12/share will reduce the number of shares outstanding to 83,334. With $100,000 yearly earnings, each share now earns $1.20 a share. Great, right? BUT, you can no longer add in the cash! It's gone! So, applying the same PE multiple of 10 to the $1.20, you end up EXACTLY where you were before, with a stock worth $12 a share. I would argue, strongly, that the company is actually worse less than before, because cash is NOT trash. It's vital to the future of a company, as it can grow sales if properly invested, or at least cushion a company from bad times.
So why does Carl want the company to initiate a buyback? Simply put, it's a great way to make a fast buck. Announcing the buyback, and then initiating it, puts upward pressure on the stock. Suddenly, extra cash is chasing the shares available for sale. Demand outruns supply (temporarily), and the price jumps. So, Carl sells into a rising market, pockets the quick gain, and departs. He could care less about "stockholder value!" He's a scorpion, stinging companies is what he does. Lesson for non-scorpions? Stock buybacks only benefit the folks who sell! Those who stay are left with a company whose cash has been frittered away to others. I think it's a form of financial rape
.
But, you ask, why couldn't the game go on ... forever? That is, if
buying stock back puts upward pressure on the price, then a permanent
buyback program would permanently lift stock prices, thus rewarding
shareholders precisely as planned.
Asking the question pretty much answers it. No stock buyback program is permanent. No company ever promises it. They can't, and would be idiots to do it. The future is unknowable, and stock buybacks are, by and large, expensive. When the money runs short, the buybacks cease. Gravity ensues.
Even if the money didn't run short (and it almost always does), you would still run into the law of diminishing returns. Eventually, the company will have bought all the outstanding stock, at ever-rising prices. The last man standing (Michael Dell perhaps) owns a single hugely expensive share, and the company is no longer public. What would you call a game where you're buying something that gets more and more expensive, precisely because you're buying it? The Hunt brothers discovered the answer when they tried to corner the silver market.
If you look at the history of stock repurchases, it becomes clear that
they are a zero-sum game. Any rise in the stock price is due largely to
increased, and temporary, demand. Once that demand is met (i.e., once
the company stops the buy-back), the price settles right back. Why do companies stop their purchases? Lots of reasons. A common one is that they never intended to complete the buyback. They rely on the announcement to goose the price, and quietly shelve the buy-back after a few months. Equally common is the economic cycle. Buybacks occur when money is plentiful. An economic downturn ends the game instantly.
This brings me to the question of timing. Executives who decide to pump earnings by repurchasing stock have, historically, had terrible timing. Invariably, they initiate buybacks when times are good, and cash is burning a hole in their pockets. Then, once the economy has cratered (it happens pretty regularly), they suddenly hoard the cash like ... gold! In fact, companies will, facing economic distress, often issue stock at distress prices in order to shore up their cash reserves. This is classic buy-high sell-low behavior. Guess who pays the price? It's not the CEOs, who typically get massive bonuses when the stock is up (due to buy-back jiggering), and then float away on golden parachutes once the shit has encountered the inevitable fan.
Occasionally you will see a company like IBM, which has bought back a
large amount of stock, and still seen the stock price rise over time.
Does this constitute proof that stock buybacks are the reason? Quite
the contrary, I would argue. IBM has been very good at increasing
revenues, even to the point that stock buybacks dwindle against the
income growth. Where would investors be if IBM had diverted this cash
to dividends instead? Far better off, I would insist. The money would
be in the hands of the stockholders now, instead of in the hands of
departed sellers.
One of the worst abuses of the stock buy-back is to fund employee and executive bonuses. The company plumps down a pile of cash, and then hands the stock over to the hired hands. So, the stock isn't retired at all, the PE ratio is not lowered at all, and the stock owners have their ownership diluted (as they now own a company worth less than before). This might be OK, if these incentives actually worked. There is, however, almost no evidence that it does. The explosion of executive compensation in the 2000-2012 period has no relationship to the performance of the companies at all! Since this was a period of relative stagnation, a rational system would have frozen executive salaries during the decade.
What can you do about all this? Very little directly. You should, however, use the information to control your enthusiasm about the next hot stock. Your company may grow from an acorn to the heavens, and you still might not reap even a fraction of the rewards. If you are thinking about a given stock, take a close look at its recent record of employee compensation and incentives. If they're at the high end, then you may be sure that management's interests are no longer aligned with yours. You'd be better off avoiding a train due for a crash. You can be sure that those discredited CEOs and CFOs will not lose a dime in the pileup, but you will lose a sock-full.
If a company really intends to reward its shareholders, there is a very
simple way to do it: the dividend! Here is the ideal: a regular,
sustainable dividend, adjusted periodically for inflation and income
growth, but modest enough to leave the company with sufficient cash to
grow the business. Old fashioned, isn't it? Alas, if only this simple recipe weren't so damnably difficult to do (as I pointed out in an earlier blog)!
To return to my broader theme, can you see a little better why I prefer bonds?
Wednesday, December 5, 2012
Saturday, December 1, 2012
Income Streams, Upriver and Down
I just love bonds, but, as I said in my last post, I can't recommend them right now. Well, that's not strictly true; it's just that I can't recommend my favorite investing technique, which involves the regular purchase of BAA 30-year bonds. Yields are simply too low; rising rates will trash principal if you buy at today's inflated prices.
So, what should you do? In the frantic hunt for yield, the flavor of the month is the high-dividend stock, particularly one with rising dividends. Do the math, say the gurus: even a stock with a moderate dividend will beat bonds handily if that dividend grows over time. They spin lovely scenarios like this: a company with a 3% dividend increases that dividend steadily over a ten-year period, say at a rate of 5% annually. So, a $100 stock will initially yield $3. After ten years of growing at a 5% rate, that $3 becomes nearly $5. Assuming the price/earnings ratio stays the same, that $100 stock is now worth $166! Add in the cumulative dividends (say $40), and you've doubled your money! Factor in the favorable tax treatment (15%) given to dividends, and you've beaten bonds to death! Lovely, right?
As I've pointed out before, there serious problems with the scenario. They derive, in the main, from the fact that dividends and interest are very different things. In the broadest sense, both are sluices from a larger income stream. What is the larger stream? Well, it's the money a company generates by doing what it does: lending money, selling automobiles, refining copper, brewing up syrup-laden lattes, etc. Interest is one of the company's core expenses whereas dividends are diverted from the income stream after expenses are paid. Logically, therefore, interest comes first and dividends trail, badly.
If a company's expenses rise more rapidly than its ability to increase sales or raise prices, then the viability of the dividend is jeopardized. THAT, folks, is exactly what happens, over and over and over. A company will establish a very nice record of paying steadily rising dividends, only to cut them severely, or even eliminate them, when tough times arrive. This isn't a rarity; it's predictable. Yes, recessions do damage a company's cash flow, and perhaps its ability to pay the dividend. But they are also a great excuse for cutting back on an obligation that will become unsustainable in the future. That is partly why dividends were pared so savagely in 2008/9 and 2001/2. In fact, EVERY recession brings waves of dividend cuts. You can count on them, and they absolutely trash the lovely scenario painted above. The haircut is twofold: you get less income, and the stock price drops to account for the diminished payout. It can take years to recover.
Instead of running off after yield alternatives, my advice is to be patient. If you're lucky enough to be receiving regular interest payments from a Bodacious portfolio, you can just sit on the money for awhile. To that money you can add redemptions (remember, you've laddered BAA bonds over a 30-year spectrum). Cash and cash equivalents will build steadily.
You will probably be surprised how rapidly today's low-interest environment will fade. Until then, I suggest you stick with bonds: just of a different type. If you look for investment grade bonds with a 1-2 year maturity, you'll discover that it's perfectly feasible to capture yields in the 2.5% to 3% range. That's generous enough to pay your taxes and cover today's inflation as well. Yeah, you're not gonna get ahead, but you're not falling behind either. Sometimes, staying even is a very good thing, all by itself. As bond income and redemption cash comes in, you can ladder your purchases, buying 1-2 years out, two or three times a year.
Then, you wait, like a spider. Eventually, rates will rise. Eventually, they will rise enough to let you go out on the maturity spectrum, and capture yields that will beat inflation and taxes, and still leave you a generous return. If you get to one of those rare moments when yields have soared, and prices plunged, then you can go for the long bomb: using leverage to lock in cyclically peak yields.
So, what should you do? In the frantic hunt for yield, the flavor of the month is the high-dividend stock, particularly one with rising dividends. Do the math, say the gurus: even a stock with a moderate dividend will beat bonds handily if that dividend grows over time. They spin lovely scenarios like this: a company with a 3% dividend increases that dividend steadily over a ten-year period, say at a rate of 5% annually. So, a $100 stock will initially yield $3. After ten years of growing at a 5% rate, that $3 becomes nearly $5. Assuming the price/earnings ratio stays the same, that $100 stock is now worth $166! Add in the cumulative dividends (say $40), and you've doubled your money! Factor in the favorable tax treatment (15%) given to dividends, and you've beaten bonds to death! Lovely, right?
As I've pointed out before, there serious problems with the scenario. They derive, in the main, from the fact that dividends and interest are very different things. In the broadest sense, both are sluices from a larger income stream. What is the larger stream? Well, it's the money a company generates by doing what it does: lending money, selling automobiles, refining copper, brewing up syrup-laden lattes, etc. Interest is one of the company's core expenses whereas dividends are diverted from the income stream after expenses are paid. Logically, therefore, interest comes first and dividends trail, badly.
If a company's expenses rise more rapidly than its ability to increase sales or raise prices, then the viability of the dividend is jeopardized. THAT, folks, is exactly what happens, over and over and over. A company will establish a very nice record of paying steadily rising dividends, only to cut them severely, or even eliminate them, when tough times arrive. This isn't a rarity; it's predictable. Yes, recessions do damage a company's cash flow, and perhaps its ability to pay the dividend. But they are also a great excuse for cutting back on an obligation that will become unsustainable in the future. That is partly why dividends were pared so savagely in 2008/9 and 2001/2. In fact, EVERY recession brings waves of dividend cuts. You can count on them, and they absolutely trash the lovely scenario painted above. The haircut is twofold: you get less income, and the stock price drops to account for the diminished payout. It can take years to recover.
Instead of running off after yield alternatives, my advice is to be patient. If you're lucky enough to be receiving regular interest payments from a Bodacious portfolio, you can just sit on the money for awhile. To that money you can add redemptions (remember, you've laddered BAA bonds over a 30-year spectrum). Cash and cash equivalents will build steadily.
You will probably be surprised how rapidly today's low-interest environment will fade. Until then, I suggest you stick with bonds: just of a different type. If you look for investment grade bonds with a 1-2 year maturity, you'll discover that it's perfectly feasible to capture yields in the 2.5% to 3% range. That's generous enough to pay your taxes and cover today's inflation as well. Yeah, you're not gonna get ahead, but you're not falling behind either. Sometimes, staying even is a very good thing, all by itself. As bond income and redemption cash comes in, you can ladder your purchases, buying 1-2 years out, two or three times a year.
Then, you wait, like a spider. Eventually, rates will rise. Eventually, they will rise enough to let you go out on the maturity spectrum, and capture yields that will beat inflation and taxes, and still leave you a generous return. If you get to one of those rare moments when yields have soared, and prices plunged, then you can go for the long bomb: using leverage to lock in cyclically peak yields.
Friday, October 19, 2012
A Dead End ... For Now
Well, the ride goes on, but I can no longer suggest climbing aboard. I just did a scan on E*Trade to find investment grade bonds yielding more than 7% yearly. The only things that came up were some AMR bonds. Guess what? These puppies are in default, despite their BBB ratings from Moody's. Folks, the risk/reward ratio has slanted decisively toward risk.
All along, I have talked about buying long-term bonds at or below par, with yields high enough to compensate for inflation. Taking into account the unprecedented opportunities afforded by margin rates hovering around 1.25%, this has meant that rich yields of 10-12% have been within reach. Well, this is still true, technically. You can still find the odd issue selling around par, with a 7% coupon. Applying 50% margin (borrowing $5,000 of a $10,000 purchase) would incur a mere $62.50 in interest, reducing the return to $637.5 for that 7% bond. So, you will still score a 12.75% return on that $5000 investment. So, what could go wrong?
LOTS of things. Just because inflation has been hiding for the past five years doesn't mean it's gone forever. A real uptick will swirl through the bond world in no time. A bond trading at par to yield 7% will suddenly be worth only $.875 when rates go to 8%. No problem if you're in for the long haul, but a massive one if you need the money anytime soon.
Also, an uptick in inflation might drastically affect margin rates. Just imagine the present margin rate going up to 3% from today's 1.25%. Now your nearly return is only $550, still over 10%, if you can ignore the capital loss of $1250 on paper.
Historically, from 1946 through 2012, the Moody's BAA seasoned rate has been around 7.6. With it hovering around 5% now, even the most exceptional situations are looking shaky. So, it's probably time for a pause. If you're a Bodacious investor following a plan, perhaps you should go ahead and buy something this year, but maybe less than usual. Instead, pay down margin loans with the difference. If you don't have margin debt, then let the money accumulate for awhile. Cash is NOT trash. Even if it just sits around, the loss to inflation is small right now.
One beauty of the market system is that, sooner or later, opportunity always knocks. With the stock market hovering near 5-year highs, it's a good bet that things will get cheaper eventually. When blood is flowing and you're scared out of your wits, it will probably be a good time to put that money to use. With any luck, the opportunities will be there in bonds, which is, as you know, my idea of the way to roll!
All along, I have talked about buying long-term bonds at or below par, with yields high enough to compensate for inflation. Taking into account the unprecedented opportunities afforded by margin rates hovering around 1.25%, this has meant that rich yields of 10-12% have been within reach. Well, this is still true, technically. You can still find the odd issue selling around par, with a 7% coupon. Applying 50% margin (borrowing $5,000 of a $10,000 purchase) would incur a mere $62.50 in interest, reducing the return to $637.5 for that 7% bond. So, you will still score a 12.75% return on that $5000 investment. So, what could go wrong?
LOTS of things. Just because inflation has been hiding for the past five years doesn't mean it's gone forever. A real uptick will swirl through the bond world in no time. A bond trading at par to yield 7% will suddenly be worth only $.875 when rates go to 8%. No problem if you're in for the long haul, but a massive one if you need the money anytime soon.
Also, an uptick in inflation might drastically affect margin rates. Just imagine the present margin rate going up to 3% from today's 1.25%. Now your nearly return is only $550, still over 10%, if you can ignore the capital loss of $1250 on paper.
Historically, from 1946 through 2012, the Moody's BAA seasoned rate has been around 7.6. With it hovering around 5% now, even the most exceptional situations are looking shaky. So, it's probably time for a pause. If you're a Bodacious investor following a plan, perhaps you should go ahead and buy something this year, but maybe less than usual. Instead, pay down margin loans with the difference. If you don't have margin debt, then let the money accumulate for awhile. Cash is NOT trash. Even if it just sits around, the loss to inflation is small right now.
One beauty of the market system is that, sooner or later, opportunity always knocks. With the stock market hovering near 5-year highs, it's a good bet that things will get cheaper eventually. When blood is flowing and you're scared out of your wits, it will probably be a good time to put that money to use. With any luck, the opportunities will be there in bonds, which is, as you know, my idea of the way to roll!
Wednesday, September 12, 2012
The Curious Case of Clear Channel
I've written frequently about bonds and risk. I've highlighted the vast differences between bond holders and stock owners with respect to risk. Time and again, the skittish nature of bond investors leads to enticing opportunities. Most recently, I've highlighted some lovely opportunities in fixed income due to the Euro crisis.
Today, I thought it would be useful to look at my failure. Of all the bond positions I bought from 2008 to the present, I have banked a loss on only one: Clear Channel Communication 7.25% of 10/15/27. My position in these bonds ($10,000 face amount) was one of the very first I made in 2008. The financial crisis was looming, and I was already scared. I had raised $50,000 in cash, anticipating the crisis. I already sensed that the sweet spot would be in bonds. So, I established four positions: Capital One 7.865% of 8/1/66, Limited Brands 6.95% of 3/1/33, and National City Corp 6.875% of 5/15/19, and the infamous Clear Channel notes. All were weakly rated as investment grade, and three proceeded to plunge into junk range. Three of the four issues subsequently rallied smartly, and all now trade at or above par.
Clear Channel is the dog. It descended precipitously into near-default, and is still rated at Moody's Ca, as close to actual default as you can get. The bonds that I purchased at 68 now trade at 50. During the depths of the 2009 panic, though, they traded as low as 8! I eventually pulled the plug on these bonds when they failed to rise above the Cc rating in the couple of years following the trough. I sold at 37, banking a nasty $3100 loss. So, why did I chicken out? Because the darn things violate the very principles I've been expounding, and I couldn't justify the continued risk. Moody's is basically telling the world that they will fail, and probably soon. Who am I to disagree?
Still, there is a whole lot to be learned from this shabby company. Clear Channel Communications went public in 2005 at $18.55, rose to $29.71 at the end of 2007, sank to $2.52 in 2008, and has rallied $5.34. So, a double off the bottom, but a 71% drop from the time the stock debuted. And, the stock's recent action is sickly indeed, down from $14.22 earlier this year, another nasty 64% drop.
A few comparisons between the stock and bond performance are in order. The stock is down 71% from the public start, the bond 50%. Along the way, though, the bond has paid 15 years (it was issued in 1997) of uninterrupted interest, a total that exceeds the initial offering price. Add in the present value of 50, and the bond has still returned 59% over that 15 year period. Not great, but it's still about 3% compounded annually.
Conclusions? Well, this narrative is a tribute to the extreme reluctance of publicly-held companies to default on their debts. Clear Channel is a sick puppy, and will likely fold eventually. But the bond holders have received every penny owed them to date. And in liquidation? Of course, all bets are off. But those bond holders will be in line head of the stock holders. They may still get their money back. The stock holders will almost certainly be out in the cold. So, would I buy these bonds with their present 16% yield? No way. Investing in sewer junk and bankruptcies is a lot like buying stocks: too many variables and imponderables. Lacking insider information and/or industry expertise, I can't gauge whether it's worth the risk.
Mainly, though, the lesson relates to issues higher up on the food chain. Investment grade bonds, particularly at the BAA levels, are the sweet spot of bond investing (hell, of all investing I would argue). They get a massive boost in yield from the ultra-cautious, and yet considerable support from the folks running the companies, who need to be able to keep borrowing. These folks in the management trenches fight heroically to keep their companies afloat, even as blue-bloods get woozy worrying about ... everything.
UPDATE, May 2013: these puppies now trade at $79, above the price I originally paid. So, even here, patience would have paid off, though they might still go glub!
UPDATE: October 2015. Took another peek. To my amazement, these sick sick dogs are still alive, trading at 63.75. Still rated CA/CCC-, utter crap. But still alive after all these years! Conclusion, as above, a tribute to the tenacity of companies in protecting their access to the credit markets. If an when they pay off at par (no, I'm absolutely not predicting this), I'll have a good laugh.
December 2018. Took a final peek. Yes, finally, these sick bonds imploded. TEN years after they sank into deep malaise. And even now the defaulted bonds are selling for 20 cents on the dollar. Now I'm not going to argue that they were ever a good investment, but you'd be surprised how much they would have yielded to an intrepid investor before they took their fatal dive. Worth the stress? No. But a total catastrophe? Not necessarily.
Today, I thought it would be useful to look at my failure. Of all the bond positions I bought from 2008 to the present, I have banked a loss on only one: Clear Channel Communication 7.25% of 10/15/27. My position in these bonds ($10,000 face amount) was one of the very first I made in 2008. The financial crisis was looming, and I was already scared. I had raised $50,000 in cash, anticipating the crisis. I already sensed that the sweet spot would be in bonds. So, I established four positions: Capital One 7.865% of 8/1/66, Limited Brands 6.95% of 3/1/33, and National City Corp 6.875% of 5/15/19, and the infamous Clear Channel notes. All were weakly rated as investment grade, and three proceeded to plunge into junk range. Three of the four issues subsequently rallied smartly, and all now trade at or above par.
Clear Channel is the dog. It descended precipitously into near-default, and is still rated at Moody's Ca, as close to actual default as you can get. The bonds that I purchased at 68 now trade at 50. During the depths of the 2009 panic, though, they traded as low as 8! I eventually pulled the plug on these bonds when they failed to rise above the Cc rating in the couple of years following the trough. I sold at 37, banking a nasty $3100 loss. So, why did I chicken out? Because the darn things violate the very principles I've been expounding, and I couldn't justify the continued risk. Moody's is basically telling the world that they will fail, and probably soon. Who am I to disagree?
Still, there is a whole lot to be learned from this shabby company. Clear Channel Communications went public in 2005 at $18.55, rose to $29.71 at the end of 2007, sank to $2.52 in 2008, and has rallied $5.34. So, a double off the bottom, but a 71% drop from the time the stock debuted. And, the stock's recent action is sickly indeed, down from $14.22 earlier this year, another nasty 64% drop.
A few comparisons between the stock and bond performance are in order. The stock is down 71% from the public start, the bond 50%. Along the way, though, the bond has paid 15 years (it was issued in 1997) of uninterrupted interest, a total that exceeds the initial offering price. Add in the present value of 50, and the bond has still returned 59% over that 15 year period. Not great, but it's still about 3% compounded annually.
Conclusions? Well, this narrative is a tribute to the extreme reluctance of publicly-held companies to default on their debts. Clear Channel is a sick puppy, and will likely fold eventually. But the bond holders have received every penny owed them to date. And in liquidation? Of course, all bets are off. But those bond holders will be in line head of the stock holders. They may still get their money back. The stock holders will almost certainly be out in the cold. So, would I buy these bonds with their present 16% yield? No way. Investing in sewer junk and bankruptcies is a lot like buying stocks: too many variables and imponderables. Lacking insider information and/or industry expertise, I can't gauge whether it's worth the risk.
Mainly, though, the lesson relates to issues higher up on the food chain. Investment grade bonds, particularly at the BAA levels, are the sweet spot of bond investing (hell, of all investing I would argue). They get a massive boost in yield from the ultra-cautious, and yet considerable support from the folks running the companies, who need to be able to keep borrowing. These folks in the management trenches fight heroically to keep their companies afloat, even as blue-bloods get woozy worrying about ... everything.
UPDATE, May 2013: these puppies now trade at $79, above the price I originally paid. So, even here, patience would have paid off, though they might still go glub!
UPDATE: October 2015. Took another peek. To my amazement, these sick sick dogs are still alive, trading at 63.75. Still rated CA/CCC-, utter crap. But still alive after all these years! Conclusion, as above, a tribute to the tenacity of companies in protecting their access to the credit markets. If an when they pay off at par (no, I'm absolutely not predicting this), I'll have a good laugh.
December 2018. Took a final peek. Yes, finally, these sick bonds imploded. TEN years after they sank into deep malaise. And even now the defaulted bonds are selling for 20 cents on the dollar. Now I'm not going to argue that they were ever a good investment, but you'd be surprised how much they would have yielded to an intrepid investor before they took their fatal dive. Worth the stress? No. But a total catastrophe? Not necessarily.
Monday, September 10, 2012
Update to the End of the World
Two blogs ago, I ruminated about events that make people fear the end of the world. I also observed that truly catastrophic events are very rare, and that planning for them is wasted effort.
In the world of bonds, such head fakes can be exceptionally lucrative. The failure of the Western world to implode in 2008-9 led to historic buying opportunities in bonds. More recently, panic among the Chickens Little of the bond world led to some juicy opportunities in a number of dollar denominated European entities. And, I'm pleased to report, reports of the death of the Euro zone are beginning to look premature as well.
Here is a tally of purchases I made earlier this year in response to the crisis:
Abbey National PLC 7.95% bonds of 10/26/29. I bought $50,000 face amount at an average discounted price of 92. They are presently trading around 110, for a paper profit of $9,000, or a 19% capital gain.
AXA SA 8.6% of 2/15/30. I bent my rule of buying at a discount, because of the very high coupon, and bought $45,000 face amount for 1.08, or $48,600. The yield to maturity of these bonds was still over 7.75%. They now trade at 118.5, a 9.5% capital gain on paper ($4,500).
Telefonica Europe B V, 8.25% of 9/15/30. Again, due to the high coupon, I bought 25,000 face amount above part at 103. They now trade at 106 for a small gain.
Telecom Italia 7.2% 7/18/36. Recently bought a $40,000 face amount at 87.25. These now trade at 97, for a $4000 paper profit, or 11%.
Telecom Italia 7.721% 06/04/38, face amount of $15,000 was bought very recently at 98. The position is essentially unchanged.
What's next? Again, who knows? However, the price action of these bonds is telling me that the terror is receding, and these relatively juicy yields will sink further, resulting in larger capital gains. So, will I cash out? By now, you should know my answer. In this day and age, yields pushing 8% are rare indeed, and I intend to hold onto these newer purchases. Remember, my portfolio's yields are enhanced by maintaining roughly 25% margin. With my margin cost at 1.25%, these most recent bonds have an effective yield of 10%! With interest payments arriving twice a year, that 10% compounds a bit.
Bottom line: as long as Ben B. keeps offering money for nearly free, this ride will go on.
Update: 5/13/13. The ride continued, both as to rock-bottom margin costs and favorable price movement.
Abbey 7.95% of 2029 are now at $121.
AXA SA 8.6% of 2/15/30 are $129.51.
Telefonica Europe B V, 8.25% of 9/15/30 are $123.74.
Telecom Italia 7.2% 7/18/36 are $105.43.
Telecom Italia 7.721% 06/04/38 are $110.58.
In retrospect, the Euro-zone bond opportunity seems clear and easy. I can attest that it wasn't. Folks, it's very hard to take action WHILE the end of the world is threatening.
In the world of bonds, such head fakes can be exceptionally lucrative. The failure of the Western world to implode in 2008-9 led to historic buying opportunities in bonds. More recently, panic among the Chickens Little of the bond world led to some juicy opportunities in a number of dollar denominated European entities. And, I'm pleased to report, reports of the death of the Euro zone are beginning to look premature as well.
Here is a tally of purchases I made earlier this year in response to the crisis:
Abbey National PLC 7.95% bonds of 10/26/29. I bought $50,000 face amount at an average discounted price of 92. They are presently trading around 110, for a paper profit of $9,000, or a 19% capital gain.
AXA SA 8.6% of 2/15/30. I bent my rule of buying at a discount, because of the very high coupon, and bought $45,000 face amount for 1.08, or $48,600. The yield to maturity of these bonds was still over 7.75%. They now trade at 118.5, a 9.5% capital gain on paper ($4,500).
Telefonica Europe B V, 8.25% of 9/15/30. Again, due to the high coupon, I bought 25,000 face amount above part at 103. They now trade at 106 for a small gain.
Telecom Italia 7.2% 7/18/36. Recently bought a $40,000 face amount at 87.25. These now trade at 97, for a $4000 paper profit, or 11%.
Telecom Italia 7.721% 06/04/38, face amount of $15,000 was bought very recently at 98. The position is essentially unchanged.
What's next? Again, who knows? However, the price action of these bonds is telling me that the terror is receding, and these relatively juicy yields will sink further, resulting in larger capital gains. So, will I cash out? By now, you should know my answer. In this day and age, yields pushing 8% are rare indeed, and I intend to hold onto these newer purchases. Remember, my portfolio's yields are enhanced by maintaining roughly 25% margin. With my margin cost at 1.25%, these most recent bonds have an effective yield of 10%! With interest payments arriving twice a year, that 10% compounds a bit.
Bottom line: as long as Ben B. keeps offering money for nearly free, this ride will go on.
Update: 5/13/13. The ride continued, both as to rock-bottom margin costs and favorable price movement.
Abbey 7.95% of 2029 are now at $121.
AXA SA 8.6% of 2/15/30 are $129.51.
Telefonica Europe B V, 8.25% of 9/15/30 are $123.74.
Telecom Italia 7.2% 7/18/36 are $105.43.
Telecom Italia 7.721% 06/04/38 are $110.58.
In retrospect, the Euro-zone bond opportunity seems clear and easy. I can attest that it wasn't. Folks, it's very hard to take action WHILE the end of the world is threatening.
Tuesday, June 12, 2012
Why Not a Bond Fund?
Overwhelmingly, financial advisers steer their clients to funds. Generally, this works out very well for them, and often not so well for the clients. Funds of all kinds, whether stock or bond, tend to have layers upon layers of fees. The more "sophisticated" (i.e. complicated) the strategy, the higher the fees. Often as not, some of these fees make their way back to the adviser who suggested them in the first place. Well, you philosophize, you get what you pay for, right?
With stock funds, I think the answer is "WRONG"! You tend to get a lot less than you paid for, as the track record of stock fund professionals is, by and large, abysmal. They rarely keep up with the indexes they supposedly track, they hop in and out of whatever looks hot, they dress up the portfolio at quarter's end so that it looks like everyone else's tired results, they give and take kickbacks left and right, and draw huge salaries along the way. All of this comes out of YOUR pocket. ETFs, the really big ones, and those that track really big indexes, do much better. They have much less turnover, are therefore tax-efficient, and have very low expense ratios. They are absolutely the way to go, if you want exposure to stocks. However, advisers rarely steer you to them.
Well, then, how about bond funds? Actively managed bond funds have most of the warts that deface their stock counterparts. Fees, fees, fees, churn, churn, churn! Yes, they may get better purchase and sales prices and manage risk a bit more artfully than you can, but the elevated fees wipe those advantages away. How about bond ETFs? Well, they're fairly new, and many of them are synthetic products. You're not really buying a portfolio of bonds, you're buying a debt obligation of a third party. I see heartbreak looming.
But, surely a low-fee bond fund (say Vanguard) is a good choice? If you really don't want to do the work, then OK. But you lose all sorts of control. When you buy a portfolio of bonds, you can decide exactly what you want to buy, and how long you want to keep it. You can ladder religiously (each year further out gets the same dollar allocation), or you can move maturities in any direction you like. I, for example, have skewed heavily to the long end. Above all, you can lock in a position. If those 7.75% Union Carbide bonds of 2096 look good, you can load up, and your grandchildren will collect the money until THEY are old. What better way for them to remember you fondly?
With a bond fund, this lock feature is not possible. Sure, you can start out with a long-bond fund and a nice high yield. Sure as clockwork, though, newbies will flock in as yields start to fall. The fund will soon be buying lower-yielding bonds to put their money to work. The fund will bear the costs of investing this new money, which means that you share those costs, and they can be substantial. Should rates rise later, you will also share the costs of redemption, which might be very high indeed. Losses incurred selling the dogs will be shared by you, even if those dogs weren't in the fund when you joined the party. The bottom line is that a bond purchase reflects your investing values at one point only, the time you buy in.
There is one scenario where the ability to control duration has serious positive consequences. Typically, upon inheritance, the deceased's assets are "stepped up" in value. That means that the tax basis for the recipient is the value at death, not the original value. So, if a bond has increased steeply in value (remember I urge you to try to buy bonds at a discount to par), the tax basis for your heir is the more recent value. Upon maturity therefore, the tax bill will be substantially lower, perhaps even non-existent. While this can work even more spectacularly in the case of appreciated stocks, the implications for bond investors are also significant.
With stock funds, I think the answer is "WRONG"! You tend to get a lot less than you paid for, as the track record of stock fund professionals is, by and large, abysmal. They rarely keep up with the indexes they supposedly track, they hop in and out of whatever looks hot, they dress up the portfolio at quarter's end so that it looks like everyone else's tired results, they give and take kickbacks left and right, and draw huge salaries along the way. All of this comes out of YOUR pocket. ETFs, the really big ones, and those that track really big indexes, do much better. They have much less turnover, are therefore tax-efficient, and have very low expense ratios. They are absolutely the way to go, if you want exposure to stocks. However, advisers rarely steer you to them.
Well, then, how about bond funds? Actively managed bond funds have most of the warts that deface their stock counterparts. Fees, fees, fees, churn, churn, churn! Yes, they may get better purchase and sales prices and manage risk a bit more artfully than you can, but the elevated fees wipe those advantages away. How about bond ETFs? Well, they're fairly new, and many of them are synthetic products. You're not really buying a portfolio of bonds, you're buying a debt obligation of a third party. I see heartbreak looming.
But, surely a low-fee bond fund (say Vanguard) is a good choice? If you really don't want to do the work, then OK. But you lose all sorts of control. When you buy a portfolio of bonds, you can decide exactly what you want to buy, and how long you want to keep it. You can ladder religiously (each year further out gets the same dollar allocation), or you can move maturities in any direction you like. I, for example, have skewed heavily to the long end. Above all, you can lock in a position. If those 7.75% Union Carbide bonds of 2096 look good, you can load up, and your grandchildren will collect the money until THEY are old. What better way for them to remember you fondly?
With a bond fund, this lock feature is not possible. Sure, you can start out with a long-bond fund and a nice high yield. Sure as clockwork, though, newbies will flock in as yields start to fall. The fund will soon be buying lower-yielding bonds to put their money to work. The fund will bear the costs of investing this new money, which means that you share those costs, and they can be substantial. Should rates rise later, you will also share the costs of redemption, which might be very high indeed. Losses incurred selling the dogs will be shared by you, even if those dogs weren't in the fund when you joined the party. The bottom line is that a bond purchase reflects your investing values at one point only, the time you buy in.
There is one scenario where the ability to control duration has serious positive consequences. Typically, upon inheritance, the deceased's assets are "stepped up" in value. That means that the tax basis for the recipient is the value at death, not the original value. So, if a bond has increased steeply in value (remember I urge you to try to buy bonds at a discount to par), the tax basis for your heir is the more recent value. Upon maturity therefore, the tax bill will be substantially lower, perhaps even non-existent. While this can work even more spectacularly in the case of appreciated stocks, the implications for bond investors are also significant.
Monday, June 4, 2012
The End of the World!
Do I have your attention? I have enjoyed the observation, whose author I cannot pin down, that "the end of the world occurs only rarely." I think there is a lot of juice in this fruity apercu.
First, in the most mundane way, the end of the world is coming without any doubt. Something, the apocalypse for the religiously minded, global warming for the scientifically alarmed, and the inevitable solar nova for the scientifically dispassionate, will bring things to an absolute end.
I can think of nothing more pointless, though, than planning for it. When society as we know it comes tumbling down, no bunker, no stockpile of twinkies and assault rifles, and no stack of krugerrands will shield you from the barbarians. Somebody with bigger guns and a meaner disposition will take it all away, and you will probably pass your scanty remaining days as a miserable minion.
In a more sensible way, though, the end of the world has occurred a number of times in a number of places. Both world wars tore holes in the existing social fabric, destroying lives, homes and livelihoods in the process. This occurs with chilling regularity in less-developed places around the world as we speak. America has been blessed, having experienced only two world-ends. The first was the Civil War, which fell unevenly upon Americans. It was an economic and social tidal wave for the South, and actually a net plus for the North. (Please don't get me wrong; those who fought on both sides experienced enormous suffering.) The second end of the world for America was the great Depression, from 1929 to the beginning of the Second World War. This event impoverished a majority of the population, and destroyed confidence in a better future for a solid generation.
So, why am I trying my hand at both history and philosophy? Simply this: the end of the world DOES, blessedly, occur only rarely. And planning for it is an exercise in futility. Don't waste your time. Instead, I think a rational person should assume that things will ultimately work out, and make plans based upon that assumption. This has direct relevance for recent events (2008-2009) and right now (the Euro crisis). Perhaps you have forgotten how black things looked when Bear Stears and Lehman Brothers went belly-up and AIG's multi-trillion dollar bets went sour. I haven't though.
I was scared to my very marrow, but ultimately followed this simple line of thought: If the US government cannot deal with this crisis, then all bets are off. I have no way of anticipating what will happen next, and no sensible way to shield myself from the collapse of our financial and social system. So, the only reasonable thing to do is assume that the US government will find a way to prevent that collapse. It was frantically signaling its intention to do just that, by handing TARP funds to America's largest banks, and arranging forced mergers left and right. It took over AIG, GM and Chrysler for that exact same reason.
From this simplification, a number of steps became obvious to me. Financial instruments of nearly every kind were terrific buys. Stocks were frantically cheap, but bonds offered once-in-a-lifetime opportunities. Citicorp and Bank of America bonds were sporting yields of 15% and more, while the best banks in America (JP Morgan, Morgan Stanley and Goldman Sachs) were all around 10%. Either the end of the world was at hand, or I was staring at the best deals of my life. As I've explained repeatedly, the purchases I made then worked out splendidly.
So what, you reply, that's old news. EXCEPT, there is a new "end of the world" lurking: Europe, the Euro, Greece, Spain, Italy, Portugal, etc. The collapse of Greece will lead to ... well, maybe very bad things indeed. A string of bank defaults might spread to Italy, Portugal and Spain. The European Union might collapse, along with the Euro. Since everybody in Europe has his/her wealth in Euros, what will happen to that wealth? Honestly, I have no idea at all. It sounds suspiciously like the end of the world to me.
There are parallels to 2008-09. Some very large banks with very diversified operations, are now selling at a discount to their assets. Their bonds have been marked down steeply, as bondholders (a notoriously skittish group) seek the safety of German bunds and American (!) treasuries. What do do, what to do? Again, I apply Occam's razor: since the end of the world serves nobody, it will, somehow, be avoided. There will be a lot of noise, a lot of terror, and ultimately a lot of money to be made by those who can control their fears.
I think the Germans, their northern neighbors, and France will eventually find a way to keep things going. The largest European banks, too big to fail, will receive a functional guarantee of survival from the folks that matter. When and how will this occur? Damned if I know. It's probably too soon to take aggressive advantage. Buying big chunks of bank bonds now might lead you to stomach-churning, if temporary, paper losses.
The problem, though, is that the bargains will melt away once people think that it's safe. To quote myself about the issue of timing: if taking action is painful, then it's probably the right thing to do. So, I would nibble. I mentioned a couple of banks in an earlier post, both with yields near 8%. I'm pretty sure those yields will go higher. But guess what, 8% is not a bad return, assuming the company survives. If you can buy more later, at better prices, then fine.
First, in the most mundane way, the end of the world is coming without any doubt. Something, the apocalypse for the religiously minded, global warming for the scientifically alarmed, and the inevitable solar nova for the scientifically dispassionate, will bring things to an absolute end.
I can think of nothing more pointless, though, than planning for it. When society as we know it comes tumbling down, no bunker, no stockpile of twinkies and assault rifles, and no stack of krugerrands will shield you from the barbarians. Somebody with bigger guns and a meaner disposition will take it all away, and you will probably pass your scanty remaining days as a miserable minion.
In a more sensible way, though, the end of the world has occurred a number of times in a number of places. Both world wars tore holes in the existing social fabric, destroying lives, homes and livelihoods in the process. This occurs with chilling regularity in less-developed places around the world as we speak. America has been blessed, having experienced only two world-ends. The first was the Civil War, which fell unevenly upon Americans. It was an economic and social tidal wave for the South, and actually a net plus for the North. (Please don't get me wrong; those who fought on both sides experienced enormous suffering.) The second end of the world for America was the great Depression, from 1929 to the beginning of the Second World War. This event impoverished a majority of the population, and destroyed confidence in a better future for a solid generation.
So, why am I trying my hand at both history and philosophy? Simply this: the end of the world DOES, blessedly, occur only rarely. And planning for it is an exercise in futility. Don't waste your time. Instead, I think a rational person should assume that things will ultimately work out, and make plans based upon that assumption. This has direct relevance for recent events (2008-2009) and right now (the Euro crisis). Perhaps you have forgotten how black things looked when Bear Stears and Lehman Brothers went belly-up and AIG's multi-trillion dollar bets went sour. I haven't though.
I was scared to my very marrow, but ultimately followed this simple line of thought: If the US government cannot deal with this crisis, then all bets are off. I have no way of anticipating what will happen next, and no sensible way to shield myself from the collapse of our financial and social system. So, the only reasonable thing to do is assume that the US government will find a way to prevent that collapse. It was frantically signaling its intention to do just that, by handing TARP funds to America's largest banks, and arranging forced mergers left and right. It took over AIG, GM and Chrysler for that exact same reason.
From this simplification, a number of steps became obvious to me. Financial instruments of nearly every kind were terrific buys. Stocks were frantically cheap, but bonds offered once-in-a-lifetime opportunities. Citicorp and Bank of America bonds were sporting yields of 15% and more, while the best banks in America (JP Morgan, Morgan Stanley and Goldman Sachs) were all around 10%. Either the end of the world was at hand, or I was staring at the best deals of my life. As I've explained repeatedly, the purchases I made then worked out splendidly.
So what, you reply, that's old news. EXCEPT, there is a new "end of the world" lurking: Europe, the Euro, Greece, Spain, Italy, Portugal, etc. The collapse of Greece will lead to ... well, maybe very bad things indeed. A string of bank defaults might spread to Italy, Portugal and Spain. The European Union might collapse, along with the Euro. Since everybody in Europe has his/her wealth in Euros, what will happen to that wealth? Honestly, I have no idea at all. It sounds suspiciously like the end of the world to me.
There are parallels to 2008-09. Some very large banks with very diversified operations, are now selling at a discount to their assets. Their bonds have been marked down steeply, as bondholders (a notoriously skittish group) seek the safety of German bunds and American (!) treasuries. What do do, what to do? Again, I apply Occam's razor: since the end of the world serves nobody, it will, somehow, be avoided. There will be a lot of noise, a lot of terror, and ultimately a lot of money to be made by those who can control their fears.
I think the Germans, their northern neighbors, and France will eventually find a way to keep things going. The largest European banks, too big to fail, will receive a functional guarantee of survival from the folks that matter. When and how will this occur? Damned if I know. It's probably too soon to take aggressive advantage. Buying big chunks of bank bonds now might lead you to stomach-churning, if temporary, paper losses.
The problem, though, is that the bargains will melt away once people think that it's safe. To quote myself about the issue of timing: if taking action is painful, then it's probably the right thing to do. So, I would nibble. I mentioned a couple of banks in an earlier post, both with yields near 8%. I'm pretty sure those yields will go higher. But guess what, 8% is not a bad return, assuming the company survives. If you can buy more later, at better prices, then fine.
Friday, May 25, 2012
Don't you just love dividends?
One of the main themes today is an emphasis on "stable" companies with generous dividends. Various advisors point out that periods with flat stock prices can nevertheless be profitable once dividends are factored in. Over longer periods, dividends make make a huge difference. These folks are absolutely right; without dividends, stock investing is, over time, a pretty pallid affair. Huge appreciation is often followed by stomach-wrenching drops. A steady diet of reinvested dividends can smooth everything out, and ultimately result in nice long-term results.
So, why not seek out those large, stable companies with stable dividends? Well, the main problem is that stable dividends are actually fairly rare and disturbingly fragile creatures. For example, the website dividendinvestor.com has a list of star performers. There are about 275 companies with three stars, indicating dividends increased for 5-10 straight years. 10-20 has about 170 entries, while 29+ (yes it jumps from 20 to 29 to make the top list) has a mere 77 members. Considering the thousands of publicly traded companies in the U..S., this is a relatively small group of companies.
So what do these income stars mean for a person looking for a steady stream of retirement income? Well, the picture is not so hot. That first groups of winners (5-10 years) means that almost all of them, at some time, either cut their dividend, froze it, or terminated it. None of those are good things. As a retiree, you need to count on income far longer than ten years. So, you'd want to pick from list two or three, the companies you can really count on. This is a relatively small group. And again, they are all only as good as their most recent results. All lists were substantially larger before 2008. Dozens and dozens of companies fell out of the all-star rankings once the great recession hit. How can you safely target the winners?
Here is the evil dynamic that can kill dividend chasers. A company runs into financial trouble for one of many possible reasons. Alert stockholders begin selling, which causes the dividend yield to rise, perhaps very sharply. A 2% dividend for a $10 stock becomes a 6% dividend if the stock falls to $3.33. At this point, yield-hungry dividend chasers might jump in, hoping to lock in those juicy returns. Like clockwork, though, this temporary situation is followed by a dividend cut, or elimination as the company pursues survival at all costs. Now, the stock plummets further, as the disillusioned income investers bail out. Finally, don't forget that some companies terminate the dividend due to financial distress, only to then file for bankruptcy or reorganization. In those dire cases, you don't just lose income, you lose your entire investment as well. So, a bit of free advice; never buy a stock just because it has a high dividend yield. You will usually wish you had held back. I have a LONG list of such dividend-oriented regrets. In nearly every such case, I would have done better to sell the stock short; in time, my returns would have been fabulous! (No, I am not touting a new "can't miss" scheme, in case you're wondering).
A dividend freeze is not so bad; the company might weather the storm and move forward in a couple of years. A dividend cut is far worse; I've cited the example of JP Morgan (a true blue blood) that cut from $.38 to $.05 in 2009. They still haven't restored that dividend completely. Bank of America is still at a penny, down from $.64 and higher). GE, perhaps the most famous "safe dividend" company of all, cut it to $.10 quarterly, a 70% drop. The dividend still only back to $.17. These are crushing cuts, if you're trying to live on the income. A complete loss of principal, though, might reduce you to munching on cat chow.
Can you see why I'm much more enthusiastic about interest income? The track record of investment grade bonds is hugely better than that of dividend stocks. Companies can go through periods of great turmoil, cut or eliminate dividends, and still pay interest like clockwork. Do they do this because they have greater loyalty to bondholders? Of course not. They pay for two fundamental reasons. First, they are legally obligated to. If there's money in the till, the bondholders can demand it. Second, every company wants access to the credit markets. If they stiff one group of lenders, they will either be unable to borrow in the foreseeable future, or at least pay painfully high interest rates. Viable companies will, therefore, go to great lengths to stay current on their bond payments. This even applies to lower-rated (i.e. junk) companies, not just investment-grade firms.
To put all this in personal terms:
Since 2008, I have bought 42 separate bond issues from 24 different companies. All of them have either been retired (paying back the entire investment at par), or continue to pay interest. Only one of the issues, Clear Channel Communications 7.25% of 2027, has been problematic. It was already junk-rated when I bought it (shame on me, a violation of my rule against buying junk), and has since descended to near-default levels (CCC). Even it, though, continues to pay on time. I did suffer a capital loss when I sold (after the downgrade), but the loss is very small compared to the huge gains most of my positions have achieved. When you consider how terrifying the world looked when I started buying these positions, I think this performance is remarkable. Bottom line? Bonds might cause you some sleepless nights, but things usually work out just fine. I don't think you can say the same about dividends.
So, why not seek out those large, stable companies with stable dividends? Well, the main problem is that stable dividends are actually fairly rare and disturbingly fragile creatures. For example, the website dividendinvestor.com has a list of star performers. There are about 275 companies with three stars, indicating dividends increased for 5-10 straight years. 10-20 has about 170 entries, while 29+ (yes it jumps from 20 to 29 to make the top list) has a mere 77 members. Considering the thousands of publicly traded companies in the U..S., this is a relatively small group of companies.
So what do these income stars mean for a person looking for a steady stream of retirement income? Well, the picture is not so hot. That first groups of winners (5-10 years) means that almost all of them, at some time, either cut their dividend, froze it, or terminated it. None of those are good things. As a retiree, you need to count on income far longer than ten years. So, you'd want to pick from list two or three, the companies you can really count on. This is a relatively small group. And again, they are all only as good as their most recent results. All lists were substantially larger before 2008. Dozens and dozens of companies fell out of the all-star rankings once the great recession hit. How can you safely target the winners?
Here is the evil dynamic that can kill dividend chasers. A company runs into financial trouble for one of many possible reasons. Alert stockholders begin selling, which causes the dividend yield to rise, perhaps very sharply. A 2% dividend for a $10 stock becomes a 6% dividend if the stock falls to $3.33. At this point, yield-hungry dividend chasers might jump in, hoping to lock in those juicy returns. Like clockwork, though, this temporary situation is followed by a dividend cut, or elimination as the company pursues survival at all costs. Now, the stock plummets further, as the disillusioned income investers bail out. Finally, don't forget that some companies terminate the dividend due to financial distress, only to then file for bankruptcy or reorganization. In those dire cases, you don't just lose income, you lose your entire investment as well. So, a bit of free advice; never buy a stock just because it has a high dividend yield. You will usually wish you had held back. I have a LONG list of such dividend-oriented regrets. In nearly every such case, I would have done better to sell the stock short; in time, my returns would have been fabulous! (No, I am not touting a new "can't miss" scheme, in case you're wondering).
A dividend freeze is not so bad; the company might weather the storm and move forward in a couple of years. A dividend cut is far worse; I've cited the example of JP Morgan (a true blue blood) that cut from $.38 to $.05 in 2009. They still haven't restored that dividend completely. Bank of America is still at a penny, down from $.64 and higher). GE, perhaps the most famous "safe dividend" company of all, cut it to $.10 quarterly, a 70% drop. The dividend still only back to $.17. These are crushing cuts, if you're trying to live on the income. A complete loss of principal, though, might reduce you to munching on cat chow.
Can you see why I'm much more enthusiastic about interest income? The track record of investment grade bonds is hugely better than that of dividend stocks. Companies can go through periods of great turmoil, cut or eliminate dividends, and still pay interest like clockwork. Do they do this because they have greater loyalty to bondholders? Of course not. They pay for two fundamental reasons. First, they are legally obligated to. If there's money in the till, the bondholders can demand it. Second, every company wants access to the credit markets. If they stiff one group of lenders, they will either be unable to borrow in the foreseeable future, or at least pay painfully high interest rates. Viable companies will, therefore, go to great lengths to stay current on their bond payments. This even applies to lower-rated (i.e. junk) companies, not just investment-grade firms.
To put all this in personal terms:
Since 2008, I have bought 42 separate bond issues from 24 different companies. All of them have either been retired (paying back the entire investment at par), or continue to pay interest. Only one of the issues, Clear Channel Communications 7.25% of 2027, has been problematic. It was already junk-rated when I bought it (shame on me, a violation of my rule against buying junk), and has since descended to near-default levels (CCC). Even it, though, continues to pay on time. I did suffer a capital loss when I sold (after the downgrade), but the loss is very small compared to the huge gains most of my positions have achieved. When you consider how terrifying the world looked when I started buying these positions, I think this performance is remarkable. Bottom line? Bonds might cause you some sleepless nights, but things usually work out just fine. I don't think you can say the same about dividends.
Sunday, May 13, 2012
What Have You Done for Me Lately?
The word is out: bonds have nowhere to go but down. Is this really true? Well, basically yes. Certainly, as to short term rates, the game is up. You'd have to be crazy to buy treasuries (of any kind), and the great majority of corporate bonds have yields so low that an upward movement in rates will trash their market value. On the whole, this is one of the least propitious times I've ever seen to invest in bonds.
So, is there NOTHING I can do for your now? Well, if I had a large lump sum, I would NOT pour it all into bonds. But if you're investing bodaciously, then this too is a year in which you will buy some bonds (remember, this is your base investment amount adjusted yearly for inflation plus any income you aren't spending). So, you would want to examine the horizon for a decently rated bond that beats present inflation by a good margin.
How would you look? My absolute favorite site for researching bonds inexpensively is E*Trade. They have a bond search function that is first-rate. Put in the your search parameters (say yields over 6.5%, ratings above junk, and maturities after 2025), and it will spit out bonds matching the parameters. I did that today, and got 18 results (excluding a number of split grade bonds rated at junk by S&P or Moodys, but investment grade by the other).
One no-brainer jumps out: a Goldman Sachs 6.45% issue 5/1/2036 trading at 97.5 and yielding 6.7%. Another is a 6.65% Bank of America bond maturing in 2026. It is priced at par. Since BOA and Goldman Sachs are among the magic ten U.S. banks receiving TARP funds in 2008/09, they have an implicit government guarantee. These bond have very little risk.
Other real possibilities relate to the Euro crisis. Some very big, and pretty sound banks have bonds with big yields: BBV Intl Finl Ltd 7% 12/01/2025 trades at 90 to yield 8.2%. This is Spain's second largest bank, with a present Moody's rating of A2 (S&P BBB). As a large sovereign nation, Spain will do nearly anything to shield this bank (and its mammoth sister Banco Santander) from default. The rest of Europe also has a vital stake in seeing Spain's banks survive. So, you'd also want to take a look at Abbey National PLC 7.95% 10/26/2029 trading just above par to yield 7.8%. It's a subsidiary of Banco Santander, but is backed by the company's UK assets.
In light of the fact that interest rates are due to go up sharply after 2014, why would you buy now? The best reason is that you're following a plan. You really don't know what's going to happen, you just think you know. Buying now locks in a predictable flow of money until the bonds mature. If present yields were near the lows of the 1950's, I might suggest holding off, as the odds would be stacked against you. But guess what? With inflation running somewhere around 2.5%, these present yields of 6.6 to 8.2% look fairly juicy. So, I would go ahead with the plan.
By the way, I have talked about the Moody's BAA yield so much that you might think I'm being literal about a 30 year horizon. Not at all. If you see something long-term (that could be as little as ten years, but more likely 15, 20, 30, or even 50 years) with favorable characteristics, then grab it. The maturities will even out over time.
Next, a word about ratings. One of the coolest things about the E*Trade website is that its bond research includes the Moody's report. This is a detailed discussion of the company, its outlook, and why Moody's think it deserves a given rating. Now I know you have heard about how the ratings agencies blundered big time in the mid-2000's. They assigned AAA ratings to CDOs that ultimately failed massively. So, why would you listen to them when they talk about bonds? Well, to be blunt, these guys didn't know squat about CDO's, but bonds are their business. They've been in that business for a century, and they're pretty good at it. Because they're writing for an ultra-cautious clientele, they tend to be quite cautious as well. That means that a given rating allows for quite a variety of things to go wrong. In addition, Moody's will assign an outlook to the rating: negative, positive, neutral. So, a BAA bond with a negative outlook contains a warning that certain bad things could happen. Bottom line, a Moody's rating will be a very good guide to what is likely to happen with a given issue. That guide will likely be more reliable than your personal research. There are never any guarantees, but a solid Moody's rating is usually reason enough for me to take action.
One final point. Each bond listing will show a bid/ask spread. The first is the price you would get if selling a bond, the latter what you will pay to purchase. This spread is a serious cost of doing business, as bond spreads are typically far higher than those for stocks. The trading fee charged by E*Trade is, in comparison, trivial (typically $1 a bond, or $10 for a $10,000 par position). My point? Bonds are NOT trading vehicles for folks like us. Buy and sell a few times, and you'll go broke. If you keep the bond (ideally to maturity), then that ask premium will decline in importance, particularly if you've bought at a discount to par. After all, what should interest you primarily is the yield, both now and to maturity. If it is generous enough, then you needn't worry that somebody else (the pro who's selling, for example) has snagged a better price.
So, is there NOTHING I can do for your now? Well, if I had a large lump sum, I would NOT pour it all into bonds. But if you're investing bodaciously, then this too is a year in which you will buy some bonds (remember, this is your base investment amount adjusted yearly for inflation plus any income you aren't spending). So, you would want to examine the horizon for a decently rated bond that beats present inflation by a good margin.
How would you look? My absolute favorite site for researching bonds inexpensively is E*Trade. They have a bond search function that is first-rate. Put in the your search parameters (say yields over 6.5%, ratings above junk, and maturities after 2025), and it will spit out bonds matching the parameters. I did that today, and got 18 results (excluding a number of split grade bonds rated at junk by S&P or Moodys, but investment grade by the other).
One no-brainer jumps out: a Goldman Sachs 6.45% issue 5/1/2036 trading at 97.5 and yielding 6.7%. Another is a 6.65% Bank of America bond maturing in 2026. It is priced at par. Since BOA and Goldman Sachs are among the magic ten U.S. banks receiving TARP funds in 2008/09, they have an implicit government guarantee. These bond have very little risk.
Other real possibilities relate to the Euro crisis. Some very big, and pretty sound banks have bonds with big yields: BBV Intl Finl Ltd 7% 12/01/2025 trades at 90 to yield 8.2%. This is Spain's second largest bank, with a present Moody's rating of A2 (S&P BBB). As a large sovereign nation, Spain will do nearly anything to shield this bank (and its mammoth sister Banco Santander) from default. The rest of Europe also has a vital stake in seeing Spain's banks survive. So, you'd also want to take a look at Abbey National PLC 7.95% 10/26/2029 trading just above par to yield 7.8%. It's a subsidiary of Banco Santander, but is backed by the company's UK assets.
In light of the fact that interest rates are due to go up sharply after 2014, why would you buy now? The best reason is that you're following a plan. You really don't know what's going to happen, you just think you know. Buying now locks in a predictable flow of money until the bonds mature. If present yields were near the lows of the 1950's, I might suggest holding off, as the odds would be stacked against you. But guess what? With inflation running somewhere around 2.5%, these present yields of 6.6 to 8.2% look fairly juicy. So, I would go ahead with the plan.
By the way, I have talked about the Moody's BAA yield so much that you might think I'm being literal about a 30 year horizon. Not at all. If you see something long-term (that could be as little as ten years, but more likely 15, 20, 30, or even 50 years) with favorable characteristics, then grab it. The maturities will even out over time.
Next, a word about ratings. One of the coolest things about the E*Trade website is that its bond research includes the Moody's report. This is a detailed discussion of the company, its outlook, and why Moody's think it deserves a given rating. Now I know you have heard about how the ratings agencies blundered big time in the mid-2000's. They assigned AAA ratings to CDOs that ultimately failed massively. So, why would you listen to them when they talk about bonds? Well, to be blunt, these guys didn't know squat about CDO's, but bonds are their business. They've been in that business for a century, and they're pretty good at it. Because they're writing for an ultra-cautious clientele, they tend to be quite cautious as well. That means that a given rating allows for quite a variety of things to go wrong. In addition, Moody's will assign an outlook to the rating: negative, positive, neutral. So, a BAA bond with a negative outlook contains a warning that certain bad things could happen. Bottom line, a Moody's rating will be a very good guide to what is likely to happen with a given issue. That guide will likely be more reliable than your personal research. There are never any guarantees, but a solid Moody's rating is usually reason enough for me to take action.
One final point. Each bond listing will show a bid/ask spread. The first is the price you would get if selling a bond, the latter what you will pay to purchase. This spread is a serious cost of doing business, as bond spreads are typically far higher than those for stocks. The trading fee charged by E*Trade is, in comparison, trivial (typically $1 a bond, or $10 for a $10,000 par position). My point? Bonds are NOT trading vehicles for folks like us. Buy and sell a few times, and you'll go broke. If you keep the bond (ideally to maturity), then that ask premium will decline in importance, particularly if you've bought at a discount to par. After all, what should interest you primarily is the yield, both now and to maturity. If it is generous enough, then you needn't worry that somebody else (the pro who's selling, for example) has snagged a better price.
Sunday, January 15, 2012
Retirement Myths
I recently read an article in Smart Money magazine about retirement and the "viability of the 4% rule." It highlights varying opinions about a "safe" yearly withdrawal percentage from a retirement account. Of course, the long-standing guideline is 4%, yearly adjusted upward for inflation. So, a $1 million account would permit an initial draw of $40,000. The article cities research indicating that 1.8% ($18,000) might be safer. It also cites another study indicating that 7% would be reasonable for a bold investor with other income sources (like a standard pension).
Hmm. As I read the article, I was thinking: how about a portfolio that yields $87,000 a year, with no draw-down whatsoever? Don't tell me this is impossible, because I built it for a close friend, and you could build it right now. I think that beats a theoretical, hind-sight-inspired portfolio to pieces.
Here is a link to a spreadsheet with this portfolio:
https://docs.google.com/spreadsheet/ccc?key=0AmMlf3bsV3rFdFBVMGpSU2tqNUFOZVJPVjloNGF6T1E#gid=0
There are quite a few things to say about it.
1. It is not a classic Bodacious portfolio, as it was not built over 30 years, but rather done from 2008 to the present. But, the values in the portfolio are current, and you could buy most of these issues for the prices indicated. The amount invested is actually more than $1 million ($1.087 million to be exact), so the lower figure would lock in $87,000 per year.
2. The portfolio is poorly laddered, precisely because it was assembled over a shorter period, and more opportunistically (I grabbed things that looked particularly attractive at various times, as money became available for investment). So, the earliest maturities are two years out (Dean Witter) and a very small amount of money. The first serious redemptions begin in 2018, and are still modest. That is due entirely to my personal preference, which was to load up on long-term bonds, and thus lock in the huge yields I was seeing at the time (note the original cost of many bonds is exceptionally low, as they were purchased in 2008 and 2009). If you intended to buy a similar portfolio right now, you would probably want to buy more bonds with shorter maturities, and fewer long-term ones. Why? Well, if inflation kicked in, you would have a steady stream of money coming from redemptions to buy the higher yields. That would cushion the blow. This would mean modestly lower income now, but greater protection from future inflation. And that lower yield would still exceed the classic "safe" 4% drawdown.
3. This portfolio is NOT risk-free. All the bonds are investment-grade (with the exception of a split junk/investment rating on a small Sallie Mae position). The largest positions are in JP Morgan and Goldman Sachs. Again, this was deliberate. If the government was willing to hand these guys billions in 2008, then they have a de facto government guarantee. My thinking is much the same for Abbey PLC, which is a subsidiary of Banco Santander, the 11h largest bank in the world (sixth largest in Europe). I am making the same assumption here, that the bank is too big to fail, and therefore won't. In building this portfolio, I focused first on the risk of default. As long as these companies remain solvent, the portfolio will gush money. Still, each issue must be monitored steadily. A ratings downgrade to junk would probably require some action, even if losses are involved.
4. This portfolio is NOT particularly diversified. First, of course, it contains bonds, and only bonds. That's a no-no for standard experts. It is highly concentrated in bank and insurance stocks, also a no-no, as investment sectors go in and out of fashion. Values can, therefore, swing up and down rapidly. Remember, though, that such fluctuations are largely irrelevant to a Bodacious investor. We're in it for the long haul, and the bonds will all, eventually, mature at par.
5. Note the modest use of leverage in the portfolio. The present value (which would be the cost to purchase, of course) is a bit over $1.4 million, while the margin loan is just about $350,000. That is a margin percentage of 24%. Without margin, the yield on these bonds would be 6.9%; with margin, that jumps to 8.7%! Since the money arrives twice a year, that yield is actually closer to 9%. That's the power of margin rates at 1.25%.
So folks, tell me, please, why you would waste time and stomach acid with stocks when you can pull this kind of steady income from a Bodacious portfolio? Remember, experts debate the safety of a 4% draw, which assumes you are depleting your investment portfolio at a steady rate, with the goal of not running dry before you die. My friend's humble portfolio will do twice as well, without depletion! When she dies, there will be plenty left for her kids. Yes, of course, inflation might have its effect down the line, but inflation could damage a standard stock-based portfolio too. There is, at least, a clear way to deal with that future inflation, as discussed briefly above.
For a future blog, I'll prepare a few alternate Bodacious scenarios, which start with things you can buy now, and look forward with various assumptions.
'
Hmm. As I read the article, I was thinking: how about a portfolio that yields $87,000 a year, with no draw-down whatsoever? Don't tell me this is impossible, because I built it for a close friend, and you could build it right now. I think that beats a theoretical, hind-sight-inspired portfolio to pieces.
Here is a link to a spreadsheet with this portfolio:
https://docs.google.com/spreadsheet/ccc?key=0AmMlf3bsV3rFdFBVMGpSU2tqNUFOZVJPVjloNGF6T1E#gid=0
There are quite a few things to say about it.
1. It is not a classic Bodacious portfolio, as it was not built over 30 years, but rather done from 2008 to the present. But, the values in the portfolio are current, and you could buy most of these issues for the prices indicated. The amount invested is actually more than $1 million ($1.087 million to be exact), so the lower figure would lock in $87,000 per year.
2. The portfolio is poorly laddered, precisely because it was assembled over a shorter period, and more opportunistically (I grabbed things that looked particularly attractive at various times, as money became available for investment). So, the earliest maturities are two years out (Dean Witter) and a very small amount of money. The first serious redemptions begin in 2018, and are still modest. That is due entirely to my personal preference, which was to load up on long-term bonds, and thus lock in the huge yields I was seeing at the time (note the original cost of many bonds is exceptionally low, as they were purchased in 2008 and 2009). If you intended to buy a similar portfolio right now, you would probably want to buy more bonds with shorter maturities, and fewer long-term ones. Why? Well, if inflation kicked in, you would have a steady stream of money coming from redemptions to buy the higher yields. That would cushion the blow. This would mean modestly lower income now, but greater protection from future inflation. And that lower yield would still exceed the classic "safe" 4% drawdown.
3. This portfolio is NOT risk-free. All the bonds are investment-grade (with the exception of a split junk/investment rating on a small Sallie Mae position). The largest positions are in JP Morgan and Goldman Sachs. Again, this was deliberate. If the government was willing to hand these guys billions in 2008, then they have a de facto government guarantee. My thinking is much the same for Abbey PLC, which is a subsidiary of Banco Santander, the 11h largest bank in the world (sixth largest in Europe). I am making the same assumption here, that the bank is too big to fail, and therefore won't. In building this portfolio, I focused first on the risk of default. As long as these companies remain solvent, the portfolio will gush money. Still, each issue must be monitored steadily. A ratings downgrade to junk would probably require some action, even if losses are involved.
4. This portfolio is NOT particularly diversified. First, of course, it contains bonds, and only bonds. That's a no-no for standard experts. It is highly concentrated in bank and insurance stocks, also a no-no, as investment sectors go in and out of fashion. Values can, therefore, swing up and down rapidly. Remember, though, that such fluctuations are largely irrelevant to a Bodacious investor. We're in it for the long haul, and the bonds will all, eventually, mature at par.
5. Note the modest use of leverage in the portfolio. The present value (which would be the cost to purchase, of course) is a bit over $1.4 million, while the margin loan is just about $350,000. That is a margin percentage of 24%. Without margin, the yield on these bonds would be 6.9%; with margin, that jumps to 8.7%! Since the money arrives twice a year, that yield is actually closer to 9%. That's the power of margin rates at 1.25%.
So folks, tell me, please, why you would waste time and stomach acid with stocks when you can pull this kind of steady income from a Bodacious portfolio? Remember, experts debate the safety of a 4% draw, which assumes you are depleting your investment portfolio at a steady rate, with the goal of not running dry before you die. My friend's humble portfolio will do twice as well, without depletion! When she dies, there will be plenty left for her kids. Yes, of course, inflation might have its effect down the line, but inflation could damage a standard stock-based portfolio too. There is, at least, a clear way to deal with that future inflation, as discussed briefly above.
For a future blog, I'll prepare a few alternate Bodacious scenarios, which start with things you can buy now, and look forward with various assumptions.
'
Wednesday, January 11, 2012
A Lump Sum Scenario
I've published another version of the spreadsheet, this time starting in 1982 with a start date of 1982, with a flat initial investment of $100,000.
Here is the link. https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdHZ2UzdsRUZ2cmRlS3dBUHNWSUVQWUE&output=html
1982 allows for a full investment cycle (30 years). It doesn't hurt that 1982 was a great year to start a bond portfolio (rates were historically high). Look and you'll wish you'd invested this way a long time ago.
Why did I choose 1982 for this lump-sum scenario? I ran it as a comparison to Charles Allmon Growth Investor 30-year results. He just retired, and Alan Abelson of Barron's praised him for beating the S&P 500 index yearly compounded return of 8.4% by 2/10ths of a point! He also praised the high cash levels and low volatility of Allmon's portfolio. Well, folks, my comparable bond $100,000 portfolio compounds over the same 30 years at 12.5% annually. It's in bonds! It gushes cash! Shouldn't Abelson be knocking at my door?
Why is the final yield figure of 7.86% so much lower than the 12.5 percent I just cited? Because it's an average yield, computed on a much larger average investment ($374,636). The average investment includes reinvested income. So, it's a matter of perspective. The first is a return on initial investment, the second a return on a weighted average investment.
Here is the link. https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdHZ2UzdsRUZ2cmRlS3dBUHNWSUVQWUE&output=html
1982 allows for a full investment cycle (30 years). It doesn't hurt that 1982 was a great year to start a bond portfolio (rates were historically high). Look and you'll wish you'd invested this way a long time ago.
Why did I choose 1982 for this lump-sum scenario? I ran it as a comparison to Charles Allmon Growth Investor 30-year results. He just retired, and Alan Abelson of Barron's praised him for beating the S&P 500 index yearly compounded return of 8.4% by 2/10ths of a point! He also praised the high cash levels and low volatility of Allmon's portfolio. Well, folks, my comparable bond $100,000 portfolio compounds over the same 30 years at 12.5% annually. It's in bonds! It gushes cash! Shouldn't Abelson be knocking at my door?
Why is the final yield figure of 7.86% so much lower than the 12.5 percent I just cited? Because it's an average yield, computed on a much larger average investment ($374,636). The average investment includes reinvested income. So, it's a matter of perspective. The first is a return on initial investment, the second a return on a weighted average investment.
Monday, January 9, 2012
At the Finish Line
I want to talk about life-cycle investing, and the advice usually dealt out to people on the path to retirement. I think you all know the refrain: go heavily into stocks when young, and move gradually into more "stable" alternatives (bonds, annuities) when entering retirement. Even then, most experts recommend a heavy dose of stocks to make up for the ever-expanding life expectancy of the elderly. I think this advice is, by and large, crap.
Consider, first of all, the plight of someone nearing retirement who still has a hefty (50-70%) commitment to stocks. Since retirement is typically the point at which you begin drawing down assets, you are painfully exposed to volatility. Take the example of a targeted 4% draw-down (the most common percentage generally recommended) on a $1 million portfolio . You might enter retirement expecting to draw down $40,000 a year. In 2011's 3% ten-year bond world (the kind of "safe" bonds experts recommend), that would involve income of $15,000 on the 50% bond portion ($9,000 if 30%), and stock sales of $25,000 to $31,000. If, however, the stock market takes a plunge of 50% (think 2008-9), that portfolio is now worth only $750,000 to $650,000 (ignoring paper losses on bonds, as they will return to par eventually). In this extreme, but clearly possible scenario, your 4% draw-down shrinks to $30,000 (or $26,000). If you take out the planned-for $40,000, you'll erode an eroded asset base, making it ever harder to recover. Don't ever forget that stock swoons can be very long-lasting. The worst case was 1929 to 1955 for the DOW, an astonishing 26 years! To break even! More recently, 1966-83 (yeah, a couple of brief recoveries, followed by more swoons) and perhaps most relevant, 2000-2010. That's an entire decade, just completed, with no gain whatsoever. If you had been drawing down on your eroded assets throughout that decade, you might in in real pain by now.
If, however, you have followed the Bodacious Bond Plan, you will be mostly exposed to bonds at retirement, as you will have been throughout your investing career. So, what happens to you when prices plunge just as you retire? NOTHING! Repeat, NOTHING! For example, beginning the 2008-2009 period, a Bodacious $1 million portfolio was spinning off around 7% yearly (the average BAA bond yield of those two years), or $70,000 yearly. Sure, the market value of the bonds might have plummeted 25% to 35% (probably not 50%) at the worst moments, but income was unaffected. So, if you spent that money, all of it, what would have happened to your income going forward? NOTHING. Next year, you would have made that same $70,000, and bond prices would have recovered very nicely. By 2011, you would probably have been sitting on large capital gains, as BAA yields are now around 5%! And, all of this income would have been available without drawing down principal, i.e., selling bonds.
By the way. Did you notice the different draw-downs for the two portfolios? The generally recommended stock-based withdrawal mandates $40,000 per year; the Bodacious bond portfolio gushes $70,000. That is 75% more income from the beginning! The yearly stock draw-down involves selling stocks, perhaps at distressed prices. My model doesn't require any sales at all, unless you need more than $70,000 per year.
Yes, the stock draw-down usually posits increases along with inflation, so the $40,000 would go up, over time, to keep purchasing power stable. However, you could achieve much the same effect by spending 65% of the Bodacious income (in this case, $45,500), and reinvesting the difference at rates that usually compensate for inflation. Then you, too, could see inflation-adjusted retirement income. As for selling at a distress price? That will not happen (barring credit rating erosion, of course) if your bond portfolio is 30 years old. Why? Your oldest bonds will mature yearly, at par. Since your practice has been to buy at or below par, there is no loss whatsoever! The principal being returned is yours to spend or reinvest.
Here is how this reinvestment approach could work. The 35% you DON'T spend from the $70,000 interest stream will leave you with about $24,500 to reinvest. If rates have gone up to, say, 8% over the year,the will enable you to purchase bonds that will yield an additional $2000. Repeating for ten years will enable your income to go up by about 28%, even as value of the portfolio bounces up and down with the vagaries of the market. That translates into a inflation "rider" of nearly 2.5%, roughly the average over the past umpteen years. Note, this initial allowance of $45,500 is still 10.5% higher than the $40,000 recommended by the gurus. I have run many scenarios, with yearly rates ranging widely along the way. These variations don't seem to matter, as income goes up steadily. You might wince to see what high rates do to the market value of the portfolio, and rejoice prematurely when rates dip, but income maintains a steady upward trajectory.
Summing up (and repeating points made in earlier blogs):
With stocks, you have many enemies. 1. Stocks prices pogo up and down, often without rhyme or reason. As you near retirement, that volatility is very dangerous, as you might plan to sell soon. 2. Even stocks with a yield (dividends) aren't all that safe. A dividend is only as good as the most recent earnings statement. When tough times arrive, the dividend can be, and often is, slashed to the bone. To be fair, though, dividends often increase to compensate for the toll of inflation. 3. Fees can kill you, both with stock and bond funds. Take a management fee of 2% off the top, each and every year, and a nice 7% yearly return drops precipitously to 5%, before taxes and inflation. You'll be lucky to stay even. 4. Churn can kill you. Each time a professional buys and sells, transaction costs (direct, as in fees, and indirect at in bid/ask spreads) erode the value of the investment. 5. Death can kill you. By this, I mean that some stocks drop to zero, never to rise again. They don't appear in the indexes, but they do in your own returns. 6. For a stock to be a good investment, you must make two correct decisions: when to buy and when to sell. Botch either, and you're gonna feel it.
With Bodacious bonds, you have some enemies too, but they're easier to recognize and combat. 1. Bond prices pogo up and down too. But as mentioned above, this is largely irrelevant, as income from the bonds is steady. 2. Bond interest is MUCH safer than a dividend. If a company can pay, it must. Most companies (particularly investment grade) do pay. If they don't, you still have a legal claim on that company's assets. You might get the money (and interest) back anyway. As to inflation, well, BAA bond payments won't increase, but they generally are issued at a yield substantially above the existing rate of inflation. 3. If you do it yourself (my hearty suggestion), there are NO fees! This is a huge advantage of managing your own portfolio. 4. There should be almost no churn in a Bodacious portfolio. You buy a 30-year BAA bond, and hold it to maturity. Next year, you do the same. As a small investor, you won't get the very best price, which is reserved for the big boys. However, you can get close, if you're patient and focus on small-size offerings. Typically they sell at a discount to large lots because the big boys can't be bothered. You will get the best price at maturity: par. 5. Death is a risk here too. You must watch the prices and ratings of the bonds in your portfolio. If an issue plummets below investment grade, sell it (even at a loss), or at least lighten up substantially. 6. For a bond to be a good investment, you need only make one correct decision: when to buy. The sale is built into the bond: maturity.
Consider, first of all, the plight of someone nearing retirement who still has a hefty (50-70%) commitment to stocks. Since retirement is typically the point at which you begin drawing down assets, you are painfully exposed to volatility. Take the example of a targeted 4% draw-down (the most common percentage generally recommended) on a $1 million portfolio . You might enter retirement expecting to draw down $40,000 a year. In 2011's 3% ten-year bond world (the kind of "safe" bonds experts recommend), that would involve income of $15,000 on the 50% bond portion ($9,000 if 30%), and stock sales of $25,000 to $31,000. If, however, the stock market takes a plunge of 50% (think 2008-9), that portfolio is now worth only $750,000 to $650,000 (ignoring paper losses on bonds, as they will return to par eventually). In this extreme, but clearly possible scenario, your 4% draw-down shrinks to $30,000 (or $26,000). If you take out the planned-for $40,000, you'll erode an eroded asset base, making it ever harder to recover. Don't ever forget that stock swoons can be very long-lasting. The worst case was 1929 to 1955 for the DOW, an astonishing 26 years! To break even! More recently, 1966-83 (yeah, a couple of brief recoveries, followed by more swoons) and perhaps most relevant, 2000-2010. That's an entire decade, just completed, with no gain whatsoever. If you had been drawing down on your eroded assets throughout that decade, you might in in real pain by now.
If, however, you have followed the Bodacious Bond Plan, you will be mostly exposed to bonds at retirement, as you will have been throughout your investing career. So, what happens to you when prices plunge just as you retire? NOTHING! Repeat, NOTHING! For example, beginning the 2008-2009 period, a Bodacious $1 million portfolio was spinning off around 7% yearly (the average BAA bond yield of those two years), or $70,000 yearly. Sure, the market value of the bonds might have plummeted 25% to 35% (probably not 50%) at the worst moments, but income was unaffected. So, if you spent that money, all of it, what would have happened to your income going forward? NOTHING. Next year, you would have made that same $70,000, and bond prices would have recovered very nicely. By 2011, you would probably have been sitting on large capital gains, as BAA yields are now around 5%! And, all of this income would have been available without drawing down principal, i.e., selling bonds.
By the way. Did you notice the different draw-downs for the two portfolios? The generally recommended stock-based withdrawal mandates $40,000 per year; the Bodacious bond portfolio gushes $70,000. That is 75% more income from the beginning! The yearly stock draw-down involves selling stocks, perhaps at distressed prices. My model doesn't require any sales at all, unless you need more than $70,000 per year.
Yes, the stock draw-down usually posits increases along with inflation, so the $40,000 would go up, over time, to keep purchasing power stable. However, you could achieve much the same effect by spending 65% of the Bodacious income (in this case, $45,500), and reinvesting the difference at rates that usually compensate for inflation. Then you, too, could see inflation-adjusted retirement income. As for selling at a distress price? That will not happen (barring credit rating erosion, of course) if your bond portfolio is 30 years old. Why? Your oldest bonds will mature yearly, at par. Since your practice has been to buy at or below par, there is no loss whatsoever! The principal being returned is yours to spend or reinvest.
Here is how this reinvestment approach could work. The 35% you DON'T spend from the $70,000 interest stream will leave you with about $24,500 to reinvest. If rates have gone up to, say, 8% over the year,the will enable you to purchase bonds that will yield an additional $2000. Repeating for ten years will enable your income to go up by about 28%, even as value of the portfolio bounces up and down with the vagaries of the market. That translates into a inflation "rider" of nearly 2.5%, roughly the average over the past umpteen years. Note, this initial allowance of $45,500 is still 10.5% higher than the $40,000 recommended by the gurus. I have run many scenarios, with yearly rates ranging widely along the way. These variations don't seem to matter, as income goes up steadily. You might wince to see what high rates do to the market value of the portfolio, and rejoice prematurely when rates dip, but income maintains a steady upward trajectory.
Summing up (and repeating points made in earlier blogs):
With stocks, you have many enemies. 1. Stocks prices pogo up and down, often without rhyme or reason. As you near retirement, that volatility is very dangerous, as you might plan to sell soon. 2. Even stocks with a yield (dividends) aren't all that safe. A dividend is only as good as the most recent earnings statement. When tough times arrive, the dividend can be, and often is, slashed to the bone. To be fair, though, dividends often increase to compensate for the toll of inflation. 3. Fees can kill you, both with stock and bond funds. Take a management fee of 2% off the top, each and every year, and a nice 7% yearly return drops precipitously to 5%, before taxes and inflation. You'll be lucky to stay even. 4. Churn can kill you. Each time a professional buys and sells, transaction costs (direct, as in fees, and indirect at in bid/ask spreads) erode the value of the investment. 5. Death can kill you. By this, I mean that some stocks drop to zero, never to rise again. They don't appear in the indexes, but they do in your own returns. 6. For a stock to be a good investment, you must make two correct decisions: when to buy and when to sell. Botch either, and you're gonna feel it.
With Bodacious bonds, you have some enemies too, but they're easier to recognize and combat. 1. Bond prices pogo up and down too. But as mentioned above, this is largely irrelevant, as income from the bonds is steady. 2. Bond interest is MUCH safer than a dividend. If a company can pay, it must. Most companies (particularly investment grade) do pay. If they don't, you still have a legal claim on that company's assets. You might get the money (and interest) back anyway. As to inflation, well, BAA bond payments won't increase, but they generally are issued at a yield substantially above the existing rate of inflation. 3. If you do it yourself (my hearty suggestion), there are NO fees! This is a huge advantage of managing your own portfolio. 4. There should be almost no churn in a Bodacious portfolio. You buy a 30-year BAA bond, and hold it to maturity. Next year, you do the same. As a small investor, you won't get the very best price, which is reserved for the big boys. However, you can get close, if you're patient and focus on small-size offerings. Typically they sell at a discount to large lots because the big boys can't be bothered. You will get the best price at maturity: par. 5. Death is a risk here too. You must watch the prices and ratings of the bonds in your portfolio. If an issue plummets below investment grade, sell it (even at a loss), or at least lighten up substantially. 6. For a bond to be a good investment, you need only make one correct decision: when to buy. The sale is built into the bond: maturity.
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