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.
Friday, May 25, 2012
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.
Thursday, December 1, 2011
Why Is This Important?
The spreadsheet shows wonderful long-term increases over very long periods of time. This is, by itself, not amazing. You'll find many stock scenarios that look far better, turning the theoretical 1947 investor into a multimillionaire. So, why isn't America awash in multimillionaires? There are several reasons, but the main one is that the widely published figures are bogus.
I think that stock yields are vastly overstated over time. First, they gloss over management fees, which reduce final results hugely. Almost all actively managed funds consistently under-perform their benchmarks for this reason alone. Second is portfolio churn. "Bad" investments are constantly being sold in favor of "good" new ones. Each time, a layer of transaction costs (buy-sell spreads, broker fees) erodes results. Third, taxes are ignored, even though many investors must pay them. Fourth, the weak, lame, crooked and incompetent are undercounted, as they usually go bankrupt and disappear from the averages. This also applies to fund families. Typically, an investment giant will launch a flock of new funds, and eventually merge the failures into the winners. The former's crummy results are no longer visible in the family's "stellar" long-term results. Factor all this in, and a long term return on a stock portfolio will easily fall to 7% annually, or less.
Now look at the Bodacious Bond Machine again. How does its 7.65% compounded return fare relative to the flaws discuss in the previous paragraph?
Fees: there are none. You run the portfolio; you don't collect a fee from yourself.
Portfolio churn: there is very little. Bonds are bought and held until maturity. Of course, bonds will, after 30 years, be retired and force reinvestment of the funds returned to you. I wouldn't call that churn, though.
Taxes: they are are typically higher on interest than on capital gains or dividends. This is a negative for a bond portfolio, but taxes can be deferred or eliminated through a tax-deferred or post-tax (Roth IRA) plan.
Fallout: this is a real issue for bonds too. Occasionally, a company defaults on its bonds, causing severe losses. However, the plan's focus on investment-grade bonds reduces this risk considerably. For example, since 1981, the average default rate for BBB- bonds (the lowest investment grade) has been .28% (see http://en.wikipedia.org/wiki/Bond_credit_rating). That drops to .16% for BBB+ bonds. In both cases, there are many years when the average rate is 0%, as defaults tend to be cyclical, associated with recessions.
Note, that this default rate would not necessarily be fully realized. Your could, for example, sell a given issue once it is downgraded to junk. For most companies, the road to default is gradual. Companies on the brink (Albertson's, Sears, Lucent, Sprint, Clear Channel, MBIA) have been declining for many years. Selling them as they turn into junk would have caused losses, but a limited portion of the investment. Even if the bond defaulted entirely, there might still be a return of capital once the company is reorganized or liquidated. One clear implication of default rates is that your bond portfolio should be diversified, both over time and company type. The first is accomplished by regular yearly purchases, achieving an automatic ladder of new bonds and ones nearing maturity. The second is your responsibility. Pick carefully, and widely.
Summary:
Can you see why this is so important? Do you now get why the case for bonds is so compelling? If a realistic expectation for a long-term stock investment is really only in the 7-8% realm, and I believe it is, then you'd be nuts to pursue that return with stocks when it is freely available with bonds. Instead of sweating bullets every time the market swoons, you can relax in the sure knowledge that your bonds will recover. Paper losses are irrelevant! A stock that drops 50% in value overnight might come back from the dead, but the bond will make the return journey for certain (barring default, of course).
So, again, why are there so few multimillionaires, either from stock or bond investing? The major reason is psychology. It's rare for anyone to really follow a plan. Psychology swings investors back and forth like a pendulum. They panic when the market has punished them, and swing to exuberance when it's soared. Since you CAN'T predict tops or bottoms, the only way to take advantage of them is to be steady. Over time, a regular investment will capture peaks (typically when bond prices are low), and keep from going overboard when prices are high (and yields low).
So, can YOU follow a plan? Probably not; most people can't. I do think, though, that my plan is far easier to follow than one based on stocks. The main reason is cash. You can see it arrive, on schedule, twice a year, every year. You can then take that cash, reinvest it, and watch even more come in, on schedule, twice a year, every year. This is very comforting. It might be enough to keep you on track, year in, year out.
My next blog will start with specific ways to implement the PLAN. Eventually, I'll also talk about a forbidden topic: bond timing.
I think that stock yields are vastly overstated over time. First, they gloss over management fees, which reduce final results hugely. Almost all actively managed funds consistently under-perform their benchmarks for this reason alone. Second is portfolio churn. "Bad" investments are constantly being sold in favor of "good" new ones. Each time, a layer of transaction costs (buy-sell spreads, broker fees) erodes results. Third, taxes are ignored, even though many investors must pay them. Fourth, the weak, lame, crooked and incompetent are undercounted, as they usually go bankrupt and disappear from the averages. This also applies to fund families. Typically, an investment giant will launch a flock of new funds, and eventually merge the failures into the winners. The former's crummy results are no longer visible in the family's "stellar" long-term results. Factor all this in, and a long term return on a stock portfolio will easily fall to 7% annually, or less.
Now look at the Bodacious Bond Machine again. How does its 7.65% compounded return fare relative to the flaws discuss in the previous paragraph?
Fees: there are none. You run the portfolio; you don't collect a fee from yourself.
Portfolio churn: there is very little. Bonds are bought and held until maturity. Of course, bonds will, after 30 years, be retired and force reinvestment of the funds returned to you. I wouldn't call that churn, though.
Taxes: they are are typically higher on interest than on capital gains or dividends. This is a negative for a bond portfolio, but taxes can be deferred or eliminated through a tax-deferred or post-tax (Roth IRA) plan.
Fallout: this is a real issue for bonds too. Occasionally, a company defaults on its bonds, causing severe losses. However, the plan's focus on investment-grade bonds reduces this risk considerably. For example, since 1981, the average default rate for BBB- bonds (the lowest investment grade) has been .28% (see http://en.wikipedia.org/wiki/Bond_credit_rating). That drops to .16% for BBB+ bonds. In both cases, there are many years when the average rate is 0%, as defaults tend to be cyclical, associated with recessions.
Note, that this default rate would not necessarily be fully realized. Your could, for example, sell a given issue once it is downgraded to junk. For most companies, the road to default is gradual. Companies on the brink (Albertson's, Sears, Lucent, Sprint, Clear Channel, MBIA) have been declining for many years. Selling them as they turn into junk would have caused losses, but a limited portion of the investment. Even if the bond defaulted entirely, there might still be a return of capital once the company is reorganized or liquidated. One clear implication of default rates is that your bond portfolio should be diversified, both over time and company type. The first is accomplished by regular yearly purchases, achieving an automatic ladder of new bonds and ones nearing maturity. The second is your responsibility. Pick carefully, and widely.
Summary:
Can you see why this is so important? Do you now get why the case for bonds is so compelling? If a realistic expectation for a long-term stock investment is really only in the 7-8% realm, and I believe it is, then you'd be nuts to pursue that return with stocks when it is freely available with bonds. Instead of sweating bullets every time the market swoons, you can relax in the sure knowledge that your bonds will recover. Paper losses are irrelevant! A stock that drops 50% in value overnight might come back from the dead, but the bond will make the return journey for certain (barring default, of course).
So, again, why are there so few multimillionaires, either from stock or bond investing? The major reason is psychology. It's rare for anyone to really follow a plan. Psychology swings investors back and forth like a pendulum. They panic when the market has punished them, and swing to exuberance when it's soared. Since you CAN'T predict tops or bottoms, the only way to take advantage of them is to be steady. Over time, a regular investment will capture peaks (typically when bond prices are low), and keep from going overboard when prices are high (and yields low).
So, can YOU follow a plan? Probably not; most people can't. I do think, though, that my plan is far easier to follow than one based on stocks. The main reason is cash. You can see it arrive, on schedule, twice a year, every year. You can then take that cash, reinvest it, and watch even more come in, on schedule, twice a year, every year. This is very comforting. It might be enough to keep you on track, year in, year out.
My next blog will start with specific ways to implement the PLAN. Eventually, I'll also talk about a forbidden topic: bond timing.
How It Works.
Again, here is the link to the spreadsheet:
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The most difficult task I faced in creating the spreadsheet was how to calculate average returns over time. Simplistic calculations yielded extreme distortions. For example, dividing the net portfolio increase by the total net investment at the end of a long time series greatly understates returns compared to inflation. This is because the cumulative effects of inflation over, say, 40 years are compared to final returns mostly generated far more recently. I finally hit upon a weighting system. This is a factor that combines the BAA interest rate for a given year with the dollar total invested that year. Dividing the sum of those factors by the total amount invested over a period of time yields an average return for that same time period. This average return can then be applied to the final portfolio value to calculate a weighted total investment. This weighted investment is the amount of money that would, compounded by the average interest rate over a time period, yield the final portfolio value.
Typically, a high interest rate will generate a far larger factor than a low one. Also, that high interest rate, toward the end of the series, will create a higher factor than the same interest rate early on (typically less money being invested earlier). The advantage of the factor is that high interest years have greater weight, as do years with high dollar investments. Years with high interest rates AND high dollar investments weigh the most. Note also that investments as long as 30 years in the past are still relevant, as the BAA yield is a 30 year yield. Bonds purchased in 1985, for example, would still be generating interest today.
To put this in other words, the weighted investment calculation converts the many yearly investments into a lump-sum equivalent. This would be a single initial investment that would yield the same long-term results. The advantage of weighted investment is that the cumulative effects of compounded interest and compounded inflation can be seen side by side. The very good news is that inflation's effect diminishes steadily over time. This is, perhaps, counter-intuitive, but actually makes good sense. Inflation compounds at a far lower rate (2.5% or so yearly) than the bonds income does (7.65% or so).
The base spreadsheet assumes a steady injection of inflation-adjusted funds every year. In most time series, the predictable spread of the BAA yield over inflation quickly brings the portfolio into the black. Every single time series has positive results for 10, 20, and 30 year periods. By 20 years, nearly every time series outperforms inflation robustly.
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The most difficult task I faced in creating the spreadsheet was how to calculate average returns over time. Simplistic calculations yielded extreme distortions. For example, dividing the net portfolio increase by the total net investment at the end of a long time series greatly understates returns compared to inflation. This is because the cumulative effects of inflation over, say, 40 years are compared to final returns mostly generated far more recently. I finally hit upon a weighting system. This is a factor that combines the BAA interest rate for a given year with the dollar total invested that year. Dividing the sum of those factors by the total amount invested over a period of time yields an average return for that same time period. This average return can then be applied to the final portfolio value to calculate a weighted total investment. This weighted investment is the amount of money that would, compounded by the average interest rate over a time period, yield the final portfolio value.
Typically, a high interest rate will generate a far larger factor than a low one. Also, that high interest rate, toward the end of the series, will create a higher factor than the same interest rate early on (typically less money being invested earlier). The advantage of the factor is that high interest years have greater weight, as do years with high dollar investments. Years with high interest rates AND high dollar investments weigh the most. Note also that investments as long as 30 years in the past are still relevant, as the BAA yield is a 30 year yield. Bonds purchased in 1985, for example, would still be generating interest today.
To put this in other words, the weighted investment calculation converts the many yearly investments into a lump-sum equivalent. This would be a single initial investment that would yield the same long-term results. The advantage of weighted investment is that the cumulative effects of compounded interest and compounded inflation can be seen side by side. The very good news is that inflation's effect diminishes steadily over time. This is, perhaps, counter-intuitive, but actually makes good sense. Inflation compounds at a far lower rate (2.5% or so yearly) than the bonds income does (7.65% or so).
The base spreadsheet assumes a steady injection of inflation-adjusted funds every year. In most time series, the predictable spread of the BAA yield over inflation quickly brings the portfolio into the black. Every single time series has positive results for 10, 20, and 30 year periods. By 20 years, nearly every time series outperforms inflation robustly.
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