In an effort to stimulate the economy, the Federal Reserve has taken unprecedented steps and has indeed succeeded in generating some of the lowest interest rates in U.S. history, bolstering the housing market. These efforts have been weighed down however, by government initiatives that have been heavy on regulation and low on job creation. While financial assets of all types have rallied, there are huge ramifications for “savers.” Many of these “savers” are part of the Baby Boomer generation that should now be retired or be approaching retirement, but in many cases are forced to keep working (assuming they have the opportunity to do so) longer to facilitate the retirement that they are looking for.
Ideally as one nears retirement, his/her portfolio allocation would shift more towards income-producing bonds, as opposed to equities. The reason for this is that bonds are higher up in the capital structure, generally offering more protection from market risk than equities. I define “market” risk as the risk of taking mark to market losses, which can be very negative for retirees due to their need to withdraw funds from their retirement assets, giving them less control of the timing of those distributions. Less market risk in bonds doesn’t mean that there isn’t risk however. Risk is a pretty worthless term unless it is qualified by a ‘type’ of risk, whether it be market risk, inflation risk, interest rate risk etc. Often bonds can move inversely to equities because major equity movements downward can often lead to interest rate cuts; which are bullish for bonds, because when interest rates go down, bond prices go up.
Historical data can be helpful but is also extremely misleading at times, because during the last 30 years or so, interest rates have generally just headed lower. Prior to that in the late 1970’s, the U.S. experienced a period of climbing interest rates, which caused devastation on fixed income portfolios. There are many similarities to the current period and that one. In the 1970’s the U.S. experienced a period of extremely slow growth, causing many to believe that it was the “end of the good times,” which isn’t much different from today’s expression of the “new normal.” When Paul Volcker and Ronald Reagan came into their respective positions and begin instituting more effective economic policies, economic growth followed and the U.S. experienced a prolonged period of very strong economic expansion. That is a very possible outcome for the U.S. economy as current government policies are quite obviously reducing economic growth and making business much harder to conduct. Government run health care and rising minimum wages might be desirable for society depending on your outlook, but there is no doubt that they raise the costs of doing business.
When policies get more accommodative to a positive business environment, I believe that U.S. economic growth could once again reach 3-4% per annum, which would have incredible ramifications. First of all, inflation is a lagging indicator. In the late 1970’s, inflation in the U.S. was running at about 13%, yet real estate was extremely stale. In the early 1980’s, real estate spiked and prices soared. We’ve never experienced such extreme and sustained expansionary monetary policies so the potential for pent-up increases in inflation are absolutely massive!
For investors that are piling into junk bonds yielding less than 5% and 10-year treasury bonds yielding 2.64%, the results could be devastating. An increase in the growth rate would also impact inflation expectations. This would cause interest rates to move substantially higher. The below table outlines the impact of just a 1% increase on various fixed income asset classes:
Source: Bloomberg
For those investors that are focused on protecting against “market” risk with bonds, the impact of “interest rate” and “inflation” risks could be immensely damaging to their portfolios. If interest rates increase just 2-4% from current levels, the losses would be staggering. The lack of available yield has pushed “savers” into equities, which are also non-coincidentally at all-time highs. This has been a tremendous rally from the Great Recession lows in March 2009, but valuations now appear to be stretched and risk-taking is getting more aggressive. Most long-only portfolio aren’t likely to produce better than 4-5% per annum results over the next decade in my estimation.
In this climate it is important to focus on buying securities that trade at a deep discount to intrinsic value, promising an adequate margin of safety. The only way to find those securities is through extensive fundamental analysis. In addition to our extensive expertise at value investing, at T&T Capital Management, we intertwine strategies such as covered calls and cash-secured puts to generate income and reduce risk. Assuming just average stock selection, I believe these strategies can add another 4-5% per annum in return potential, while reducing risk. The biggest negative to the strategy is that when deployed, one is sacrificing potential upside at times. A year like last year when the S&P returned about 32% can be quite challenging, but fortunately our stock selection has been above average, which helped us return about 36% for clients in 2013 and 30% the year before, versus about 14% for the S&P 500. Of course past performance is not indicative of future results but I’d be hard pressed to find a retiree or Baby Boomer that couldn’t benefit from this type of combination of value investing and conservative options selling strategies to generate income, reduce risk and to instill a disciplined selling process. Below is a link to the article and I’d encourage you to evaluate your exposure to both interest rate risk and the risk of taking permanent losses of capital through being exposed to overvalued equities.
If you’d like a free portfolio review, please don’t hesitate to give us a call at 949-630-0263 and we’d be happy to provide that!