Due to the Federal Reserve’s zero interest rate policy (ZIRP) and quantitative easing measures, retirees and savers find themselves with very few investment options for generating much needed income. Conventionally, as people get closer to retirement or are indeed actually retired, financial advisors have recommended a shift towards income-generating investments such as bonds and annuities. The reason for this is that because retirees are more likely to be drawing funds from their investment accounts, the fact that bonds tend to have less volatility than stocks, it reduces the risks of investors getting burned by the short-term volatility that inevitably occurs from time to time with stock prices.
As I write this article the yield on the 10-year Treasury note is around 2.39%, while recently troubled countries like Spain and Italy have just as low, if not lower 10-year yields on their government bonds. These yields aren’t indicative of immense financial strength or extremely low long-term inflation risk, but instead are the result of unprecedented global Central Bank policies designed to artificially lower rates. While low interest rates typically do indeed drive up asset prices, they also unfairly penalize net-savers that are relying on interest income to safely provide for their retirement. In addition, many retirees and income investors don’t understand the considerable interest rate risks of piling into bonds and annuities in a record low interest rate environment.
For example, a 1% increase in interest rates would likely result in a loss of about 8.9% of the 10-year Treasury note. This means that it would take about 3.72 years of interest payments just to get back to even on that investment. In a world in which monetary stimulus has never been more prevalent, long-term inflation risks cannot be discounted; therefore the probabilities of much higher interest rates 3, 5 and 10 years down the line seem quite high. A big reason for this lack of understanding of interest rate risks is due to the fact that rates have generally headed in a downward trajectory since Paul Volcker crushed inflation in the early 1980’s. This has been bullish for both stocks and bonds, providing an excellent tailwind for long-term investment performance.
Pressure from low bond yields has pushed savers into higher risk assets such as stocks, REITs, MLP’s etc. This has worked quite well as the market has been appreciating, but valuations on many of these assets seem to be quite stretched. We’ve recently discussed the fact that the CAPE index is about 40% higher than historical averages. Therefore, to make money moving forward we at T&T Capital Management (TTCM), believe it is essential to utilize a deep value discipline. This means that we are not looking at investing in the stock or bond market per se, but instead we are buying deeply undervalued shares in individual businesses. Usually these businesses are trading inexpensively due to short-term problems that we are confident can be overcome within the next 3-5 years, allowing for substantial appreciation in the equities. In addition for income oriented investors, we combine this deep value approach with strategies such as covered calls and cash-secured puts to generate additional income and decrease risk.
This dramatically reduces both the inflation and interest rate risks that fixed income investors should be extremely concerned with in this low interest rate environment, but also doesn’t expose you to as much market and valuation risk as just owning index and mutual funds outright. There are reasons why everybody does not utilize these strategies, namely it is not easy. It requires a great deal of expertise, research, patience and experience. Fortunately, at T&T Capital Management we possess these qualities and are able to utilize them for the purposes of protecting and growing our clients’ hard-earned capital. For this service we charge between 1-2% a year on the assets that we manage, so I believe we offer an incredible value when you factor in the work and service that we provide. Obviously past performance is not indicative of future results, but this is what we have done thus far and I believe our value proposition will get even better over the next 3-5 years versus alternative investments such as index and mutual funds due to their over-exposure to the equity and fixed income markets.
Below is a link to an article outlining Morgan Stanley’s call for 7 years of losses for investment grade bonds moving forward, which I most certainly agree with. If you’d like to discuss your portfolio and how you can implement a sound financial plan moving forward please don’t hesitate to call me directly at 949-630-0263. Thank you very much and I look forward to speaking with you soon!