Fixed income investing

 The bond market changed in 2008. Before that, it was actually possible to never touch stocks and still retire.

I no longer believe that to be true. There are 2 things working against a fixed income investor:

1/ The way inflation is measured is constantly being changed. I doubt there are very many people for whom the CPI actually shows real inflation as they experience it.  It's easy to do your own research with expenses if you have just one checking account that you're pulling money from. When I tracked my expenses over the period of a few years, it was an eye opener. A 5-year TIPS got me around 20% at maturity, but expenses went up close to 50%. This is from 2019-2024. If the discrepancy between CPI and your actual experienced inflation is 50% (i.e. when CPI is 1%, you experience 1.5%), this has minimal impact at low values of CPI. The hotter that CPI runs, the bigger the impact. For example, if you have an investment that tracks the CPI and CPI is 4%, you are essentially losing 2% of purchasing power per year. And that's before taxes, which brings us to #2.

2/ Taxes are a killer with fixed income in a taxable account. With the NIIT, for someone in the 35% tax bracket, the total tax rate is 38.8%. With a 3 month t-bill earning 3.6% state tax free (this matters in a lot in states like CA that have a high state income tax), one would end up with only 2.2% after tax. Current CPI is 3.3%. So this is a guaranteed loss of purchasing power. The highest yield on the treasury curve is 4.88% for a 30 year bond. After tax that leaves 2.98%! Yes, even if one was crazy to risk capital for 30 years, they would be guaranteed losing to CPI right now, let alone actual spend which is actually much higher than 3.3%. TIPS in taxable account aren't going to be of much help, plus they come with the added disadvantage that you have to pay taxes on the inflation adjustments even without getting paid--the opposite of tax deferral! Products like BOXX may help, but they require taking added risk which I don't fully understand.

Corporate bonds are even worse because the yield spreads vs treasuries are low and they are subject to state tax. So even they don't keep up with inflation.

If a bond book was written before 2008, it is probably not very relevant for today's investing environment.  When bond investing worked, this book was probably the best book:
https://zvibodie.com/book/worry-free-investing/
You can now buy a pdf for $5 at the link above.
The gist of the book was that you only start investing in stocks when your basic retirement needs are covered by fixed income instruments (money market funds, CDs, stable value funds, treasuries, TIPS, I-Bonds, E-Bonds). This is almost impossible to achieve today as you'd be constantly falling behind.

It's OK to hold bonds. Just know that historical data that shows that it can keep up with inflation (or even exceed it) no longer holds.

Some thoughts on ZIRP/NIRP

ZIRP stands for zero interest rate policy.  NIRP stands for negative interest rate policy.  As governments and corporations are awash in debt, ZIRP and NIRP appear to have been embraced whole-heartedly by central banks.

As the federal reserve started to lower its benchmark interest rate back towards zero (it is zero as of this writing), I started to think about what this means for fixed-income investments if they decide to go from ZIRP to NIRP.

In some of the online forum discussions, folks said a drop of 0.5% in interest, e.g. from +0.25% to -0.25% is the same as, e.g., a drop from +0.5% to 0%.  To show that this is not really accurate, I presented the following example.

Lets say to have $x to invest at an interest rate of r% for a length of time t.  Then as t goes to infinity:

• if r > 0, then the balance, x goes to infinity.
• if r = 0, then the balance stays exactly the same at x.
• if r < 0, then the balance x goes to 0.

In other words, with a negative interest rate, one's balance starts reducing over time and eventually goes to zero.  I hope we (the US) don't get to NIRP, but with the economy the way it is, there's no telling.  Japan and the EU have been in NIRP for a while now.  Large corporations have benefited from this.  LVMH for example had an offering of negative yielding bonds to finance its purchase of Tiffany & Co.--a case of investors actually paying LVMH to borrow their money!

The downsides of ZIRP and NIRP

Some of the down sides of ZIRP and NIRP are:

1. It penalizes savers and those that depend on interest for fixed income.
2. It causes people with money to speculate on assets such as stocks and real-estate. 
3. It causes real-estate prices to rise so houses are out of reach of the middle class without taking on excessive debt and becoming house poor.  This also means that any extended dip in house prices and employment can stress banks as their loans go bad.  This is what happened during the housing crisis.
4. It forces pension funds to speculate in stocks in order to meet their obligations.  This means that any extended dip in stocks will cause a number of these pension funds to become insolvent, putting their ability to pay out pensions at a risk.
5. It leads to rampant financial engineering by companies where they take on long term debt to buy back their own stock enriching their stockholders and executives.
6. It exacerbates wealth inequality in society since people that are wealthy to begin with (e.g. private equity, hedge funds, large businesses) have access to cheap money that retail investors and small businesses do not.

#3 and #4 pretty much mean that once ZIRP/NIRP are used by the central bank, the entire economy becomes dependent on frequent and larger interventions by the central banks.  At some point in time (I think we are already there now) the central banks own the entire market and there is no more real price discovery.

Proponents of ZIRP/NIRP argue that the pros outweigh the cons.

How to invest in a ZIRP/NIRP environment?

This is hard question to answer and I'm not really qualified to do it, but here are some of my thoughts.

Simple investment in savings and CDs are not likely to yield much.  I'm not a big fan of "yield chasing" where you open an account with an online bank only to have them reduce their rates a few months later.  Typical yields in a ZIRP environments are close to zero, lower than 0.1%.  That amounts to an annual return of less than $1000 on each $100,000 invested.  And then there's typically taxes that need to be paid even on those measly returns!

I don't like the idea of being forced to invest in stocks especially since there's an ethical dilemma where I don't want to support the kinds of financial activity that is destroying people's lives.  I know stocks will go up (don't fight the fed, as they say), but still.

Gold is an option, but one has to be careful of the pitfalls of investing in various types of gold and the possibility of price manipulation.

Treasury products such as I Bonds and EE Bonds are a possibility but you have to create and manage an account with treasurydirect.gov and some folks have reported less than desirable experiences when needing any kind of customer support.  The products also aren't as liquid--minimum holding period, interest penalty if cashed within a certain time period, etc., and there are annual limits on the amount that an individual can buy each calendar year -- $10K of each as of this writing.

If I figure something out, I will update this post.

In the meantime, this is what the chair of federal reserve thinks savers should do.  It just amazes me that the chair of the federal reserve and many politicians equate a 401(k) with risk assets.  It doesn't have to be that way.  Most 401(k)'s offer a stable value fund or money market fund as an investment option.  Those 401(k) savers are not benefitting from the federal reserve's policies.

Update 06/27/2020

The fed made a statement saying they will keep rates near zero until at least 2022.

Simple investment portfolios

I have previously written about worry-free investing (my first blog post!).  I have more or less being following that approach (i.e. mostly fixed-income investments).  However, the monetary policy of the last few years in the US has made me start to rethink that approach.  Historically low interest rates (typically < 1% on a savings account) coupled with stocks going sky high (a nearly 200% gain since the low of March 2009) makes me feel like I'm "missing out."  In all likelihood, I will never actually implement any of these portfolios, but the primary reason for this, as with my post about ways to own gold, is to consolidate my learnings on this subject.  I will continue to add to this as I learn more about the subject.

The basic asset classes

Most simple portfolios comprise a weighting of 2 or more of the following asset classes.

• Stocks (small cap, mid cap, large cap, ...)
• Bonds (short term, mid term, long term, ...)
• Real-estate
• Precious metals
• Cash

Simple portfolios

The following are are of the simple portfolios that are supposed to weather all economic times.  They are supposed to work on auto-pilot using a fixed allocation of various asset classes and so they require minimal maintenance.  These simple portfolios also tend to have better returns than many actively managed funds when measured over longer periods of time.

• Couch-potato portfolio (50% stock, 50% bonds)
• Coffee house portfolio (10% in various stock funds, 40% fixed income)
• Permanent portfolio fund (25% stocks, 25% bonds, 25% gold, 25% cash)
• Using age to determine what percent of assets should be in stocks (110 - age)
• Ms. Cheat Sheet sample portfolio for recessions (100 - age in low volatility stocks [USMV], age/2 in bonds [BSV], age/2 in cash)

I should note that none of these portfolios was able to successfully dodge the financial crisis of 2008-2009.  In particular, here's an excellent article by Doug Short on the pros and cons of the Permanent Portfolio Fund, and another one about diversification.

There are variations of these to try to bring in more diversification, but I think that unnecessarily takes away from the simplicity.  If I ever decided to try something different than the worry-free investing approach, it would probably be one of these or a very minor modification of it, e.g. 20% in an S&P500 index fund and the rest in US treasuries or cash.

Several "lazy" portfolios are described here.

Timing the market

All of the above simple portfolios are of the set-and-forget type.  At most, the only maintenance that may be recommended would be rebalancing at the end of each quarter or at the end of the year to make sure the asset allocation hasn't moved too much off target.  The effect of rebalancing is widely debated.

Is it possible to time the market?  I'm not sure if it can be done reliably.  In the short term the answer is a definite "no."  In the long term, it may be possible by careful observation and interpretation of macroeconomic data.  I have been following several economic blogs since 2005, and only one of those blogs -- CalculatedRisk -- has made several correct predictions about the economy, including recession calls, and the bottom of the real-estate market in terms of home prices and inventory (see the "economic predictions" section towards the end of this post).  However, the author of that blog refuses to offer investing advice.  If he is actually able to call the next recession correctly, I think I will have to assume that timing the market is possible!

I recently came across this article from Doug Short (he updates this at the end of each month) which explains a market timing strategy based on moving averages as described in the Ivy Portfolio.  Doug's page is updated monthly with the signal that indicates whether to remain invested in the fund or stay in cash for each of 5 funds - VTI (total US stock market), VEU (world, ex-US), IEF (7-10 year treasuries), VNQ (US REIT), DBC (commodities).  Scott's Investments has a nice spreadsheet for the Ivy Portfolio that is updated in real-time.  The moving average strategy for various durations can be backtested here.

Finally, someone in the bogleheads.org community suggested this method which takes into account both market trends and the unemployment rate.  Apparently using two indicators avoids some of the whipsaws that the Ivy Portfolio method is subject to.

Market valuation indicators

The following are some of the indicators used for measuring the valuation of the stock market (i.e. to determine whether stocks are over- or under-valued).  Because periods of over- and under-valuation can persist for long periods of time, they are perhaps only useful in terms of what to expect in the long term.  Additionally, there are other factors such as interest rates that affect the valuation at any given time.  But here are the indicators:

• Price-to-earnings or P/E
• Price-to-dividend or P/D -- the dividend for the S&P 500 can be obtained here
• Tobin's Q
• Market Cap to GDP
• Price/earnings growth ratio or PEG ratio
• FINRA margin debt (formerly NYSE margin debt) (@yardeni.com)
• Greg Mannarino's MMRI (DXY * 10Y yield) / 1.61

Some useful tools and references

• stockchoker.com
• portfoliocharts.com - Provides charts showing how any portfolio would have performed using data going back to 1972.  Here is the data for one of the sample portfolios called the "Golden Butterfly, but users can design their own portfolio to generate each of those plots (although it is a somewhat slow process). 
• Morningstar Investing Classroom
• finviz.com - Stock screener.
• World's most ethical companies by Ethisphere
• A list of S&P 500 companies with no debt

TIPS

(This is a follow-on to my post on worry free investing.)

TIPS is an acronym for Treasury Inflation Protected Securities. The objective of TIPS is very similar to I-Bonds which I described in an earlier post. The idea is to offer a safe investment whose objective is to track the rate of inflation. Basically it is designed to protect the purchasing power of money over time. Again, in my opinion TIPS are one for the best investments available for tax-deferred and tax-exempt accounts such as 401(k)s, IRAs, Roth IRAs, etc.

Unlike I-Bonds the interest rate is fixed, but the principal adjusts with inflation. Every 6 months a fixed rate of interest is paid on the inflation-adjusted principal. At the time of maturity, the holder of the bond either receives the face value of the bond or the inflation adjusted principal, whichever is higher. TIPS are sold in maturities of 5, 10, and 30 years.

The reason why I say that TIPS work best in tax-deferred and tax-exempt accounts is because any changes in the principal due to inflation in a given year are subject to tax in that year. I don't like the idea of paying taxes on changes in principal before the bond matures. Of course, if you need an investment that works similar to TIPS for a taxable account, the right vehicle would be I-Bonds.

There are several ways to own TIPS.

• Mutual funds such FINPX and VIPSX. There are 2 things to be cautious about. The first is expenses. As of this writing, the expense ratio for FINPX is 0.45% and that for VIPSX is 0.25%. Expenses eat into the total return, and given that these investments are just about keeping up with inflation, one should be very careful about fund expenses. The second thing is that funds constantly have to buy and sell bonds on the open market because of investors buying into or selling their position in the fund. As a result, they are subject to market ups and downs.
• Closely related to mutual funds are Exchange Traded Funds (ETFs) such as TIP. This has the same problem as mutual funds -- expenses and being subject to market ups and downs. In addition, one usually has to pay a brokerage fee to buy or sell them since they are traded like stocks. As of this writing the expense ratio of TIP is 0.20%. This is slightly less than for both the mutual funds mentioned above, but you do have to factor in the brokerage transaction fees.
• Holding the bonds directly in a brokerage account till maturity. I think this is best way to own these bonds. Many brokerages offer these for purchase at treasury auctions for no fee. This is how I have been buying them. If this is something of interest, you should check with your brokerage about how to participate in auctions. The bonds are offered only a few times a year. For bonds offerings during the current year, you can look at the schedule put out by the US Treasury. If you decide to go this route, also pay very close attention to those issues marked as "Reissue". Because they are reissues, they essentially command the market price for what the original issue is selling for. I didn't know about this when I first started buying these, but now that I know about it, I probably won't be buying securities from an auction when they are marked as a reissue.

You can get more information on TIPS at TreasuryDirect.

TIPSwatch is a nice blog dedicated to the subject of TIPS.

I-Bonds

(This is a follow-on to my post on worry free investing.)

I-Bonds are savings instruments sold by the US Treasury. In my opinion, these are one of the best long-term savings vehicles. You can get more information from TreasuryDirect, specifically here. I would also highly recommend reading the FAQ.

Why do I like I-Bonds? Here are some of the reasons:

• They preserve the buying power of your money by tracking inflation. The interest rate comprises 2 parts -- a fixed component and a variable component. The fixed part remains fixed for the life of the bond. The variable part adjusts with inflation (or deflation) every 6 months. Even with deflation, the bonds are guaranteed to never pay below 0%.
• The interest on these bonds grows tax deferred till maturity or till they are redeemed, just like an IRA. On redemption, only the accumulated interest will be taxed.
• If redeemed for qualified education expenses, even the interest may be exempt from taxes. This has little applicability for me at this time, so I haven't really looked at the details of this.
• The interest is exempt from state taxes.

What are some of the gotchas?

• You can only buy $10,000 worth of I-Bonds per year via TreasuryDirect.
• You can buy an additional amount of I-Bonds if you overpaid on your federal income taxes.  You would request the refund be used to purchase the I-Bond.  The limit for this is $5000.  Some folks deliberately overpay taxes in order to take advantage of this.
• The fixed rate is very low nowadays. There was a time when the fixed portion of the rate was 4%. Now they usually come in at less than 1%.
• They are not redeemable for the first 12 months after purchase. After that, if redeemed within 5 years there's a 3 month penalty. After 5 years they can be redeemed at any time with no penalty.
• They cannot be held in a tax-deferred account such as a 401(k) or IRA. But it's the safest place to be for money outside of tax-deferred accounts.

How do you buy them?

• Create an account on TreasuryDirect, link a savings or checking account, and transfer money to TreasuryDirect and use it to buy I-Bonds. In this case, the I-Bond will only appear in the TreasuryDirect account online, and there will be no paper trail for the I-Bond. I would recommend printing a copy of the holdings in the account each time a purchase is made.
• If you have overpaid on your federal income taxes, you can request that the refund be made by purchasing a paper I-Bond.

I-Bonds will earn interest for 30 years. After that, paper bonds stop earning interest, while bonds in TreasuryDirect will be redeemed for cash earning 0% in the TreasuryDirect account.

One more thing worth pointing is that if you have a mix of paper bonds and bonds at TreasuryDirect, you can request conversion of the paper bonds to bonds in your TreasuryDirect account.

Update 07/14/2011

According to a recent press release, paper bonds will no longer be sold as of Jan 1, 2012. It remains to be seen whether they increase the purchase limit for electronic purchases.

Update 02/04/2012

According to a press release of Jan 4, 2012, the limit for electronic I-Bonds has been raised from $5,000 per year to $10,000 per year.

Update 03/06/2014

Talked about the option of using federal income tax refund to by a paper I-Bond.

Worry free investing

What led me down the path of worry-free investing was trying to understand and quantify the risk that one takes when they invest in stocks. Conventional wisdom says that if you have money that you won't need for 30 or 40 years, then that should go into stocks, because the long-term returns from stocks handily beat the returns from other investments such as bonds, real-estate, and certificates of deposit (CDs).

What percentage of the portfolio should be in stocks? What percentage in bonds? How much in cash? What if the stock market doesn't deliver its historical returns? How much do you need to invest in order to achieve a certain retirement goal?

I had posted this as a topic for discussion on misc.invest.financial-plan. Someone pointed me to the work of Zvi Bodie, a professor at Boston University. Bodie has co-authored a book titled Worry Free Investing that takes the voodoo out of the above questions. He tells you how you can meet your retirement goals with very conservative investments. In other words, if you're willing to save more, then you really don't need to take on the added risk of investing in the stock market. I am a very conservative investor so the message of the book really resonated with me. The book is out of print, but you can buy it from his website for $5. He also has a bunch of free short videos on this subject.

If your stomach churns with the gyrations in the stock market, this might be an approach worth considering.

In subsequent posts, I have discussed TIPS and I-Bonds which are two of the worry free investments recommended in Bodie's book.