No, Preferred Stocks Are Not a Replacement for Bonds

Preferred Stocks

Typically I don’t spend much of my time attending investment and wealth management conferences. For the most part these events are just organized sales platforms for fund and insurance companies to pitch their latest products to advisors (who then turn around and pitch them to their clients).

Count me out.

However, I make exceptions if a sizable percentage of the content is academic research, for example, or if there is a greater emphasis on topics such as index investing or tax-efficient portfolio management.

Last week I decided to spend part of my Tuesday afternoon at the Private Wealth Mountain States Forum that was held here in Denver. I was invited as a guest speaker on a panel discussion entitled Fixed Income: Identifying Liquidity Risk and Finding Yield to provide some commentary and perspective on the bond markets.

With interest rates remaining persistently low, it wasn’t surprising at all that this topic found its way on to the forum’s agenda. Investors are clamoring for yield and turning to asset classes such as preferred stocks, REITs, and junk bonds to find it.

Likewise, I also wasn’t surprised to find myself playing the role of the “lone wolf” on the panel. While my panel colleagues were preaching the typical active management talking points of “picking your spots” and “avoiding overbought” assets, I did my best to serve as the voice of reason for those that were interested in listening.

My goal in attending was to hopefully save a few souls from being tempted by the allure of “outsmarting” the market (with the help of a high-fee manager of course). Reviewing my notes following the forum, I thought it would be helpful to share what I covered during my speaking time on the panel.

Remember the Purpose of Fixed Income in Your Portfolio

Yes, it’s true. Interest rates are historically low. That isn’t really breaking news. In reality, we’ve been in a declining rate environment since the early- to mid-1980s. The yield on the 10-year treasury is currently hovering around 1.60%. In 1981 it peaked at more than 15.0%!

Undoubtedly, declining rates have hurt savers and made it more difficult to earn a respectable income from “safe” investments. However, this fact pattern doesn’t change the primary role that fixed income should be playing in our portfolios. The first obligation of our bonds is to dampen the volatility of the stocks that we own and to reduce the downside risk of our overall portfolio. Don’t ever forget that!

Simply put, even for the most conservative of individual investors, it’s typically a poor idea to invest all of your eggs in the fixed income basket. Instead, it’s generally wise to include at least a small allocation to equities in our portfolio both for purchasing power protection (i.e. managing inflation risk) and for tax efficiency (stocks can take advantage of long-term capital gains rates).

Accordingly, while the majority of retirees would prefer higher interest rates for their bond investments, they are likely still reliant on the stock portion of their portfolio for countering longevity risk and keeping their tax bill in check. This leads me to my next point…

Yield is Not a Replacement for Principal Protection

Some investors assume that because a particular security or asset class has a “high yield” that by itself means that it can serve as a replacement for the existing bonds in their portfolio. This line of thinking varies of course, but a lot of investors have convinced themselves that a higher yield equates to greater safety for the investment.

Repeat after me: High yield is not a replacement for principal protection!

To illustrate this, take a look at the chart from Morningstar below (click to expand):

Preferred Stocks and Other High-Yield Asset Classes

The chart shows the performance from April 2007 to February 2009 for five ETFs representing the following asset classes:

  • High-yield bonds (HYG – iShares iBoxx $ High Yield Corporate Bond ETF)
  • US REITs (VNQ – Vanguard REIT ETF)
  • Energy Stocks (VDE – Vanguard Energy ETF)
  • Preferred Stocks (PFF – iShares U.S. Preferred Stock ETF)
  • US Bonds (BND – Vanguard Total Bond Market ETF)

As you can see, the “bond alternative” asset classes experienced declines ranging from 34.21% for energy stocks to 69.80% for US REITS. By comparison, the broad US bond market was not only quite stable, but it actually increased by a modest 2.15% during this same period.

I don’t know about you, but I’d much rather stick with even (very) low yielding bonds, than trying to add yield with an asset class that can decline as much or more than my stocks. Simply put, the very asset classes that many investors are chasing as they hunt for yield are the exact opposite of “safe bond equivalents.”

Don’t kid yourself otherwise.

A Total Return Approach is a Much More Efficient Way to Create Income

Lastly we need to remember that we do in fact have some control over when and how we take distributions from our accounts. There is no rule that says we must rely only on the interest-earning assets in our portfolio for income. Rather, we can use a combination of interest, dividends, and capital gains in order to generate the cash we need for withdrawals from our portfolio. This approach is what is commonly known as “total return” investing.

Let’s say, for sake of argument, that the combined interest and dividend yield for a $100,000 portfolio is 2% (or $2,000). However, our target withdrawal rate for the year is 3.50% (or $3,500).

Where does the additional money come from?

Let’s assume that in addition to the 2% yield (the income return), our portfolio also increases in value by a modest 3% (the capital return). To generate the additional “yield” we can simply sell $1,500 of our portfolio (hopefully at long-term capital gains rates) and then withdraw it, along with the $2,000 of interest and dividend income, in order to reach our $3,500 target.

Of course in some years our portfolio may actually decline in value. However, in other years our portfolio is likely to increase in value by much more than 3%. As a result, the strategy becomes to use the “excess returns” we get in the really good years to provide for withdrawals in the not so good years.

Ultimately, total return investing can be a much more flexible and tax-efficient path to generating portfolio income. Likewise, in a low rate environment, it may be the only path to provide the returns we need.

State of the Union Tax Reform: Are Your Taxes Going Up?

State of the Union Tax Reform

In his State of the Union address last night, President Obama laid out grand plans for reforming the tax code and eliminating loopholes. Most of this was done in the name of providing relief to the middle class and putting a stop to special interest tax breaks. Politics aside, essentially the president’s budget calls for $320 billion in new taxes primarily targeted at high-income earners and banks.

A call for new taxes should not be overlooked when it comes to financial planning; however, I think there is some important perspective we need to consider in light of the president’s proposals. With that in mind, let’s look at a couple of the reforms the president put on the table which could have the greatest impact on you:

529 Plans

– Under current law (in place since 2001), contributions to a 529 savings plan grow tax-free. As long as the withdrawals are used to pay for qualified college expenses, no taxes are paid on distributions either.

– That’s why 529 plans are probably the single best vehicle for most families to save for their children’s college. In addition to the federal tax benefits noted above, some states (including Colorado) also offer a state income tax deduction on contributions.

– The president’s plan would revert us back to pre-2001 tax law by taxing withdrawals from 529 plans, even if they are used for college expenses.

– This is really an odd proposal since it would have the most significant impact on the very demographic the president said he was focused on helping: the middle class. That said, it’s pretty unlikely that this change would ever make it through Congress. More importantly, the current proposal only calls for changes on future contributions, not money that has already been contributed. Thus, there is no reason to abandon 529 plans at the current moment.

Increase to the Capital Gains Tax Rate

– As part of the ironically named American Taxypayer Relief Act (ATRA) which went into affect on January 1, 2013, the top marginal tax rate for long-term capital gains was raised from 15% to 20%. In addition, a 3.8% “net investment income” surtax also went into effect. The resulting rate amounts to 23.8% for those taxpayers in the 39.6% marginal income tax bracket.

– Obama’s proposed budget would see the top capital gains tax rise from 23.8% to 28%, the highest since 1997. This would amount to a nearly doubling of the highest applicable long-term capital gains under the Obama administration (from 15% to 28%).

– While this change would only impact those taxpayers in the highest tax bracket, it’s important to remember that this group often includes small business owners. That’s because most small businesses are structured as pass-through entities (e.g. limited liability corporations or S-corporations), meaning that the business income flows through to the owner’s return. The owner then pays taxes on that income, even if they reinvest it into the business.

– Similar to the proposed change on 529 plans, the spike in capital gains taxes is also a long-shot to see the light of day with a Republican-controlled Congress. Although future changes are always possible, the same strategies to maximize after-tax returns generally apply in all tax environments. This is a good reminder to focus on what we can control and ignore what we can’t.

Other Proposed Tax Reforms

– Eliminating the Step-Up in Basis: Current tax law provides that inherited assets benefit from a step-up in tax basis to the extent the fair market value of the asset at the time of death is higher than the decedent’s basis. Obama’s State of the Union tax reform proposal would do away with this basis adjustment, meaning an inherited asset would keep the decedent’s original basis (with certain exceptions). The step-up in basis is a significant tax benefit for many Americans and a critical consideration when it comes to investment and financial planning.

– Cap on Retirement Plan Accruals: For many American’s, the most powerful tool to save for retirement is through an IRA and 401k plan. The president’s State of the Union tax reform plan intends to cap the total amount an individual can accrue in such retirement plans at $3.4 million. While this may seem like a lot of money, as we live longer and see fewer benefits from other sources of retirement income, it could have a significant impact on some retirees.

Ultimately, this is likely much ado about nothing, as they say. Although the president delivered a long list of talking points on tax reform, there simply isn’t much bite to the bark since Republicans are unlikely to pass most of the proposals. It’s important to keep a close eye on any changes in legislation, but for now, it’s business as usual.

The Backpacker’s Guide to Investing – Part 2

Wealth Engineers Guide to Investing

In Part 1 of The Backpacker’s Guide to Investing, we talked about the importance of having a well-thought-out investment plan (as well as a backup plan, since the unexpected should always be expected).

I also shared why you should always take advantage of limited resources when they are available, because once they’re gone, they’re gone. This includes investing as soon as possible to lengthen your time horizon and the power of compound interest, as well as getting 100% of your employer’s match.

If you haven’t already read Part 1, I’d encourage you to start there first.

Today, we are going to talk about how weight affects what you pack on the trail and why I’m happy to wear some functional, but pretty ugly clothes in the backcountry. Here’s Part 2 of The Backpacker’s Guide to Investing:

4. Weight is Your Enemy

As a backpacker, you generally want to keep your pack as light as you possibly can. This not only spares your back from unnecessary strain, but it will also allow you to trek longer and further since you won’t be burning as much energy.

Likewise, as an investor, you need to keep as much weight out of your portfolio as you can. This weight primarily comes in the form of unnecessary commissions, investment expenses, and taxes.

It’s very common for a typical portfolio to be dragged down by 3% to 5% in fees, expenses, and taxes every year. If your portfolio is earning 6% to 8% per year, that’s a huge burden and will eat up 50% or more of your return.

That’s why you need to be very diligent about keeping your expenses to a reasonable level and employing a tax efficient investment strategy.

Simply put, don’t squander your hard-earned money by paying unnecessary commissions or fees. There’s absolutely no reason to pay a load to buy a mutual fund these days. Likewise, you shouldn’t be paying more than 0.20% to 0.40% in annual mutual fund or ETF expenses.

Finally, it’s critical to understand the tax implications of your investment decisions. Ignoring taxes can erode the return potential of your investments.

5. A Few Things are Worth the Extra Weight (or Cost)

Part of the enjoyment of venturing into the mountains is the reward of getting to camp near a lake, river, or other natural beauty.

Ideally, that means setting up your tent in the early- to mid-afternoon and still having several hours of sunlight to relax in.

To really get the most out of the trip, I always pack a few things that are absolutely worth the extra weight:

  1. Sandals – There is no better feeling than tossing your hiking boots aside and throwing on a pair of sandals after a long hike.
  2. A book – Whether it’s a paperback or a Kindle, being able to spend a few hours reading in the peacefulness of the wilderness is unbeatable.
  3. Coffee – It doesn’t weigh that much, but even if it did, no one is taking my morning cup of joe away from me.

I’ve also invested in several items that either help reduce weight or make for a much more enjoyable adventure. Are they more expensive than the alternatives? You bet. Are they worth every penny? You better believe it. Here are a couple:

GSI Pinnacle Dualist
GSI Pinnacle Dualist
REI Sleeping Pad
REI Sleeping Pad
  1. GSI Pinnacle Dualist – As a backpacker, this is the greatest thing since sliced bread. It packs two bowls, two insulated mugs with lids, and two collapsible sporks all into a pot with a strainer lid. The pot then fits inside a molded stuff sack that doubles as a wash basin. On top of that, my ultralight stove and fuel fit inside. And the entire package weighs just 21.6 oz and is the size of a 6″ by 6″ box. It’s incredible.
  2. REI Lite-Core 1.5 Self-Inflating Sleeping Pad – Sleeping on the ground isn’t fun. Neither is carrying one of the huge roll-up mats you can buy for $20. Instead, every backpacker should get a lightweight, compressible air pad. The one I bought from REI quite a few years ago weighs just 27 oz. and stuffs into a sack that measures only 5.5″ by 10.75″. It’s way more comfortable than the foam pads and takes up a lot less space.

When it comes to investing, the same principles apply. The costs of investing have come down dramatically. Almost to zero in some cases.

You can purchase index funds for free and the cost of ownership for a basic portfolio will run you 0.10% or so per year (and probably less after you factor in securities lending offsets).

Likewise, you can minimize taxes through smart planning. Obviously, this means maximizing tax-deferred and tax-free retirement accounts. It also means intelligent portfolio design and management in your taxable accounts.

However, are there instances when it’s worthwhile to carry a little extra weight or pay more for a better solution? I believe so. Here are a few examples:

  1. Diversifying internationally – Investing in international developed market stocks costs more than it does to buy U.S. companies. The same is true of emerging market stocks. However, both provide a clear opportunity to diversify the equity side of your portfolio and investors would be foolish to pass up the opportunity.
  2. Diversifying across risk factors – Likewise, employing a factor-based investment approach, whereby you seek to invest in specific types of stocks with unique risk/return characteristics is also more expensive. That said, the diversification benefits and higher expected returns from smaller stocks, value/low-price stocks, profitable companies, etc. clearly outweigh the higher expenses of owning such funds.
  3. Professional advice – I’ll start this by saying I could easily be accused of having a bias here, but I’ll make what I believe is a genuine case anyway. I believe that unbiased, high-quality advice is often worth more than you pay for it. This can be true with anything from hiring a lawyer to getting a home inspection. Sometimes that advice protects you from making poor decisions or finding yourself in hot water. Other times professional advice can add a significant amount to your bottom line. In still other cases, the time and effort you save by hiring a professional is worth it to free your life up for other things. When it comes to working with my clients, it’s almost always a mix of all three.

John Bogle is famous for saying, “In investing, you get what you don’t pay for.” In general, he’s absolutely right. However, I think smart investors would agree that there are indeed a few things that break that rule of thumb.

6. There are No Points for Style

There are several things that I wear on a backpacking trip that I wouldn’t exactly call fashionable. In fact, the only times that I wear or use these things are on hiking trips.

Such items include a sun hat, a mosquito net, and pants that convert into shorts.

sun hat
Sun Hat
Mosquito Net
Mosquito Net
Convertible Pants
Convertible Pants

Why do I wear them? Because they work. Without these things, my trip would either be miserable or would require me to pack extra weight.

As investors, not a day goes by that we don’t hear about the latest hot investment or guaranteed way to make money. Whether on CNBC, in the Wall Street Journal, or at a networking event, who hasn’t had been intrigued by one or more of the following:

1) Hot stocks, IPOs, or fund managers
2) Non-public real estate investments or developments
3) Private equity
4) Hedge funds
5) Start-up businesses or angel investments
6) Currency trading
7) Wall Street products that provide “market upside and no downside”

I could go on and on. However, the independent research and evidence behind such investments, isn’t good.

The returns rarely hold up to the lofty promises of the people who pitch the investment, particularly after you adjust for fees, taxes, and risk.

And you’d better carefully understand the risks. Far too many times I’ve seen investors lose large sums of money or find themselves personally on the hook for debt because they didn’t take the time to understand the commitment they were making.

That’s why, the message about investing should be clear: There are no points for style!

Returns aren’t delivered because an investment sounds exciting or makes for entertaining conversation at a cocktail party.

The majority of strategies and investments that have a strong track record of delivering results for individual investors are somewhat lacking in panache: diversification, asset allocation, discipline, low fees, low taxes, index funds, etc.

If you want to buy the latest “hot” investment, just remember that it will likely do more for your talking points at a party than it will for your bottom line.

Part 2 Wrap Up

I’m sure there are more parallels between backpacking and investing that I’ve missed. However, the points at the end of the day are pretty simple:

  1. Have a well-thought out, written plan
  2. Prepare in advance for bumps in the road
  3. Don’t miss out on critical, but limited opportunities
  4. Avoid unnecessary weight that limits how far you can go and how fast you can get there
  5. Know when carrying some extra weight or paying for better stuff is worthwhile
  6. Seek function over form if you want to be successful

If you follow these tips, I’m very confident you’ll do well. If you’d like some help, let me know.