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A Frank Conversation About Interest Rates and Risk
- By Travis Echols
- •
- 29 Jul, 2017
Originally written on 2/6/2017.
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After a
three-decade decline in interest rates (since the early 1980s), have
interest rates finally bottomed? The 10-year U.S. Treasury
yield has been below 4% for over eight years. Will rates remain low or
will they rise? How can fixed-income investors earn a good, predictable
interest rate without losing ground to inflation or
other financial hazards?
Conversations I have about interest rates usually go something like this.
Why are interest rates so low?
U.S. interest rates are low because of slow economic growth and low inflation. Also, foreign central banks continue to buy bonds, pushing down global yields. As a matter of fact, the rest of the world’s rates are even lower than the U.S., which is still near record lows. So investing in foreign bonds is not the solution to the low-yield problem.
Will interest rates rise in the near future?
Some economists think that to see significantly higher yields, we probably need to see both a hawkish Fed and high inflation—and that the probability of both of those things happening is low. They argue that even if U.S. rates rise and the new presidential administration’s policies are inflationary, the “lower for longer” trend seems sustainable well into the year while Europe and Japan continue to experiment with negative policy rates and quantitative easing.
Other economists see some of the Trump policies, such as lower corporate tax rates and lower regulatory burdens, spurring small company growth and the general economy. Also President Trump’s emphasis on infrastructure spending, coupled with lower tax rates, could lead to a higher budget deficit and higher inflation. They think this heating up of the economy and inflation would cause Central bankers to raise rates accordingly. Rates have already drifted higher after the U.S. presidential election in anticipation of some of these outcomes.
No one knows, but I think it is more likely than not that there will be a gradual increase in interest rates going forward.
Why should I invest in bonds for interest income?
In my article, Why Invest in Bonds, I say that a primary reason for investing in bonds is to produce interest income. Bonds are generally capable of producing a higher regular income (called a coupon) than stock dividends. Another primary reason for using bonds is to reduce the volatility of a common stock portfolio. Safety of principle is the main concern.
Why are rising interest rates potentially risky for me as a bond holder?
Rising rates means new bonds are being issued at higher rates than older bonds. That is good for new bond buyers. But what about the value of the old, lower-rate bonds? Who would pay full price for your 4% bond if buyers can purchase a new 5% bond instead? The answer is, nobody. To sell your 4% bond, you will have to discount its price. That means its price on the market has declined. This explains why bond prices and bond interest rates are inversely related.
With the general decrease in interest rates over the last thirty years, bonds have prospered many investors through interest and price appreciation. This run-up in bond prices is something every bond holder should pay close attention to. The last long bond bear market lasted 35 years, from 1946 to 1981. Government yields went from 2% to 14%, decimating the value of long bonds bought in the 1940s and 50s. (Source: The Bear Book, John Rothchild John Wiley and Sons Inc.)
Again, here in early 2017, we find interest rates hovering near historically low numbers as in the late 1940s.
I am not projecting another 35-year bear market for bonds in the future, or interest rates reaching 14% again, but one cannot help but see more downside than upside potential for bond prices going forward.
Maybe I should just wait for rates to rise?
Waiting for interest rates to rise would make sense if you could predict that rates would rise significantly in a short period. But there is a good possibility they will not. And if you are wrong, you have cost yourself precious interest you could have been earning, making it harder and harder to catch up the longer you wait. This chart illustrates the cost of waiting.
For example, if you locked in now at 3.05% in very high-quality corporate bonds for six years, rates would need to shift up by 4.05% in four years to make up for only 2.8% earned in the first 4 years.
If you waited only one year and earned 0.15% in a money market, you would need 3.78% for the next five years to be equivalent to the 3.05% invested now for 6 years. Rates would need to shift up by 0.90% in one year, which is not likely to happen.
Now imagine the cost to those investors who have been procratinating for the last eight years, waiting for rates to rise significantly—and rates have not!
In light of future interest rate uncertainty, how can I be earning interest now and avoid losing money in bonds if interest rates rise?
One way to mitigate the risk of a price decline is to hold your 4% corporate bond until maturity, at which time you will receive the last interest payment and the par value of the bond (if bonds are bought at par, the coupon is equal to the yield, or if bonds are bought at a premium, it's because the coupon rate is higher than the prevailing market rate, or if bought at a discount, it's because the coupon rate is lower than the prevailing interest rate).
What is the trade-off to just owning a corporate bond mutual fund versus individual corporate bonds? The trade-off is the mutual fund offers diversification (several companies) and perhaps liquidity and professional management that an individual bond portfolio may not. The individual bond portfolio offers protection from price declines due to rising interest rates; mutual funds do not. Furthermore, mutual fund investors could get scared and sell off if mutual fund prices begin to fall, exacerbating the decline. Higher yielding bonds bought in the mutual fund can eventually offset these price declines, but this could take up to two years or more, depending on various factors.
But if it is feasible to diversify your individual bonds using different companies in different industries (such as materials, information technology, telecommunications services, energy, financials, health care, industrials, real estate, and consumer discretionary), and receive professional help in researching the companies, this can be a win-win. You can own a professionally-selected diversified portfolio of individual bonds that you can hold until maturity, making price movements in the interim irrelevant.
If interest rates remain low or move lower, the higher interest payments enrich the investor and the investor may also enjoy some price appreciation. If interest rates rise, the investor is enriched by the interest payments without the concern of price decline. And at maturity, the monies can be reallocated elsewhere, or reinvested into even higher-paying bonds, or lower maturity bonds paying the same yield.
The beauty of this strategy is this. Either way, regardless of interest rate movements, the investor is making a steady income without taking on excessive risk.
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- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
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Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
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If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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The latest book I am reading is “ The Psychology of Money ” by Morgan Housel. Chapter 3 is entitled “Never Enough”. In this chapter, Housel talks about when rich people do crazy things. He tells stories of wealthy people who never had a sense of enough and wrecked their reputations, families, freedom, and happiness because of it. I have also talked to older couples who tell me they once had a much better retirement in view, but the quest for more led them to make unwise investment decisions that left them financially crippled in retirement. The importance of knowing when you have enough is not only vital to when you retire but also how you retire. It can affect how you invest, how you withdraw, and your overall satisfaction before and during retirement. Be sure to read to the end where I summarize a few key takeaways. Housel makes the four following observations in chapter 3 of his book. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
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So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Are you wondering about the impact of the
2020 election results on your retirement? If so, you are not alone. The two political parties are greatly polarized. While the Democrat party has moved further toward ethno-centric socialism, the Republican party has moved further toward nationalistic populism. The difference in the two parties’ goals for our country is wider than ever. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
Serving Cumming, GA, Forsyth County, and the surrounding areas of John's Creek, Alpharetta, Milton, Duluth, Buford, Suwanee, Flowery Branch, and Gainesville
