Low interest rates and concurrent high prices in fixed income markets present investors with very difficult choices. We have written numerous pieces over the last year commenting on the extended valuations in the U.S. equity market.
More importantly, though, low rates and high fixed income prices create an uncomfortable dynamic for risk averse investors. To achieve balanced portfolio returns consistent with historical standards will necessitate accepting more risk. Given current prices, this risk is underpriced and should be avoided. Against this backdrop, a disciplined approach to managing bond allocations in a portfolio is necessary to keep the typical low risk portion of a portfolio secure. By extension, expectations for returns must be reduced.
Risk does not equal short term volatility
Risk is rarely defined accurately. Most of the financial literature equates risk to volatility. This definition has the benefit of being measurable mathematically, but it fails to tell the full story. If an investment fluctuates to the downside over a short time, the temporary change in value should have no impact on a long-term investor. The long-term investor ignores the skit tishness of others and does not lock in losses while others run scared. Price gyrations certainly induce fear, and we have to guard against the behavioral risk to take action, but in and of itself volatility without investor action doesn’t fully qualify as risk. A better explanation equates risk with the probability and magnitude of capital losses. Put more simply, the greater the likelihood an investment can lose money, the higher the risk. In any investment, risk must be balanced against the potential reward. Taking some risk is a necessity, but if the magnitude of loss is great relative to the potential return, the investment is unat tractive.
Managing potential risks
Our definition, is unfortunately, unmeasurable a priori. The future is unknowable, and there is no discrete calculation available for potential future losses. Howard Marks explains the challenge well in a 2014 memo:
• Investing requires the taking of positions that will be affected by future developments.
• The existence of negative possibilities surrounding those future developments present risk.
• Intelligent investors pursue prospective returns that they think compensate them for bearing the risk of negative future developments.
• But future developments are unpredictable.
So how do we handle this? Through careful security selection and disciplined asset allocation, we build portfolios in which the possible loss incurred under unfavorable scenarios (even if unlikely) is far outweighed by the potential gain. No one can predict the future, but we want portfolios protected under all outcomes. We don’t know with any precision what the level of interest rates will be a year from now. But with history and experience as a guide, we can assume the level rates might be, measure the gain or loss under each case, and position the portfolio accordingly.
Historically low rates
We associate elevated valuations with higher risk. Today we are faced with unprecedented and highly unattractive valuations for bonds. Bond prices move inversely with rates; the lower the interest rates, the higher the price. Capital gains will follow if rates fall, but losses will mount quickly if rates rise. Fixed income portfolios have benefited greatly from a secular trend of falling rates for more than 30 years (see Figure 1). With rates now so low and near the once unthinkable zero bound, the amount bonds could appreciate under a falling rate scenario is limited. Even absent the 30-year decline, interest rates are significantly lower than in just the more recent past (see Figure 2). If rates were to rise, capital losses would likely wipe out much of the interest income bonds provide. We, like many other investors think there is a case for low rates to stay in place for some time. Expecting this base case does not mean rates won’t go up at all. The losses from only a 100 basis point (one percentage point) increase in rates would be material. Considering our framework of balancing risk and reward, exposing the safe part of portfolios to significant interest rate risk is unacceptable. The combination of limited capital gains and the potential for material capital losses, coupled with low interest payments will make reaching historical rates of returns unlikely.
Return expectations based on recent history are unreasonable
The leading index of intermediate corporate bonds generated a total return (income and capital gains) of nearly 6.3% a year over the last 10 years. That same index currently yields only 2.4%; to return 6% a year would require significant capital gains and rates to fall by over five percentage points. Is this possible? Corporate bond yields would have to reach negative 3%! This is highly unlikely and would be completely unsustainable. If corporate bonds fall to 0% (also unlikely, but possible) total returns would be nearly 4% annually, still a far cry from the 6% returns of recent past. That unfortunately is our best case outcome. If rates were to increase to the average rate of the last 10 years (roughly 4%), the total return would be approximately 1.6% per year, barely keeping up with inflation. To reiterate, expectations for future fixed income returns must be adjusted.
Chasing returns requires increasing risk
Reaching for potentially higher returns forces the need to extend duration, lower the credit quality of the portfolio, or increase equity allocations. The risk associated with these options is priced unattractively.
The longer the term of a bond, the more sensitive the value is to interest rate changes. We refer to duration as the measure of interest rate sensitivity. Extending duration involves buying bonds with maturities farther into the future. Longer term bonds generally carry higher interest rates than shorter issues. For example, a two-year U.S. government bond currently yields 0.8%, while the 10-year treasury yields 1.6%. Increasing duration adds to current interest income but carries a higher probability of capital loss if interest rates increase. The extra 0.8% in return earned through the term of the 10-year bond would be eliminated with a 100 basis point increase in rates. Should interest rates go back to the average experienced over the last ten years, a 10-year bond would lose over 12% in value, compared to a less than 1% loss in the two-year bond.
The U.S. government is broadly seen as the most credit worthy borrower in the world but isn’t the only investment option available. The debt of corporations with sound financials also makes for solid investments. Corporations do, however, run the gamut of credit worthiness. The highest rated bonds are termed investment grade. Lower quality credits are affectionately known as high yield (less affectionately known as junk bonds). The less certain investors are about the credit worthiness of the borrower, the more return they require to bear the potential risk the issuer defaults. The difference between the lowest risk bond (the treasury) and the higher risk (corporate and high yield) is called the spread. The lower the spread, the more expensive is the bond. Business and economic conditions play a role in the spread widening or narrowing. As conditions for each issuer deteriorates, the spreads widen to compensate investors for increased risk. Currently investment grade and high yield spreads sit on the lower end of recent historical precedent (see Figures 3 and 4). In other words, high yield bonds are expensive relative to safer credits than is typical. A return to only recent spread highs would result in a 15% loss for high yield bonds. Similarly, investment grade bonds would lose only 2% of their value. These losses would be in addition to the risk of any rate increases generally.
In fact, high yield bonds have only been more expensive in 15% of all other quarters going back 20 years. With secularly low rates, and cyclically low spreads, high yield bonds offer lit tle return relative to history, but carry the same default risk they have in the past.
Equity shareholders are subordinate to debt holders in the capital structure of corporations. If a company faces challenges in paying its obligations, the bond holders get paid first. This characteristic alone implies equity is a riskier investment than fixed income. We structure portfolios with a balance of equity and fixed income to ensure there is stability to provide for the cash requirements of each client. The greater the funding needs, and the shorter the investment horizon of the client, the lower the equity allocation. With low expected returns from bonds, some investors may consider increasing their equity allocations in an effort to increase short-term returns. Over long periods of time, equity outperforms fixed income but introduces a higher chance capital can be lost. These periods of equity market declines can be untenable and can last for years at a time. Over the last 40 years, the S&P 500 had an average annual total return of 12.4% versus 8.2% for the corporate bond index.
The downside of course is that in one of those years, equity markets experienced a loss of 36%, while the worst year for corporate bonds was down 8.3%. With equity market valuations extended historically, adding equity above strategic asset allocation targets does not adequately compensate for the additional risk.
What are we doing about it
In investing, the critical decisions are never easy. As Rob Arnott put it, “what is comfortable is rarely profitable.” With today’s unusually low rates, fixed income offers lower returns than we are used to, and accepting lower returns in the short-term certainly isn’t comfortable. But taking losses in the safe part of the portfolio will feel even worse should rates normalize. Increasing the probability of loss is currently not commensurate with the extra return available in today’s markets. Consequently, we are keeping durations short and credit quality high. This strategy keeps portfolios secure and provides the flexibility to reinvest at more attractive rates when interest rates increase. This might disappoint a short-term investor who is concerned only about next year’s returns, but should please an investor that is seeking to grow wealth and to enjoy higher returns over the long-term.
The Back Page
If you are charitably inclined, you may find yourself writing many small checks each year to your favorite charities. Writing a check may be simple, but a private foundation or donor advised fund may be a better way to take control of your charitable legacy and maximize the effect of your charitable intentions. Each of these techniques enables you to:
• Establish a long-term charitable giving program that can be integrated with your income and estate tax planning.
• Make a large donation and receive an income tax charitable deduction in the same year, while spreading the gifts to charities over time (subject to limitations).
• Create a charitable legacy that can continue its work long after you are gone. Although they have similar benefits, there are some key differences between these two tools that will help determine whether either would be a good fit for your charitable goals.
A private foundation gives you more operational control than a donor advised fund. You can choose to organize it as a trust or nonprofit corporation, decide how it will be governed and, most importantly, set the parameters of its charitable mission. A private foundation makes grants to public charities of at least 5% of its assets each year.
In exchange for this level of control, there are some disadvantages. You will need to spend some of the funds set ting up the entity and applying for tax-exempt status, and will incur ongoing administrative costs (such as preparing and filing tax returns). As a result, it may not be worth creating a private foundation unless you plan to make a substantial contribution to it. Another disadvantage is that your income tax deduction is limited to 30% of your adjusted gross income for gifts of cash and 20% of adjusted gross income for capital gain proper ty. Any excess contributions may be carried forward for five years, but if you die with any unused excess contribution, the deduction for those contributions is lost. Finally, the IRS imposes more stringent restrictions on the operation of a private foundation than on a public charity. You must follow the IRS rules carefully in order to maintain tax-exempt status and avoid paying harsh penalties. Furthermore, the IRS requires annual reporting of detailed information that becomes public and is readily available on the Internet.
Donor Advised Fund
A donor advised fund is similar to a private foundation in that its sole activity consists of making grants to qualified charities. A donor advised fund is more economical for smaller gifts. The account can be opened simply by opening an account at a sponsoring financial institution and does not require you to incur legal or accounting fees. Contributions are treated like gifts to a public charity. The financial institution takes care of the ongoing administrative requirements and, in exchange, charges your account a fee.
You can determine the amount of publicity that you receive with a donor-advised fund. The fund can be named for you or your family or you can remain completely anonymous. A contribution to a donor-advised fund is deductible for income tax purposes up to a limit of 50% of adjusted gross income (AGI) for gifts of cash and 30% of AGI for capital gain property, just like a gift to a public charity. Any deduction not used may be carried forward for five years.
A donor advised fund does not provide you with as much control over the funds as a private foundation. The donor, or a person designated by the donor, may recommend grants to public charities but any grant request is reviewed by an advisory committee and may be denied. If no grants are recommended within a certain period of time, the financial institution may make a distribution for you. You may also have more limited investment choices set by the institution.
Which option is right for you? In most cases, it will depend on your specific goals and needs. If you are considering a sizable charitable gift, you may want to consider a lasting, structured gift using a private foundation or donor advised fund. You may find that planned giving can be a more satisfying experience than check-writing and can ensure that you maximize your tax benefits and foster a legacy of your own design. If you would like more detailed information about these techniques, please contact your Boston Financial Management advisor.
Important: This article does not contain any legal or tax advice. You should always consult with your attorney, accountant or other professional advisors before changing or implementing any tax, investment or estate planning strategy.
IRS Circular 230 Disclosure: Pursuant to IRS Regulations, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.