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Investing Blog Roundup: William Bernstein on Fixed Income

This week I enjoyed watching a brief interview of William Bernstein, by Christine Benz of Morningstar. In the interview, they discussed a handful of fixed-income related topics from what type of bonds Bernstein recommends, to what to do about low interest rates, to the usefulness of delaying Social Security as an alternative to purchasing an annuity.

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How Does Human Capital Affect Asset Allocation?

One of the major trends in finance in recent years is the increasing popularity of the “human capital” concept. In case you’re not familiar with the idea, your human capital is defined as the value (as measured today) of all of your future earnings from work.

In short, the ramifications are that:

  1. Over time, you must accumulate financial capital in order to make up for the fact that your human capital is being depleted as you move toward retirement (at which point it will be mostly, or entirely, depleted), and
  2. When considering how much risk to take on in your portfolio, you should consider how much risk you’re already taking on via your human capital.

How About a Few Examples?

Janelle is 24 years old, and she is employed by the federal government in a position with a great deal of job stability. In other words, she has a great deal of human capital (because she’s young, with many years of work ahead of her), and it is very low-risk. As a result, Janelle can afford to take on a good deal of risk with her portfolio.

Geoffrey is 28, and he’s self-employed in a business with an unpredictable income. Because Geoffrey’s overall economic picture is dominated by a large amount of high-risk human capital, he should probably take on very little risk with his portfolio.

Beth is 68 years old and retired, with no intention of going back to work. At this point, her human capital is depleted. Beth can afford to take on a moderate amount of risk with her portfolio.

(Important caveat: All of the above examples are extreme simplifications, ignoring numerous other factors that would typically affect a person’s risk tolerance.)

Human Capital and Investing Guidelines

Most often, when I see human capital brought up in a book or article, it’s as a rationale for why most investors should shift toward more conservative allocations as they age. The idea is that most people’s human capital is bond-like (because most people’s income is relatively stable), so as their bond-like human capital decreases, they should increase the allocation to bonds within their portfolio.

That’s fine, as broadly-applicable guidelines go. But I think the more useful application of the human capital concept is to use it as a tool for contrasting different people’s economic situations and considering how they should tailor their portfolios accordingly. If your human capital is high-risk, it’s not particularly relevant that most people’s human capital provides a nice, safe, bond-like income.

The common sense takeaway: The riskier your job, the less risk you should take on in your portfolio.

Taxes on Bonds and Bond Funds

A reader writes in with a question about taxes on bond funds:

“When I own a Treasury bond fund, I’m guessing I would be paying taxes on the interest through the term of the bond. When I sell, would there be additional tax consequences?

I get that other types of investments — stocks for example — have price changes that affect the tax consequences when I sell. But a Treasury bond would only have interest, right? No gains/losses, because it pays at a fixed rate?”

Before discussing how a bond mutual fund is taxed, it’s probably easier to back up a step and discuss the tax treatment of an individual bond.

If you buy a bond for when it’s originally issued, and you hold the bond until it matures, yes, you would only have to pay taxes on the interest along the way.

However, if you buy a bond and sell it prior to its maturity date, you would probably have either a capital gain or a capital loss, because the sale price would almost certainly be either higher or lower than what you paid for it. (Because, as we’ve discussed here before, bond prices move up and down in the opposite direction of market interest rates.)

If the bond is sold for a capital gain, it would work the same as selling a stock for a capital gain. That is, if you had held the bond for one year or less, it would be a short-term capital gain, taxed at your ordinary income tax rate. If you had held the bond for greater than one year, it would be a long-term capital gain, taxed at a maximum rate of 15%.

Taxes on Bond Funds

Owning a bond mutual fund works a bit differently. Each year, shareholders of mutual funds are responsible for paying taxes on:

  1. Their share of the interest and dividends earned by the fund’s holdings, and
  2. Their share of any net capital gains realized within the fund’s portfolio (that is, gains that occur when the fund sells investments within its portfolio for an amount greater than what it paid for them).

In other words, with mutual funds (including bond funds), you often have to pay capital gains taxes even while you still hold the fund.

Finally, when you do sell the fund, there will typically be a capital gain or loss on that transaction, calculated just like you’d expect: proceeds from the sale, minus your cost basis in the mutual fund shares that you sold.

Important note: Your cost basis includes not only the amount you paid for the initial fund shares you purchased, but also any dividend/gain distributions that you chose to reinvest in order to purchase additional shares.

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Investing Blog Roundup: Can Your Stock Portfolio Be Too Diversified?

Despite the fact that I don’t link to it terribly often (because most Oblivious Investor readers are in the U.S.), Canadian Couch Potato is one of my favorite investing blogs. This week, the author (Dan Bortolotti) tackled a question that comes up fairly often with new investors:

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Picking Bonds Based on Performance and Yield

Two readers recently wrote in with similar questions about selecting the type(s) of bonds to use for the bond portion of your portfolio.

Long-Term vs. Short-Term Bonds

Reader #1 asks:

“As of today, Vanguard’s Treasury bond funds have the following performance figures:

  • Vanguard Long Term Treasury: 1-year return = 31.6%, 10-year average annual return = 9.08%
  • Vanguard Intermediate Term Treasury:  1-year return = 8.7%, 10-year average annual return = 6.2%
  • Vanguard Short Term Treasury: 1-year return = 1.45%, 10-year average annual return = 3.54%.

Based on that information, why isn’t everyone buying long term Treasury funds?”

Bond prices and market interest rates are inversely related. When one goes up, the other goes down. And that makes perfect sense if you consider an example.

Arthur buys a 10-year Treasury bond paying 2% interest. Five years later (when his Treasury bond is now effectively a 5-year bond), market interest rates have risen, and new 5-year Treasury bonds are yielding 3%. The result: Because of the rise in rates, nobody would be willing to buy Arthur’s 2% bond unless he offers to sell it at a discount. (That is, interest rates have gone up, so the price of his bond has gone down.)

And the longer a bond’s duration, the more severely its price will change as a result of market interest rate changes. Specifically, the size of the price change will be approximately equal to the change in interest rates, multiplied by the bond’s duration. So, for example, a bond with a 5-year duration would lose approximately 5% of its price if the applicable market interest rate increased by 1%.

In other words, the reason that long-term bond funds currently have higher past performance records than shorter-term bond funds is simply that:

  1. They have a longer duration, and
  2. Interest rates have been falling fairly steadily over the last few years (thereby pushing bond prices up, with the prices of longer-term bonds going up the most).

As far as the question of “why doesn’t everybody buy the long-term fund,” the answer is simply that the opposite phenomenon can happen as well. That is, in a rising-rate environment, bond prices fall, and it would be the longer-term bonds whose prices would fall most severely.

Nominal Treasuries or TIPS?

Reader #2 writes in asking:

“Currently all TIPS with a maturity of less than 20 years have a negative yield. And even with 20-year TIPS the yield is just 0.09%. In contrast, 20-year normal Treasuries currently yield 2.28%. Even a 3 month normal Treasury (yield = 0.10%) beats a 20-year TIPS. I don’t understand why experts still talk about TIPS as a useful tool when normal Treasury bonds look so much better.”

What makes TIPS unique is that their principal adjusts upward with inflation, and their interest payments are based on the inflation-adjusted principal. In contrast, both the principal and interest payments on nominal Treasury bonds are fixed. As a result, comparing the yield on TIPS to the yield on nominal bonds does not tell you which one will actually earn a greater return.

For example, when we see that a 20-year TIPS has a yield of 0.09%, we know that (as measured in nominal dollars), its return will be 0.09%, plus any inflation that occurs over the 20 years. So by comparing that to a nominal 20-year Treasury with a 2.28% yield, we can see that if inflation is more than 2.19% per year (that is, 2.28%, minus 0.09%), the TIPS will provide a greater return. (And conversely, if inflation is less than 2.19%, the nominal Treasury bond will provide a greater return.)

So the answer to the question of why anybody would use TIPS is simply that many people are worried about the possibility of inflation that’s greater than the difference between nominal Treasury yields and TIPS yields.

Why Annuitizing Reduces Risk

In Friday’s roundup I briefly mentioned that annuitizing part of a retirement portfolio not only reduces the probability of running out of money, but also makes the oops-I-ran-out-of-money scenario not nearly as bad. Several readers asked how both of those things work.

Reducing Portfolio-Depletion Probability

The reason that inflation-adjusted lifetime annuities reduce the risk of portfolio depletion is that they provide a higher payout rate than you can safely take from a stock/bond portfolio. For example, even with today’s super-low interest rates, a 65-year-old female can purchase an inflation-adjusted lifetime annuity with a 4.4% payout.

To see the impact annuitizing would have, let’s look at an example.

Susie is 65 years old and recently retired with a $400,000 portfolio. She expects to need $30,000 of income per year in retirement, and her annual Social Security benefit will be $14,000. In other words, she hopes to spend $16,000 per year from her $400,000 portfolio.

If Susie does not annuitize any of her portfolio, she’d have to use a 4% withdrawal rate ($16,000 ÷ $400,000) to provide the desired level of income.

If Susie uses half of her portfolio ($200,000) to purchase a single premium immediate inflation-adjusted lifetime annuity, the annuity (given a 4.4% payout) would provide  $8,800 of income per year. As a result, she would only need another $7,200 of income from the non-annuitized part of her portfolio. That works out to a 3.6% withdrawal rate.

Naturally, Susie is less likely to deplete her portfolio with a 3.6% withdrawal rate than with a 4% withdrawal rate.

Improving the Worst-Case Scenario

And possibly even more importantly, if Susie does end up depleting her portfolio, she’ll be left with an income of $22,800 per year ($14,000 Social Security + $8,800 from the annuity) rather than the $14,000 per year she’d be left with if she didn’t annuitize any of her portfolio.

Don’t Forget About Delaying Social Security

As we’ve discussed before, delaying Social Security benefits is economically equivalent to purchasing an inflation-adjusted lifetime annuity — one with lower credit risk and a higher payout than you can get from an insurance company.

For example, for somebody with a “full retirement age” of 66, if your Social Security benefit would be $18,000 per year at age 62, it would be approximately $31,680 per year if you waited until age 70. By giving up eight years of $18,000 in benefits, you’ve effectively spent $144,000 ($18,000 x 8) to purchase $13,680 ($31,680 — $18,000) of annual inflation-adjusted income. That’s much higher than the 4-5% payout you can get from an inflation-adjusted annuity.

In other words, delaying Social Security has the same two risk-reducing effects as annuitizing part of your portfolio (i.e., reducing the probability of depleting your portfolio and protecting you somewhat in the event that you do deplete your portfolio), and on a per-dollar-spent basis, it provides more of those risk reductions than an annuity from an insurance company would.

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