An argument for reducing your reliance on bonds to fund retirement.
Bond Investing is not the same anymore. What used to be considered "routine" in the bond market now comes with a lot of caution flags:
* Buying AAA-rated munis?
Can you trust the rating agencies? If not, is the issuer healthy?
* Bonds backed by mortgages?
Will the underlying mortgages survive or go belly-up?
* Newfangled cash substitutes?
Are they as liquid as you think they are?
* Flock to CDs for safety?
Is the underlying bank in good financial shape?
(if not, will the FDIC have to recover your money for you?)
* Fixed Income hedge funds?
Do you really know what is inside that fancy "Limited Partnership?"
* Energy and food prices are up.
How will higher inflation impact your bond investments?
If you believe as we at Emerald do that inflation is a real threat to your long-term wealth growth plans, it follows that bond investing will be a whole new ball game going forward. A very different outlook is needed for the investor and his advisor. Why is this? A quick review of history and investment basics will explain.
For over a quarter-century now, interest rates have been falling. High-quality bonds prices do not behave like stock prices. Stock prices are determined by everything from how profitable a company is, to what news events the company releases, to the desire of buyer and sellers (regardless of what the actual news is on the company). High-quality bonds are different. Their prices are determined largely by interest movements.
Interest rates can change due to a number of factors that are fundamentally-based. But while a stock can go up or down regardless of the actual news (due to buying and selling forces of the market), bonds are more about mathematics. If interest rates go way down, bond prices are going to go up. Not maybe, not probably. They WILL go up.
This is what happened throughout most of the 1980's and 1990's with only temporary breaks such as in 1994 when the Fed raised interest rates seven times. If you were a bond manager in the last two decades, life was sweet. Your track record makes you look like a genius. In fact, it was actually the greatest bond bull market in modern history that made most bond managers appear heroic. Now that signs are growing that this party is over, it will hit many investors with a shock that will rival that experienced when the Tech stock bubble popped.
I still think that the shock of seeing your high-quality bonds drop in value is a bigger emotional issue for most people than seeing stocks plunge. Most investors realize that the stock market can be volatile. They don't necessarily realize that bonds can lose a lot of value, too.
Retirees need a financial life preserver
Even if rates don't go up, many "high quality" fixed income securities (such as CD's, Treasuries, and Agencies) may have a NEGATIVE real return for the first time in a long time. That is, they yield less than your inflation rate. The interest rate you earn is less than the rate at which your cost of living is goes up. That is a problem for retirees on a fixed income, and for future retirees who are preparing their portfolios to generate the cash flow they will eventually need.
At Emerald, we have long been dissatisfied with many of the traditional solutions for retirement, which is why we have developed over the years an alternative approach to solving the problem. We certainly hope that our industry will continue to innovate to offer more than yesterday's solutions to a very unique issue that now faces the Baby Boom generation.
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EMERALD ALLOCATION STRATEGIES PORTFOLIO UPDATE
We bought REITs two months ago with an 18-36 month outlook. However, the dramatic rise in interest rates has changed the outlook for this sector and we have a 5% loss on the position. At the same time, REITs are trading in tandem with the S&P 500 so their low correlation quality is not currently showing itself. We own fixed income short positions in Hybrid, so we have a concern that further weakness in REITs will drag the gains we expect there. Recently, given the frenetic market environment, we felt it was more prudent to sell the position out and reevaluate it later this year. For taxable accounts, this has the added benefit of harvesting a tax loss.
The preceding article is not a complete analysis and should not be considered investment advice. Emerald Asset Advisors, LLC is a registered investment advisor. If you would like to receive more information about Emerald, please contact us for a copy of our disclosure document, Form ADV Part 2 and Schedule F.
(c) Emerald Asset Advisors
www.emerald-eas.com
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