The case for passive investing is a compelling one.  Year after year we hear stock pickers say the same thing, which is “now is the time for active management”.  Yet year after year the data becomes more compelling that stock picking is not a reasonable way to expect to outperform the broad markets.  Standard & Poor’s (S&P) produces a semi-annual report that measures the performance of active mutual funds versus the S&P indices.  The report is known as the SPIVA report.  Each year the data shows approximately 90% of active stock pickers fail to beat their underlying benchmark.  This is true across all market caps.   Additionally, S&P produces a persistency scorecard that looks at the success of the few active managers that have outperformed their benchmarks.  Unfortunately, only a small fraction will continue to do so for just a few years. 

This information tells us that in general, the average investor is far better off gaining exposure to the broad markets with the use of traditional index funds and ETF’s.   They are less expensive, more tax efficient, and the probability of outperforming a benchmark is quite low.   So since the data is so compelling, is it as simple as Archie Bunker used to say, “Case Closed”, or is there a better way? 

The answer is a resounding, Maybe!

There seem to be two possible paths that can lead to higher longer term performance, although both will incur slightly higher costs to implement.   These two options are the Equal Weight approach, the other is the Dividend Aristocrat approach. 

Equal Weight Indexing

The majority of traditional broad market indices use a cap weighting approach.  This means that the companies that make up the largest market capitalization are the ones that make up the largest share of the index.  Market cap is the determined by multiplying the number of shares by the price of the stock.   So by definition, using this method will always mean that you are allocating more resources to securities that have already appreciated the most.  This may mean that you are buying more of the stocks that are theoretically overvalued.   

An equally weighted index uses the same exact companies, but simply disperses the dollars in equivalent proportion to each area of the market.  So rather than own more of Apple or Google than you might own of Home Depot, you would own an equal portion of both.  This would imply that you are putting more money in companies that theoretically have more room to grow, and less money in companies that may already be a bit expensive.   There is some evidence that supports this in the long run. 

As an example, looking at the S&P 500 Index through December 31^st of 2018, the 10 year returns were as follows:

S&P 500 Index                  13.12%

S&P 500 Equal Weight   14.95%

The challenge facing the equal weighted approach is the volatility.  Using this equally weighted approach, you would have seen the Beta, which is a measure of volatility increase from 1.00 to 1.02 and the 10 year standard deviation of the portfolio increase from 13.60 to 15.65. 

What this demonstrates is that the equal weighting worked, if you were willing to take on the greater volatility to achieve the higher result.

Dividend Aristocrats

Another plausible approach is the use of the Dividend Aristocrat strategy.   Using this approach, a particular index is again equally weighted, but then is also screened for companies that have a track record of not only paying dividends, but consistently increasing dividends for a stated duration of time.  There are numerous indices that screen for this or some hybrid of this strategy.    One example is the S&P 500 Dividend Aristocrat approach, which is designed to incorporate only companies that have consistently increased their dividends every single year for at least 25 years. 

Looking at a similar 10 year time frame for the period ending December 31^st 2018, the results are as follows:

S&P 500 Index           13.12%  

S&P 500 Aristocrats  14.63%

While we see outperformance in the Aristocrat approach, we arrive there in a different way.  In this case, the difference is from less volatility.   The Beta on the S&P 500 Aristocrat’s was reduced from 1.00 to 0.82, while the standard deviation declined from 13.60 to 13.28.

What we see is a track record of outperformance from both approaches.  Yet they arrive there with different methods.  The Equal Weight approach does so by lowering market capitalization and increasing risk, and the Aristocrats do so by concentrating on companies that demonstrate consistency which theoretically lowers risk.  

So which is the better strategy?

The answer is not so simple.  There is no guarantee that this track record of outperformance will continue.  The investor looking for longer term growth may be more inclined to seek the historically higher return coupled with the higher volatility.  It could also be argued that they could simply increase their weighting to small-cap and mid-cap stocks to have achieved a similar result.

The investor that is retired or closing in on retirement who may be more likely to be dependent on income may wish to utilize the historically lower volatility Aristocrat approach.

Perhaps the best answer is a combination of the two approaches.  Ultimately, the answer is likely investor specific as with any investment strategy.  

It is also important to note that the cost of utilizing such strategies will not only typically involve higher expense ratios.  In addition, because these market indices maintain an equal weighting, they tend to rebalance more frequently, which runs the risk of a slightly less tax efficient result due to the higher turnover.   It is important to consult with your financial advisor to see how such an approach might benefit you.

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Real Estate Investment Trusts (REITs) are an asset category with a long history of solid investment returns that do not always demonstrate a direct correlation to the rest of the investment universe.   They have served as an excellent diversifier when combined with other traditional investments.

REIT’s are companies that own or finance properties that produce an income.  These properties can range from commercial real estate across many industries such as manufacturing locations, residential real estate rentals, hospitals, office parks, storage parks and strip malls, etc.    Most REITs function in a relatively simple to understand manner.   The cash flow from the rented properties pass thru to the owners of the REIT, which can be anyone who wishes to invest.  They are organized under a tax code that requires that they distribute at least 90% of their taxable income to the shareholders as dividend income.  As a result, REITs typically produce a dividend income stream that is favorable when compared to many other investment options.

There are several types of REITs, such as;

Equity REITs: which own properties directly to realize the rental cash flow.

Mortgage REITs: which aid in the financing of these properties by issuing loans, or purchasing loans on properties to realize the cash flow from the mortgage payment.

However, a more important distinction is the difference between publicly traded REIT’s and private REIT’s.

Public REITs are investments that must be registered with the Securities Exchange Commission, and comply with various reporting requirements such as filing a public quarterly report in order to provide transparency.   Many of these public REITs are some very well know names with brand recognition such as Public Storage or Simon properties.  There are also many public REITs that are not as well known to the general non-investing public.

Because these investments trade on a public exchange, they are highly liquid and can be sold daily during normal trading hours.   As an investor you can assess the value of your holding in a highly efficient market daily.  It is not uncommon to find dividend yields in this asset class of 4%-6% annually.

Private REITs are investments that are not subject to the same reporting requirements, and are only required to file their initial public offering with the Securities Exchange Commission.  As a result of the reduced compliance and regulatory burden, it is not unusual to find higher dividend cash flows associated with the private investments than can commonly be close to an 8% annual dividend yield.

However, there is often a significant upfront cost usually used to compensate the selling agent and the firm distributing the shares publicly, which can be as much as 10%, and sometimes more.  The larger concern is that of liquidity.   Due to the fact that these securities do not trade on a public exchange, trying to assess their day to day value is often quite difficult.   So while an investor may not feel that they are experiencing the daily fluctuations associated with the stock market in which public investments trade, their asset values are still changing daily.  This is somewhat analogous to being asked what the value of your home would be on a specific day.  You may be able to give a good estimate based on your knowledge of the community, but the true value cannot be determined until you find a willing buyer.

Publicly traded financial markets not only help us understand the value of our investments instantly by constantly matching buyers and sellers, a process known in economics as price discovery.   They also produce a high degree of liquidity by bringing many investors together in one location   One of the larger challenges with private REITs is that they offer no such regular price discovery after they have been issued, and therefore liquidity can be a significant concern.

It is not uncommon for private REITs to place many restrictions on the redemption and liquidation of these assets.   In some cases an investor must wait for a year or two before they can take any redemptions at all.  It is also common that investors can be restricted to taking redemptions at specific points, such as quarterly or annually.  These redemptions are often offered at no more than the original offering or less.  There have also been cases in which investors have been told that redemptions are totally suspended, and they can withdraw nothing until notified otherwise.   These types of restrictions are perfectly legal in a private security.

This is not to suggest that all private REITs perform poorly.  Some have done quite well.   However, investors looking to invest in such securities should be well aware of the potential lack of liquidity.  They should also be sure to do their research on the management team and the properties being purchased.  Such investments require enhanced due diligence without a relatively efficient public market that should already reflect all available information in the price.

Investors that are averse to having their funds tied up for an unknown duration of time should look to the public market for such investments.  In doing so, there is still a degree of due diligence that must be done when buying an individual public REIT to insure that the company meets with your risk tolerance.  Investors concerned with diversity to minimize this risk can invest directly into a mutual fund or an exchange traded fund that tracks the REIT marketplace.

As an example, the FTSE Nareit Index of REITs is comprised of more than 160 holdings primarily in the US marketplace.   The FTSE EPRA Nareit Global Index of REITs is a market index that is made up of over 290 holdings globally, with approximately 40% of them outside the United States.   These market benchmarks or similar benchmarks can be acquired through various investment funds that offer exposure to a marketplace of REITs with quite a bit of diversity, and significant liquidity at a very nominal cost.

Each individual has their own set of unique financial circumstances that may or may not benefit from different investment vehicles.  As with any investment product, it is advisable that you consult with your financial planner or investment professional in order to complete the proper due-diligence before investing in REITs, or any other investment vehicle.

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Those of us that lived through the financial crisis of 2008 as active investors remember it quite well.  Many who never invested at all may still remember it rather vividly.  What often gets overlooked is how quickly financial markets recovered in terms of asset prices.

In the aftermath of the financial crisis, the US economy began an incredible period of consecutive years without a recession.   A recession is defined at two or more quarters in which the Gross Domestic Product (GDP) contracted.  As of October 2018, the US has officially been out of a recession since June of 2009, a period of more than 10 years.    However, real GDP (GDP adjusted for inflation) has not exceeded 3% annualized since 2005.   The economic recovery has been relatively anemic by historical standards.   Only recently has there been any significant increase in capital expenditures as it relates to business investment among the nation’s top companies, which was up 39% in the first quarter of 2018 according a report published by the Tax Foundation.  So it’s certainly understandable why some may still feel as though the effects of the financial crisis continue to linger.

But what about your investment portfolio?

If you have 401k, IRA, personal investment account, or even a pension plan (which is supported by financial investments) the story is a bit different.    A closer look at various asset classes tells a story of a much quicker recovery in many areas of the financial markets.   Imagine you had the misfortune of beginning to make your first investment in September of 2007.   That was the very early stages of the financial crisis.   After significant immediate declines in asset prices, where would you be by September of 2017, precisely 10 years later?  Below is a list of various key asset classes and the average performance they produced over this time period.

Asset Class                           Average Annual Rate of Return

S&P 500 Index                                       7.20%

Ten Year US Treasury Bond          4.60%

Gold                                                              5.70%

Cash (3 Month T-Bill)                         0.40%

CPI (Inflation Index)                           1.70%

FHFA Home Price Index                  1.00%

Crude Futures Index (Oil Prices) -4.30%

As we look at the various different asset classes, we can see that even after suffering the catastrophic losses seen in 2008 into early 2009, the US stock market was still the number one performer on a total return basis 10 years later.

The first lesson to be learned is that one should never get too caught up in the emotions of what seems like a financial catastrophe.  The losses at the time were steep, with the S&P 500 falling by a staggering -49% at its lowest point of 2008, only to close the year with a -37.16% decline.  Then there was another -28% decline early in 2009 before turning positive for the year.   At the worst point during this decline, there was utter panic among many investors, and the media was more than content to help foster that panic in a quest to advance ratings.   It seemed as though it was the end of the world for investors everywhere.   Of course, it wasn’t the end of the world, nor was it the end of investing.

What a look back in the rear view mirror tells us as investors is that markets always recover in time, and given enough years, the stock market is typically the long term winner as it relates to performance.   This is not to discount the importance of other asset classes, including those referenced above.  Investing with a concentration in any one asset class is typically unwise, and any one stock even more foolish.   An investment portfolio should be well diversified, and maintain an allocation to various asset classes in proportion to the risk level that is appropriate for the individual.  That will be different from investor to investor, depending on numerous variables such as age, income need, and the timeframe to a specific goal.

However, what is important is that once an appropriate allocation of risk is developed, an investor must have the discipline to weather the storm of the next recession and market downturn.   These periods of downturns in the market are inevitable and expected to the seasoned investor.  As we see from the above referenced data, even the worst of downturns has ultimately not changed the end result.  Those who consider themselves to be a novice or relatively new to investing should remember that when the next market correction comes along with the next recession, there will be a few key phrases you’ll hear when you turn on the news channels.  They’ll tell you “This time it’s different”, or “We have never seen anything like this before”.

Perhaps it will be different.  In fact it likely will be, as each recession is unique in some way.  However, none of this should deter you from sticking to a soundly diversified investment portfolio, as that is an excellent way to outpace inflation and generate wealth for your future, and the future of your family.

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Russell Investments 2018 Q4 Executive Summary

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Insurance coverage is a vital part of financial planning.  When most people think of insurance they envision life insurance, auto coverage, homeowners or even in some cases long term care coverage.   However, one of the most overlooked and reasonably inexpensive insurance is that of umbrella insurance.

An umbrella policy is a form of insurance that is designed to cover excess liability over and above the policy limits of a traditional insurance policy.  When an insured individual is held liable, the initial insurance policy would serve as the primary coverage.  Should the liability exceed those limits, the umbrella coverage would then activate to cover the additional liability.

In most cases the umbrella coverage is there to essentially backstop either your homeowners insurance or your auto coverage, as those are the primary policies which shield you from personal liability.

Many people may not have thought about the need for such coverage, while others may have considered it and then dismissed it.   It is important to consider the many circumstances in which such a liability may occur.    As an example, you may be an extremely responsible individual who has never been held liable for anything in the past.   However, accidents can and do happen.   What happens if you have an auto accident and killed or permanently maimed a young surgeon that just completed medical school who happens to be married with several children?   One of the things that can and likely will be considered is the lost earning power of the individual, and the impact to his family.    Many auto policies only carry 300k-500k dollars in liability coverage.  In such a scenario, if you are sued above your policy limits, your personal assets may be in jeopardy.

Perhaps you are someone who is so confident in your ability to avoid an accident, you still choose to dismiss such coverage.   But what happens when your spouse, or even your teenage children are behind the wheel of a vehicle?  If that child or spouse is in a similar circumstance, their liability will become your liability.

Although more than 80% of umbrella policy claims paid tend to be related to auto incidents, not every liability has to occur behind the wheel of a vehicle.   In some cases you can experience significant liability in your own home.  A delivery man can slip on the walk way to your front door and opt to take legal action for a fall he sustained.  Possibly your dog could have bitten a neighbor.   Or one of your children had a friend over the house for a swim, and they accidently drowned in the pool.

While none of these are pleasant thoughts, and some are downright horrific, that is the nature of insurance.   It exists to make us “whole” in a financial sense in the face of an unpredictable event.   The types of events that trigger such liabilities are never pleasant experiences.

The possible list of liabilities that exist are endless.  Fortunately the cost of an umbrella policy is typically fairly reasonable, and among the less expensive policy premiums paid throughout the year.  It is not uncommon for an umbrella policy to be issued for just $300-$400 a year for as much a $1 million in excess liability coverage.   Policy premiums can be affected by a number of variables, such as where you live, how many drivers live there, and your prior history.

In some cases if the increased insurance premium is problematic, it might be wise to raise your deductible on your basic policies to help offset the additional policy premiums.

The amount of coverage necessary depends on various factors.   How much you earn is a consideration.  Also, what your net worth is would be a significant variable in determining coverage.  In some cases a 1 million dollar policy may be more than sufficient.  In other cases it may be prudent to take on significantly more coverage.

It is also important to note that an umbrella policy is typically not going to cover you for any liability incurred in the course of conducting your work.  These policies that are issued to insure personal liability will not cover you for a commercial liability, and should not be viewed as a substitute for commercial insurance.

It is generally wise to consult with your financial advisor as well as your property and casualty insurance agent to discuss the adequate amount of coverage that is suitable.

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https://landmarkwealthmgmt.com/wp-content/uploads/2018/07/Russell-Investments-Q3-2018-executive-summary.pdf

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https://landmarkwealthmgmt.com/wp-content/uploads/2018/07/Morningstar-Market-Outlook-for-3Q-2018.pdf

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In late 2017 congress finalized the Tax Cuts and Jobs Act (TCJA) which was effective beginning in January 2018.   There were a number of changes to both corporate and personal income tax rules.  A number of these tax laws have a sunset provision that is due to expire beginning 2026.  Let’s take a look at a summary of the changes related to individual tax law changes.

Individual Marginal Tax Rates

The individual marginal tax brackets were seven separate brackets which were progressive in how they were applied ranging from 10% to 39.6%.  Beginning in 2018, there are now seven brackets ranging from 10%, 12%, 22%, 24%, 32%, 35% & 37%, which are still applied progressively.   However, there are a number of changes in how those brackets will be applied and at what income thresholds.  In some cases, this can result in higher wage earners reaching a higher marginal bracket much faster due to their single filing status.

As an example, in 2017 all taxpayers (other than those filing “Married Filing Separately”) became subject to the 35% bracket at the same level of taxable income ($416,700).  Beginning in 2018, the 2^nd  highest bracket may now apply based upon filing status.  In 2018, unmarried taxpayers will have the same 35% bracket apply once taxable income exceeds just $200,000 rather than what was $416,700.   Yet, joint filers will have the 35% bracket apply at a reduced level of $400,000 and married separate filers will have the 35% bracket apply once taxable income exceeds $200,000.

Trusts and Estates

Beginning in 2018, trusts and estate tax rates will be subject to four tax brackets (10%, 24%, 35% and 37%) with the highest bracket applying for 2018 to taxable income in excess of just $12,500.

Capital Gains

The tax rates on capital gains remained unchanged with the thresholds for capital gains now being applied based on the following income tiers.

Rate                              Single                   Married Joint         Head of Household  Trust & Estates

Standard Deduction

One of the biggest changes relating to the TCJA is the increased standard deduction.  As a result of this new standard deduction, many more Americans, particularly those with little debt will no longer need or want to itemize their deductions.  The new base standard deduction is $24,000 for married taxpayers filing joint returns, $18,000 for taxpayers filing as Head of Household and $12,000 for all other taxpayers for 2018.   Married couples over age 65 will receive an additional $1,300 each.   Single filers over age 65 receive an additional $1,600.   This deduction will also be adjusted for inflation after 2018.    It should be noted that along with this increased standard deduction, the personal exemption is suspended until the year 2026.

Alternative Minimum Tax

The often dreaded AMT was NOT eliminated by the TCJA.   However, there were some changes pertaining to the AMT.  Beginning in 2018, the exemption amounts have been increased to $109,400 for joint filers ($54,700 for separate filers), $70,300 for unmarried taxpayers and $24,600 for estates and trusts.

Itemized Deductions

Beginning in 2018, for those who continue to itemize their deductions, a number of itemized deductions have been eliminated:

1. All expenses related to tax return preparation;
2. All unreimbursed employee business expenses;
3. Appraisal fees for charitable contributions;
4. Investment expenses;
5. Union dues.

 Qualified Residence Interest (Mortgage Interest & Home Equity Loans)

Prior to 2018, the deduction for Qualified Residence Interest was limited to interest paid on up to $1,000,000 of borrowing that qualified as “Acquisition Indebtedness” (Mortgages up to 1 million) and up to $100,000 of borrowing that qualified as “Home Equity Indebtedness” (Home Equity Loans).

Prior to 2018, Acquisition Indebtedness was defined as debt incurred to acquire, construct or substantially improve a principal residence or a second home.

Home Equity Indebtedness included any borrowing secured by a principal residence or second home, with no restriction as to the use.

Beginning in 2018, the amount of eligible Acquisition Indebtedness borrowing is reduced to $750,000 for any debt incurred on or after December 15, 2017.

So moving forward in order for mortgage interest to remain deductible, the mortgage cannot exceed the cap of $750,000.   There was some confusion around the use of home equity loans as a deduction, as the tax law eliminated the deduction of Home Equity Indebtedness.   However, The IRS, in early 2018, issued an Information Release to clarify the difference between the Internal Revenue Code definition of Home Equity Indebtedness and the use of the term “Home Equity” by banks in describing or naming the loans they are making. The release made it clear that regardless of what terminology a bank uses to describe a loan, if it is used for “acquisition, construction or substantial improvement” then it can qualify as Acquisition Indebtedness (subject to the dollar limitations).  Essentially, this means that home equity interest payments remain deductible in many cases, so long as it is used for the above criteria.

State and Local Taxes (SALT Deductions)

One of the least popular areas of the tax code, particularly for those that live in high tax states is the reduction of the SALT deduction.  Prior to 2018, what was paid in SALT was listed as a deduction on your Federal income tax return.   Beginning in 2018 this amount is capped at an aggregate of $10,000 per return.  This means that whether you are a married or single filer the total is $10,000.  There was some initial confusion as many taxpayers thought this applied only to their property taxes.  In reality this is on ALL State and Local taxes paid.  So a high earner in a high taxed state like New York or California may have exhausted their entire deduction via the State income taxes paid, rendering their entire property tax bill non-deductible beginning in 2018.   Those individuals who earn lower wages or reside in states with no State income tax may not be negatively affected at all.

Child Tax Credit

Prior to 2018, a taxpayer could claim a child tax credit of up to $1,000 per qualifying child under the age of 17. This amount was phased out by $50 for every $1,000 that the taxpayer’s AGI exceeded certain threshold amounts.

Beginning in 2018, the child tax credit is increased to $2,000 per eligible child.  The income level at which the credit phase-out begins is increased to $400,000 for taxpayers filing married filing jointly and $200,000 for all others. The credit continues to phase out at a rate of $50 for every $1,000 that AGI exceeds the threshold amounts.

 Alimony Payments

There were some fairly significant changes pertaining to alimony.  In prior years, the recipient receiving the alimony payments might need to report that payment as taxable income, and the paying spouse could deduct that payment made to their ex-spouse.  Beginning in 2019 (not 2018), alimony payments are no longer deductible on any divorce agreement executed after December 31^st 2018.  Additionally, such payments are no longer taxable to the recipient.

529 College Savings Plans 

There was one significant change pertaining to 529 plans.  Under prior law, in order for 529 distributions to be treated as tax free, qualified expenses required the student to be enrolled at least half-time in a college, university, vocational or other post-secondary school.

Beginning in 2018, qualified expenses include tuition at an elementary or secondary public, private or religious school (along with various expenses related to home-schooling) up to a $10,000 per-student, per-year.

Pass-Through Entity Deduction

One of the most significant changes imposed by the Tax Cuts and Jobs Act is the creation of the new “Qualified Business Income” deduction.  Pass-Through entities are typically small business established in various forms such as S-Corp’s, LLC’s, LLP’s, etc.   These entities pay tax at the ordinary income tax rates as all of the income from business profits pass-through to their personal tax return.

As per the TCJA, non-corporate taxpayers (including trusts and estates) that have Qualified Business Income (“QBI”) from a partnership, S Corporation or sole proprietorship can take a deduction of up to 20% of the QBI.  QBI is generally defined as the net amount of income, gain, deduction and loss relating to a qualified trade or business and effectively connected to the conduct of the trade or business within the United States.

For pass-through income from a service business, a limitation phases in when the owner’s taxable income (from all sources) exceeds $157,500 for single taxpayers and $315,000 for married taxpayers filing joint returns and is completely phased-out when taxable income exceeds $207,500 and $415,000 respectively.

Certain types of income are specifically excluded from being treated as QBI, and therefore not eligible for the deduction.  Investment income along with reasonable compensation payments, guaranteed payment to a partner for services rendered and payments for services to partners not acting in their capacity as partners are not included.

A limitation is imposed on income from certain specified service businesses, including businesses that perform services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading or dealing with securities and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.

Self-employed individuals that are organized as a pass-through should inquire with their tax advisor to see if they will benefit from this 20% deduction.

Estate Taxes

Another significant change to estate planning strategies is the increased estate exclusion.  For 2018 the new exclusion is $11,200,000, adjusted for inflation annually.  Utilizing proper planning techniques, that figure can be doubled for a couple.  This makes the risk of being impacted by the estate tax much less significant for most Americans.   However, depending on the state in which you live there may be additional estate or inheritance taxes that may still require a degree of more sophisticated planning.  It is still wise to consult with an experienced estate planning attorney in your local area.

There were many changes to the tax code not covered in this summary, and a number of these modifications referenced are set to expire beginning 2026.  The tax code is something that is inherently complex, and it is often wise to make sure you are consulting a qualified tax advisor that can also work in tandem with your attorney and/or your financial planner to insure that you are utilizing the proper planning techniques.

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The high yield fixed income market, also known as “junk bonds” is often one of the most misunderstood asset classes by many investors.   In recent years with interest rates at historically low levels, many investors have attempted to look at different investments to enhance the cash flow generated from their portfolio.   One such area has been the high yield marketplace.

 High yield bonds by definition are bonds that pay a coupon (interest payment) in excess of the normal interest rate environment as a result of their lower credit quality.  They are typically below investment grade debt instruments.  There are several different rating agencies that rate fixed income credit quality. One such agency is Standard & Poors (S&P).  S&P ratings indicate any fixed income position with a rating below BBB is classified as below investment grade or “junk” status.

 The term “junk” can sound quite derogatory in nature, and may insinuate that it is something to stay away from.  This is not necessarily the case. There is almost always a place for lower quality fixed income within the confines of a longer term investment plan. The first thing to understand is how high yield bonds correlate to other assets.  Most fixed income investments are inversely correlated to interest rates.  That means that when interest rates are rising, an existing bond offering a lower interest rate declines in value.  The relationship here is simple to understand. Imagine that you hold a bond issued by a corporation that matures in 10 years and pays 5%.  If rates rise to the point that the 5 year treasury pays 6%, why would anyone want to buy your bond paying 5% when they have to wait twice as long to get their investment back?  The answer is that they likely wouldn’t.  As a result, if you attempted to sell your bond early, it would sell at a discount (loss) from your original purchase, if you bought it as a new issue.  This is known as interest rate risk.

Yet, high yield bonds generally function in the opposite manner.  As a result of the substantially higher rates paid, the emphasis of concern in pricing these instruments is rooted in the issuer’s ability to pay back the original principal payment due to the lower credit quality of the issuer. High yield bonds are classified as below investment grade because the underlying company is perceived to have a less stable set of financial conditions.   The reason for the positive correlation with interest rates is based on this concept of solvency.    If interest rates are rising, this is generally perceived as the result of the Federal Reserve increasing rates to slow the growth rate of the economy and prevent higher inflation.    Since the economy is theoretically expanding, the probability of a company surviving through more prosperous economic times has therefore likely increased.   Hence, their ability to repay their debt obligations has also likely increased.   Likewise when rates are declining, that is usually indicative of some concern of an economic contraction, and perhaps even a recession.    While in a period of contraction, the earnings of Fortune 500 companies may decline.   However, it is typically unlikely that these large multinationals will go bankrupt.  In the case of less credit worthy companies, a company that already has financial concerns will likely find it much more difficult to weather the economic storm.   Therefore the ability to satisfy their debt obligations will be called into question.  It is for this reason that the high yield bond market tends to move most often with interest rates rather than against them.

High yield bonds also tend to get issued without “call protection” on the individual bonds.   A callable feature is an aspect of a bond issuance that permits the issuer to redeem the bond early if the economic environment of the company improves.   In such a scenario where the growth of the company is so strong that they are no longer considered to be a credit risk, or of junk status, they may opt to call in some bonds, and then issue newer debt at lower rates based on their improved financial condition.  However, this means you as the investor will not see the return you anticipated had you been able to hold the issue until its full maturity.

What about buying individual High Yield Bonds?

In general, it is not prudent for the average investor to buy high yield bonds individually.  The risk of repayment can be enormous. The key to buying into this market is typically diversification.  The majority of retail investors will not likely have the capital to broadly diversify this portion of their portfolio across hundreds of holdings.   Furthermore, the likelihood that the average investor has completed the necessary financial analysis in each individual company’s financials is also improbable.   Most investors will be served far better by capturing exposure to these areas through mutual funds and ETF’s.

When should you buy High Yield Bonds?

The purpose of buying into this area of the market is that it serves as a potential hedge against interest rate risk.   Should an investor have a fixed income portfolio of treasuries, government agencies and good quality corporate bonds, they will be exposed to the negative/inverse correlation when rates rise over time.   As a result, having a small portion of your fixed income portfolio allocated to this area of the market will offset a portion of that risk, while simultaneously paying a higher income.   Such a holding simply balances the risk associated with the better quality debt holdings.  It is important to note that these positions are typically a much smaller percentage of the overall holdings than that of traditional fixed income.  In cases where a portion of your portfolio is exposed to stocks or stock funds, it should also be noted that high yield bonds may correlate closely with them as well.  The correct percentage exposure in an individual’s portfolio is going to be specific to that person’s financial goals and time frame. The same can be said of any asset class, as each situation must be addressed in a unique manner.

While their performance is often dictated by different economic environments, it is still not prudent to attempt to time these cyclical trends.  As is the case with any asset class, pricing is often reflected in anticipation of a changing environment, and exploiting shorter term price inefficiency can be very difficult, and even more challenging to accomplish on a consistent basis.

High yield bonds are generally classified as a higher risk investment, and should be treated as such.   Yet, from a financial planning perspective, when used appropriately in the proper proportion of an individual portfolios overall asset allocation, they will likely bring down the overall risk of your investment strategy by reducing the correlation across portfolio holdings.   As with any asset class, it is advisable that an investor discuss this with their financial advisor and complete their due diligence before taking a position.

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