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NEW RULES FOR BOND INVESTING

Planning for the Individual Investor

Stan Richelson, J.D.,LLM & Hildy Richelson, Ph.D. Scarsdale Investment Group, Ltd., Blue Bell, PA 19422

215-646-8768; 215-646-7693Stan.Richelson@Comcast.net

Authors: The Money-Making Guide to Bonds: Straightforward Strategies for Picking the Right Bonds and Bond Funds, Bloomberg Press.© Stan Richelson and Hildy Richelson 2006

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The Case for Bonds

• There are beliefs that we take for granted that guide our lives, and we assume that they are true.

• For example, the statement that stocks will always outperform bonds is assumed to be true in financial planning.

• The corollary to that is that bonds are for old people.

• We are here to make the case for bonds and to suggest new ways to look at bond investing.

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Bonds Suitable for Individuals

• Individual Investors and Institutions should follow different investment rules because they are not alike.– Endowments keep growing/investors

ultimately draw down their capital– Endowments live forever/ investors ultimately

die

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Indecision

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Richelson’s Bonds for the Individual Investor

Plain Vanilla Bonds• Highly rated individual

bonds• Treasury bonds• US Agency bonds• Highly rated US corporate

bonds• Highly rated muni bonds• Foreign bonds-US

currency denominated

Not Bonds for Us• Junk bonds• Emerging Market bonds• Foreign currency bonds• Mortgage backed

securities • UITs• Bond Funds• Bond ETFs

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Stock vs. Bond Performance

• Old Rule: Stocks will always outperform bonds over every 10-year period.– Since stocks have outperformed bonds in the past,

they will continue to outperform bonds in the future.– Stocks’ higher risk will bring greater rewards.

• New Rule: It is uncertain that stocks will outperform bonds over every 10-year period because the world of the present is different than the past.

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Stock vs. Bond Performance

• Stock Investing has been risky in the past• Crash of 1929 • Crash of 1987 (508 points or 22.6%)• Bear market of 2000-2002• Japanese stock market declined 80.5% from 1989

to 2003.• Will stocks be risky in the future?

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History of Dividends on Large Company Stocks

• 1926 to 1954: Dividends always above 5%• 1950: Dividends peaked at 8.77%

• 1975 to 1985: Dividends generally around 5%• Current dividends

– On large company stocks:1.8%– On most small and midsize company stocks:0%

• 1926-1959: Dividends higher than interest paid on long-term Treasury bonds

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Effect of Dividends on Stock Performance

• Stock Performance 1824 to 2005

With Dividends: $1 grew to $3.2 million

Without Dividends: $1 grew to $374

• Are you willing to bet your client’s retirement on the hope that past performance will be repeated without significant dividends?

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Effect of Losses in First Years of Retirement

• Losses in the first years of retirement devastate portfolio performance.– Retirement date: 1973. Market loss -14.6%– Retirement date: 1974. Market loss - 26.5%– Retirement date: 2000. Market loss - 9.1%– Retirement date: 2001. Market loss - 11.9%– Retirement date: 2002. Market loss - 22.1%

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Effect of Losses in First Years of Retirement

• Story of Bob Goodtiming, owner of a $1 million portfolio– Retirement year 1: stocks decline 10%. He

withdraws $100,000.– Retirement year 2: stocks decline 10%. He

withdraws $100,000.– Beginning of retirement year 3: Portfolio is

down to $620,000.– The Wal-Mart job is looking very attractive.

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Historical Stock Returns After Costs

• Old Rule: The historical return of stocks is around 10%.

• New Rule: The actual historical return on stocks is much less than 10% when taxes, transaction costs and bad timing are taken into account.

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Persistent Drags on Stock Performance

• The 10% historical return on stocks ignores the following:– Income taxes paid to Federal, and sometimes

to state & local governments.– Transactions costs when stocks are bought

and sold.– Investor’s bad timing due to emotion.

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Actual Returns After Costs for Bonds

Bond performance is enhanced when compared to stocks considering– Taxes: No taxes on municipal bonds– Transaction Costs: One time cost if bonds are

held to maturity– Volatility: Doesn’t matter if held to maturity– Investors bad Timing: None, if held to maturity

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Stock=Growth; Bonds=Income

• Old Rule: Bonds are for income and stocks are for growth.

• New Rule: Bonds can provide both growth and income.– Zero coupon bonds provide growth. e.g. A US

Agency zero coupon bond, selling at 50% of its face value at its due date, will double in 12 years, yielding almost 6%.

– Interest paying bonds provide growth if the income is reinvested instead of spent.

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Inflation

• Old Rule: Stocks provide a hedge against inflation. Bonds are destroyed by inflation.

• New Rule: Stocks do poorly when there is significant inflation. Bond holders increase cash flow in inflationary times, when interest rate rise.

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Inflation

• Stocks have performed poorly when there is a lot of inflation.

• In the 1970’s there was record breaking inflation– 1973 the Dow was at a high of 1020– 1974 the Dow was at a low of 470;

• a loss of 55%

• One reason: Competition with high yields on bonds. In the 1970’s bond yields ranged from a low of 6% to a high of about 9%.

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Rising Interest Rates & Bonds

• Old Rule: Rising interest rates are bad for bond investors because the value of bonds decline.

• New Rule: rising interest rates are an opportunity to increase income, yield and cash flow.

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Rising Interest Rates & Bonds

• If interest rates rise, an investor will not have a loss if he holds to maturity.

• Rising interest rates are a blessing, not a curse. It results in increased cash flow.

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Using Bonds in a Rising Interest Rate Market

• Reinvest cash on hand

• Reinvest maturing bond capital

• Sell the short-end of the laddered portfolio and reinvest the capital in longer dated bonds.

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Cash or Invest?

• Old Rule: Interest rates are currently near a 40-year low, so stay in cash because interest rates must rise. If you invest, you will lose money.

• New Rule: Invest your cash when you have it because you cannot predict if interest rates will rise or fall.

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Quick History of Interest Rates on Long-Term Treasury Bonds

• Current interest rates are actually above average for the last 85 years.– 1921-1966: Interest rates on long-term

Treasury bonds less than 6%. 1944 was the low, with rates at 2%.

– 1967-2001: Interest rate on long-term Treasury bonds always above 5%. 1981 was the high, with rates at 13.9%.

– 1921-2005: Average of about 4.9%– May 2006: About 5.2%

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Bond Diversification

• Old Rule: Always diversify bond portfolios into all bond sectors, including junk and emerging market bonds to maximize returns.

• New Rule: Don’t diversify into sectors for added return when the spread between safe bonds and risky bonds is small. Stay only in safe bonds to avoid losses.

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Bond Diversification

• Referring to the high-yield sector of the bond markets, Warren Buffet said in 2004 “Yesterday’s weeds are being priced as flowers.”

• The spread between the 7-year Treasury bond and junk bonds has ranged roughly over the last twenty years between 3% and 10%, and is currently near its low.

• After losses, at a 3% spread you are doomed to a lower return than Treasurys because of the greater risk of default.

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Bonds vs. Bond Funds (ETFs)

• Old Rule: Investing in bond funds or bond ETFs is the same as investing in individual bonds.

• New Rule: Bonds come due. Bond funds do not have a maturity date and therefore are a different kind of investment.

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Bonds vs Bond Funds (ETFs)

• Bond funds and bond ETFs– Provide diversification, not essential with high quality

bonds.– Risk portfolio losses if interest rates rise.– Charge fees & trading costs– Subject the investors to additional taxes.

• Individual bonds – Are less expensive if bought and held to maturity– Target planning for life events

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Performance vs. Cash Flow

• Old Rule: Bond investing is all about performance and trading.

• New Rule: Bond investing is about creating a cash flow.

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Investments for Volatility or Stability

• Old Rule: View investments as separate from earned income.

• New Rule: Harmonize and integrate cash flows from bonds and earned income, viewing earned income as a variable and bond income as the core for stability.

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Planning for Transitions

• The client’s earned income should be viewed as variable because they may – Want to walk away from a job– Get laid off or become disabled– Need support for investment transitions-e.g. real

estate where the asset is very illiquid

• Bonds are not just for old people. At every age, people need the flexibility to change what they do and how they live, and deal with bumps in the road.

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We Live What We Teach

• We never had a bond default, nasty client call or a sleepless night because of our bonds.

• Except for the last 5 years, we had a high return on bonds.

• Last 5 years, even the lower rate of interest on bonds was higher than the return on stocks due to the bear market of 2000 to 2002.

• Our returns overall from our laddered portfolios were higher than 5% because our call protected bonds continued to pay at higher rates.

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Bond Investments for All Ages at All Times

Fixed income investments provide a

predictable cash flow that will enable you and your clients to

change your lives.

Scarsdale Investment Group, Ltd., Blue Bell, PA 19422

215-646-8768;215-646-7693