Economists think everyone should convert most of their retirement nest eggs into annuities and receive a stream of income that’s guaranteed for life. Very few people actually do that. They want to keep control and have the hope of achieving a higher return, even when they don’t invest aggressively or have a good investment track record. Justin Fox of Harvard Business Review takes a look at annuities and why people don’t buy them for retirement. He doesn’t break any new ground, but it’s a good review of all the angles and has some good quotes and links.
The sustainability of Social Security is a topic for another day. When it comes to annuity puzzles, though, there’s one more factor worth mentioning. In the Palliser novels of Anthony Trollope, which have constituted most of my bedtime reading for the past month, there’s endless discussion of how much money people have. These 19th century fortunes, however, are almost always described in terms of the annual income they produce, not the lump sum.
Hardly anybody talks about investments that way now. Part of it is just that most of us expect to live from our jobs, not the inherited wealth still so crucial in Trollope’s world (and even more so in Jane Austen’s half a century earlier) — so whatever fortune we may have built or inherited isn’t expected to produce income just yet. But I also wonder if asset values have come to play such a big role in modern economic life that we’ve forgotten what those assets are for. In countless ways, financial discourse in the Western world in general and the U.S. in particular has shifted from a focus on income to a focus on assets or net worth.
The Wall Street Journal caused a lot of turmoil this week with its behind-the-scenes report of the big change at PIMCO, when Mohammed El-Erian resigned and the firm promptly promoted six new deputy chief investment officers to assist Bill Gross. El-Erian had been heir apparent at the firm. A subscription might be required to view the WSJ report. If you can’t access it, consider this summary at Bloomberg.com. There’s also this rejoinder from Gross.
I don’t know how accurate the report in the WSJ is, especially since it apparently has no input from El-Erian or Gross. It’s easy to string together a few anecdotes to support a point of view, especially when there no conflicting evidence is reported. I’m also not sure how much it matters if the entire story is true. El-Erian was a very good spokesman but didn’t distinguish himself as a money manager with the funds he was running at PIMCO or in his brief stint as the head of the Harvard Endowment. We also can’t tell from the outside if he was good at being CEO of the firm. What matters to investors is the investment returns. Many of the funds at PIMCO are fairly autonomous, and I’m sure Gross always has made his own decisions at the funds he manages. What the recent changes really mean are that after Gross leaves, PIMCO no longer will be identified with one person. The plan was to have a transition from Gross to El-Erian as the public face of the firm. Now, it will be like the other large mutual fund firms in that he would be clearly identified with only one person.
Some at Pimco have been told to leave the firm but stuck around instead, waiting for Mr. Gross’s anger to ebb and for him to change his mind, according to these people.
Bill Powers, a former Pimco senior executive who left in 2010, says Mr. Gross “routinely grew tired and wary of those closest to him who had assumed significant responsibility, power, and compensation. After a four to five-year honeymoon period, the chosen one’s halo would turn into a crown of thorns where interactions with Bill would turn adversarial, short, and unpleasant.”
When Mr. Gross establishes an investment thesis, he usually doesn’t appreciate dissenting views, employees and former Pimco traders say. Once, when a senior investment manager said a bond in Mr. Gross’s fund appeared to be expensive, Mr. Gross responded: “OK, buy me more of it,” according to a Pimco executive. The purchase was made.
Recently co-CIO and CEO of PIMCO, Mohammed El-Erian announced he would be leaving the firm. The departure raises a lot of questions for investors. Here’s a good review of the key questions and some answers from Morningstar. The answers are mostly speculation and guesswork. We have to figure out how El-Erian’s departure will affect the decisions made by the firm’s daily investment committee meetings and other intangible things. My recommendation after such changes at a large firm is to wait before taking action but watch things more carefully than usual. I don’t expect big changes in the firm’s actions or results, but one never knows.
That situation has been exacerbated by significant departures from the firm in recent years. In 2010 it was Paul McCulley, mainly known outside the company as a Fed watcher but one who was very involved in the investment committee and ran PIMCO’s cyclical forums. His input was clearly crucial, and it was evident that he played an important role in challenging and debating other members of the group, especially Bill Gross, Chris Dialynas, and El-Erian. Dialynas has been another important voice on the committee, but he, too, has stepped down, at least for now. He had been the portfolio manager of PIMCO Unconstrained Bond (PFIUX) as well as a very senior, long-tenured manager with a strong, opinionated voice on the committee, and it was clear that he, too, played a balancing role in the group. He announced a sabbatical late last year that is now slated to begin in April. And though PIMCO has hinted that it could be for only a year or so, he took a much longer leave in the 1990s, and it hasn’t been said whether he would rejoin the investment committee, if and when he does return to the firm.
Periodically I try to make the point that forecasting the economy or an investment doesn’t matter unless you make the forecast both accurately and before it is priced in to the markets. Sometimes markets are surprised by events or changes. Other times markets are ahead of the curve, so the actual events don’t stir markets. One good example of markets pricing in changes before they occur is the bond market.
This post describes a new study that found the bond markets tend to price in changes in Fed policy about six months before the Fed actually makes a change. Speeches by and interviews with Fed officials apparently are followed closely by bond traders and cause them to change their portfolios.
Traders and investors start pricing in changes in the central bank’s overnight target rate as much as half a year before the change takes place, according to a National Bureau of Economic Research paper published this week.
“The market prepares for [Federal Open Market Committee] announcements much farther in advance than had previously been demonstrated” in prior studies, Danish researchers Dick Van Dijk, Robin Lumsdaine and Michel van der Wel wrote. “We find strong evidence of anticipatory set-up, going back as far as six months prior to an FOMC meeting,” they noted.
Tax-exempt bonds crashed earlier in 2013. First there was all the talk of the Fed reducing its bond buying, known as tapering. Then, there was the bankruptcy of Detroit. I said in Retirement Watch that the crash created opportunities and recommended a portfolio position to capture them. Now, James Tisch, CEO of Loewe’s, said he agrees. He thinks tax-exempt bonds are worth considering now by almost all investors because prices declined so much.
Tax-exempt revenue bonds rated AA and maturing in 30 years yield about 4.6 percent, according to data compiled by Bloomberg. The interest rate is up from as little as 3.04 percent in January. The $3.7 trillion municipal market has lost about 2.4 percent this year, according to Standard & Poor’s data.
Loews’s insurance subsidiary CNA Financial Corp. (CNA) said in July that it was buying state and local-government debt for its $46 billion investment portfolio. The strategy was a reversal for Tisch, who said earlier this year that interest rates were so low that bonds were competing in an “ugly contest.”
The markets went into panic mode in the spring when Ben Bernanke said the obvious, that quantitative easing and zero interest rates wouldn’t be around forever. The markets also were surprised when the Fed didn’t change its policy at the September meeting. Bill Gross of PIMCO sets everyone straight in his latest monthly essay. Gross says to expect low interest rates for some time. He points out there is a difference between QE, Fed policy, and a higher “policy rate.” For a range of reasons, low short-term interest rates are going to be with us for a while, and that will keep a lid on other interest rates, though they’ll probably rise faster than short-term rates. PIMCO is looking for the short-term rates to stay low (and go below today’s rates) until 2015 or so.
It’s the policy rate, both spot and forward, that prices markets and drives economies and investment decisions. QEs were simply a necessary medicine for rather uncertain and illiquid times. Now that more certainty and more liquidity have been restored, it’s time for the policy rate and forward guidance to assume control. Janet Yellen, future Fed Chairperson, would agree, as would oft-quoted Michael Woodford, Columbia University professor and 2012 Jackson Hole speaker, who seems to have become the private sector’s philosophical guru for guidance and benchmarks, that will now attempt to convince an investment public that what you hear is what you get.
But if QE is soon to be out, and guidance soon to be what remains, I think investors should listen and invest accordingly. Not with total innocence, but sort of like a totally hyena-aware lion cub – knowing there’s bad things that can happen out there in the jungle, but for now enjoying the all clear silence of the African plain. In bond parlance, the all clear sign would mean that the Fed believes what it says, and if their guideposts have any credibility, they won’t be raising policy rates until 2016 or even beyond. The critical question to ask in terms of the level and eventual upward guide path of the policy rate is how high a rate can a levered economy stand? How much wood can a woodchuck chuck? How high a rate can a homebuyer handle? No one really knows, but we’re beginning to find out. The increase of over 125 basis points in a 30-year mortgage over the past 6–12 months seems to have stopped housing starts and importantly mortgage refinancings in its tracks. It was the primary “financial condition” that Chairman Bernanke cited in his September press conference that shifted the “taper to a tinker to a chance” that maybe they might do something next time.
Recent market events challenge some traditional economic theory. When the Fed keeps interest rates low, that isn’t supposed to cause real long-term rates to rise. But it often does. The reason appears to be that investors need to seek higher yields to compensate for the low rates engineered by the Fed. Here’s a speech to economists explaining the theory, and giving a pretty clear explanation of how it works. It might be too academic for some, but for most iti s worth reading through.
The theory we sketch involves a set of “yield-
oriented” investors. We assume that these investors allocate their
portfolios between short- and long-term Treasury bonds and,
in doing so, put some weight not just on expected holding-period returns, but also on
current income. This preference for current yield could be
due to agency or accounting
considerations that lead these investors
to care about short-term measures of reported
performance. A reduction in short-term nominal rates leads
them to rebalance their portfolios toward longer-
term bonds in an effort to keep their overall yield from declining too much.This, in turn,
creates buying pressure that raises the price of the long-term
bonds and hence lowers long-term yields and forward rates.
I’m on record believing that investors over-reacted in May and June. A few words from Ben Bernanke made them think the Fed was about to rise rates substantially. Investors sold bonds and other income investments, causing significant price declines. The move in interest rates that resulted was far greater than justified by economic fundamentals. I advised buying some income investments in July after markets stabilized. It turns out I was a bit early. Another sell-off occurred in July and early August.
Here’s a good explanation of why this recent move down in bonds is excessive. Bonds and related investments likely will stabilize now or even recover for a while. The economic fundamentals and likely Fed actions for the rest of the year don’t support this kind of change. It’s probably a good time to implement the ideas I suggested a month ago.
According to BAML, these fund managers are now 57% underweight bonds. This is the lowest since the start of 2011, which was also a turning point in bond prices (chart below, from Short Side of Long, March 2013; the black line is at 57%). This is a big change from May, when funds were 38% underweight bonds. In 3 months, funds have reduced their bond weighting by 19 percentage points. That’s a big move.
I moved tax-exempt bonds into some of our Retirement Watch portfolios recently, after the May-June meltdown. That’s a controversial move, because most people invest using a rearview mirror. Instead, they should notice that after the decline many tax-exempts are bargains and provide a margin of safety. You need to buy carefully, or buy a quality mutual fund or closed-end fund (my preference). Here’s someone else’s thoughts on this and other investments.
Consider that New Jersey Turnpike 4.73% tax-free yield. We sat in a meeting with one of our New Jersey clients and reviewed his portfolio. The client is a successful businessman. He was joined in the meeting by his financial professional. We dissected his New Jersey tax bracket. He is somewhere in the 51%-52% marginal tax bracket. He is a New Jersey resident paying federal income taxes and New Jersey taxes at the top rates. He bumps up against levels which limit his deductions and expenses when he completes his tax return. And we must add the Obamacare tax he pays. That is how his marginal tax rates reach 52%.
Sitting in that meeting, we took apart 4.73% as a yield that he can obtain by investing in a long-term debt instrument with a senior claim on the revenues of the New Jersey Turnpike. The compounding taxable equivalent yield for him is approximately 9.5%. He can get that yield year after year.
Should you abandon bonds and bond funds now that interest rates seem near their long-term lows and are likely to rise, perhaps for decades? Bill Gross of PIMCO no doubt has given this question a lot of thought, and he delivered his thoughts in his most recent monthly essay. Not surprisingly, Gross says you still should have bonds in your portfolio. He also says there are ways bond investors and bond fund managers can defend their principal against rising interest rates. The new strategies he outlines are more complicated and difficult to implement, but they involve a lot more than simply changing the duration of a bond portfolio, the leading strategy in a bond bull market. Take a read and see if it works for you.
Insurance companies, pension funds – all institutions with liability structures that require matched asset hedging require fixed income assets on the other side of their balance sheet. The recent several months’ experience of higher yields was, in fact, a blessing for them, as their future liabilities went down faster than the price of their bond assets did! Individuals with 401(k)s invested in bond mutual funds didn’t see it that way, although similar logic applies if they present-value their home mortgage liabilities. But I write not to praise higher interest rates, but to bury antiquated portfolio management strategies that would lose money because of them. I write to alert you to evolving thinking that might win this new war without causing you – the investor – to desert an historical and futurely valid asset class that we believe can still provide reliable income and hopefully steady returns even in the face of higher interest rates.
While PIMCO has been rather prescient at warning of New Normals and then predicting the inevitable turn of near zero percent yields, it is an open question whether we are still marching three feet apace with 65-pound backpacks into the face of 1,000 machine guns, or safely burrowed in fox holes with revised strategies adaptive to a new era. Trust me, no investment firm has given this transition more thought. While our strategic execution in May/June of 2013 can and has been publically faulted, we are confident that we know how to win this evolving bond war. We have spent months – indeed years – preparing for this new dawn. We intend for you – our clients – to be surviving veterans of this battle, not casualties. PIMCO will not go down at the Somme.