Municipal Bond Worries
In 2010, prominent industry analysts warned of a looming fiscal crisis among state and local governments. Some experts even predicted widespread municipal bond defaults in the US.1 Investor fears intensified in late 2010 when the municipal bond market experienced one of its largest selloffs in decades, which drove down prices and raised yields.2 While factors unrelated to credit concerns may have contributed to the selloff, some investors were motivated by a perception of rising credit risk among municipal bond issues.3
So, is the municipal bond market at risk of massive default? No one knows—and we are not in the prediction business. But your view probably depends on your economic expectations and familiarity with the municipal bond market. With this in mind, consider these principles:
- The municipal bond market is large and diverse. The media often report on municipal bond problems as though the market is a single, uniform sector. In reality, the market comprises an estimated $3 trillion in debt, with over 50,000 state and local issuers and about two million outstanding issues. These bonds are rated across a broad spectrum of credit categories and have different characteristics and structures for paying their obligations. Such complexity does not afford simple observations about the market.
- Historical default rates are low. Muni bonds have a strong track record of repayment. One reason is that state and local governments are motivated to avoid default since failure to pay affects their ability to raise capital in the future. Another reason is that most issues repay investors from either project revenues or from a general fund backed by the taxing power of the issuer. Chart 1 shows bond default rates in the US from 1970 to 2008. There have been no defaults in the top-rated investment grade tier (AAA/AAA). Most defaults are limited to the non-investment grade universe.
Chart 1: Bond Default Rates—Cumulative Percent (1970-2008)
- Most fiscal problems are concentrated in a few large states. An estimated 58% of the recent budget shortfalls have occurred in five states: Arizona, California, Illinois, New York, and Texas.4 However, operating budgets deal with short-term revenues and costs, while municipal bond debt represents long-term borrowing to fund infrastructure projects (e.g., roads, bridges, schools, water systems, and hospitals). Moreover, current levels of state and local government debt, as well as interest payments on that debt, remain well within the historical range.5 Of course, many states are also wrestling with unfunded pension liabilities that may ultimately impact their budgets, but these tend to be longer term obligations as well.
- Municipal bonds are assessed according to actual financials, not models or projections. Some reports have compared the municipal bond market to the subprime mortgage securities market prior to the financial crisis. The circumstances are different. For one, state and local issuers are subject to financial disclosure rules, and the information they provide affects the market prices and credit ratings of their bonds. Also, municipal bonds are not exotic instruments with complex structures that obscure the underlying credit rating and market value of the assets.6 While municipal bond reporting is not as timely or thorough as reporting on corporate debt, investors hold an instrument that is more transparent than the mortgage derivatives that helped spark the financial crisis.
- Current market conditions do not imply unusually high risk. The market incorporates information and expectations into prices, including perceived risk, as illustrated by rising bond yields during the financial crisis and in the recent municipal market selloff. However, since the start of the recession in November 2007, average yields for the AAA-, AA-, and BBB-rated municipal securities have fallen.7 Also, total market volume as measured by total number of trades has been generally flat over the last three-year period.8
Risk Management Issues
Investors should always consider ways to manage risk in their fixed income portfolios. Here are a few guiding principles:
- Hold shorter-term issues. This approach may help reduce volatility and credit risk while enhancing liquidity. Also, fixed income investors who hold investment grade bonds must also consider their exposure to changes in interest rates. Bond prices move in the opposite direction of interest rate changes—and the longer a bond’s maturity, the greater its price change.
- Stay broadly diversified. Holding many municipal bond issues and avoiding concentration in a particular state, sector, or issue type can help reduce the impact of a few non-performing bonds. If default rates were to rise, investors with a well-diversified municipal portfolio should be less exposed.
- Focus on quality and use market pricing to confirm credit ratings. The most creditworthy bonds are those rated AAA or AA, and most of the current problems involve lower-rated bonds. Although ratings are useful, recent history in the mortgage-backed securities market has shown that a bond may not be rated accurately. A bond that is rated AAA should trade in a similar price range to other bonds with similar characteristics and a comparable rating.
Portfolio Decisions
Investors can either hold a portfolio of individual municipal bonds or buy shares in a fund. Building a portfolio of individual bonds offers more direct control over maturity, face value, bond type, credit range, and other issue characteristics. This approach may be useful for matching future liabilities and pursuing other investment objectives. But achieving broad diversification with a custom portfolio may prove a challenge, and the portfolio may be illiquid and expensive to trade, and require more attention and oversight than is feasible for an individual.
Investors often favor professional fund management for many reasons, including those specific to the way the bond market operates. Since bonds are traded through a network of dealers and not a centralized exchange, price discovery may not be easy. Muni bonds also tend to be illiquid since only about 0.7% of the market is traded daily (i.e., only 14,000 out of 2 million issues). These market realities result in high transaction costs. In fact, research shows that municipal bond trades are significantly more expensive than equity trades of equal size.9
Professional managers should have better access to multiple dealers and have the capacity for large- volume trades, which renders a cost advantage over smaller investors. Funds also offer better liquidity and broader diversification across issue type, maturity, credit quality, and geography. A shareholder can access daily share price and know the average credit rating within the portfolio. Equally important, managers should monitor average yields at different maturities, qualities, and regions to gauge the relative riskiness of different issues.
On the downside, managed funds can lose value and shareholders do not control the selection of bonds in the portfolio.
End Notes
1. Shawn Tully, “Meredith Whitney’s New Target: The states,” CNNMoney.com, Sept. 28, 2010.
2. Dan Seymour, “Default Uneasiness Chases Investors from Muni Funds,” American Banker, Jan. 25, 2011.
3. Ben Levisohn, Jane J. Kim, and Eleanor Liaise, “Munis: What to Do Now,” The Wall Street Journal, Jan. 15, 2011.
Other factors that possibly contributed to the selling pressure are: (1) a major Treasury selloff in late 2010, (2) Standard & Poor’s downgrade of “tobacco bonds” to junk status, (3) expiration of the Build America Bonds program in 2010, and (4) extension of the Bush-era tax cuts.
4. Randall Forsyth, “The Sky Isn’t Falling on the Muni Market,” Barrons.com, January 7, 2011.
5. Iris J. Lav and Elizabeth McNichol, “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm,” Center on Budget and Policy Priorities, Jan. 20, 2011.
6. Agnes T. Crane, “States’ Troubles Are Not the Real Risk for Muni Bonds,” The New York Times, Jan. 30, 2011. Also see Randall W. Forsyth, “Man Bites Dog in the Muni Market,” Barrons.com, Feb. 1, 2011.
7. Bank of America Merrill Lynch 1-10 Years AAA-BBB US Municipal Bond Index.
8. Municipal Securities Rulemaking Board (MRSB) 2010 Fact Book.
9. Lawrence E. Harris and Michael S. Piwowar, “Secondary Trading Costs in the Municipal Bond Market,” Journal of Finance, June 2006, Volume 61, Issue 3, pp 1361-1397.
Disclaimers
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Municipal securities are subject to the risks of adverse economic and regulatory changes in their issuing states.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
Door-to-Door Con Artists
From the Denver District Attorney’s Office:
Like the daffodils that come up in the spring, so too, do “Travelers” – con artists who roll in to town in shiny new pick-up trucks, and peddle door-to-door. They offer fabulous “home improvement” offers, claiming to have “left over” asphalt or roofing materials, and can do the job at a bargain price. The catch is that you must deal now!
Travelers, (and those who copy them) usually look for older, more established neighborhoods, or houses in need of repair. They actively target older victims, often canvassing residential areas looking for elders working out in their yards. In exchange for the money, they will perform shoddy or deceptive work; or often, no work at all. Bogus landscape and tree-trimming “companies” also make an appearance about this time of year. Similar to home-improvement cons, other unscrupulous peddlers who solicit door-to-door include magazine sellers, or groups purporting to be legitimate charities. Children can also be part of a charitable scam. Alert neighbors in Denver recently reported youth going door-to-door collecting money for the “troops overseas”.
Door-to-door con artists are seldom violent. All the same, it’s best to keep your garage and other doors locked when working outside. If inside your house, make sure the screen doors are locked before answering the door. Let your neighbors know when you spot questionable solicitors in the vicinity, and call the police. Left unchecked, Travelers who have had have earlier success in one neighborhood have been known to return there the following year.
The best advice is to NOT DO BUSINESS WITH DOOR-TO-DOOR SOLICITORS AT ALL! Reputable companies have no need to conduct business door-to-door. In the case of a major home-improvement, it’s always a good idea to get several bids. For information on selecting a contractor, charity or preparing bids, contact the Denver/Boulder Better Business Bureau at www.denverbbb.org
Denver DA’s Fraud Line: 720-913-9179
Deficits, Debt, and Markets
As government spending hits record levels around the globe, some politicians, economists, and pundits are warning that rising indebtedness may drag down economies and financial markets. This issue has raised concern among investors who assume that a government’s fiscal policy is closely linked to the country’s economic growth and market returns.
The graph below shows the projected state of indebtedness around the world.1 Over half the Organization of Economic Co-operation and Development (OECD) member countries expect to have debt-to-GDP levels above 70%—and the US, Canada, and the UK project debt levels exceeding 80% of their economic output.
Government efforts to stimulate these economies out of recession may partly explain this level of borrowing, which is high compared to historical levels. But longer-term trends such as aging populations, expanding public pensions, and rising health care obligations are compounding the fiscal challenges of these countries.
Global investors may be particularly concerned about the economics of government spending in countries around the world. So how does public debt affect economic growth and market returns? The evidence might surprise you. Although rising levels of government debt create headwinds for economic growth, a country’s deficit and debt levels do not seem to adversely impact capital market returns.
Let’s explore these issues by addressing a few popular questions about sovereign debt:
Do rising deficits drive up interest rates?
Yes. As borrowing increases, a government must offer higher interest rates on its debt to compete for capital. The public sector consumes savings and investment that may have otherwise fueled private sector growth—a displacement of resources known as the “crowding out effect” in economic theory. Additionally, as debt levels rise, market concerns about higher default and inflation risks put additional upward pressure on interest rates.
Consistent with this theory, our analysis shows that current interest rates reflect expectations of future deficits2 but that current government deficits and debt do not predict future interest rates or bond returns.3 So, long-term interest rates rise when the market expects future deficits to increase. However, today’s interest rates and bond prices already reflect information about current government spending, and markets quickly incorporate new information.
Do higher deficits hamper economic growth?
It depends on a country’s debt level. Using World Bank data from 1991 to 2008, we compared current deficits to future GDP growth in sixty-seven countries and found an increasing interactive effect between deficits, debt, and economic growth. High-debt countries that run deficits are more likely to experience lower economic growth over the next three years. But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation in future GDP growth. The combination of high debt and deficits can create headwinds for economic expansion, but slower growth is not guaranteed.
So investors are justified in having some economic concern about higher government spending and borrowing. But the impact on investment returns is less clear. Let’s now consider the potential effect on equity markets.
Does low economic growth result in diminished equity returns?
No. This relationship can be tested by comparing a country’s GDP growth to its equity market performance in subsequent years. We conducted this analysis using all the developed countries in the MSCI universe, divided each year into high-growth and low-growth “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.
The graph below illustrates this relationship in terms of a dollar invested in high- versus low-GDP growth portfolios from 1971 to 2008. The low-GDP growth portfolio’s higher annual return would have generated slightly more wealth for the period. The chart details the average annual return and real GDP growth for both groups.
Applying the same methodology to the MSCI emerging market countries shows an even greater return difference, although the data period is much shorter (2001 to 2008). The return of the high-growth country portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the low-growth portfolio (-4.94% GDP growth).
Other research has confirmed a weak relationship between a country’s economic growth and its stock market returns.4 Several factors may contribute to this decoupling effect. For one, with globalization, a multinational company’s stock price in its home market may not reflect economic conditions in other countries. Also, the fruits of economic growth do not accrue exclusively to public companies, but also to income earners, non-public businesses, and private investments.
Finally, consider that risk, not economic growth, determines a stock’s expected return. Research indicates that this principle also applies to a country’s stock market.5 Similar to value and growth stocks, markets with a low aggregate price (relative to aggregate earnings or book value) have high expected returns, and markets with a higher relative price have lower expected returns. Consequently, while holding a “growth market” may be a rational investment approach, investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected GDP growth.
Do fiscal deficits lead to currency depreciation?
No. It is commonly believed that large fiscal deficits and high debt cause a currency to depreciate as the government borrows more from foreign sources, and investors who are concerned about inflation and default risk flee the currency. Although recent developments in the US would seem to support this relationship, there is less convincing long-term evidence that deficits affect currency rates. During the 1970s and 1980s, the dollar strengthened while the government increased deficit spending.6 This observation is consistent with academic studies concluding that exchange rates appear to move randomly, and there are no models to date that can reliably forecast currency returns.7
Conclusions
Some economists claim that developed market countries are moving into an era of high government deficits and lower market returns. While higher deficits and debt may impact a nation’s interest rates and economic growth to some extent, the investment implications are not easily discerned. History does not offer strong evidence that current deficits predict future bond or equity returns in a country’s financial markets, or anticipate short-term currency movements.
Investors should assume that stock and bond prices reflect all that is currently known and expected about government spending and debt, economic growth, risk, and other issues affecting performance.
Endnotes
1. The Organization of Economic Co-operation and Development (OECD) is an international economic organization of thirty-three countries founded in 1961 to stimulate economic progress and world trade. It defines itself as a forum of countries committed to democracy and the market economy.
2. Today’s interest rates reflect expectations of future deficit levels. The analysis compared five-year US deficit projections (as a percent of GDP) to yield spreads (five-year US Treasuries minus three-month US Treasuries) from 1992 to 2010. The yield spread increased 29 basis points for every one percentage-point increase in projected deficits. Data sources: Baseline projected deficits from the Congressional Budget Office; yields from Federal Reserve Bank of St. Louis.
3. Today’s deficits do not predict tomorrow’s interest rates or bond returns. Regression results show that current deficits do not reliably predict changes in the five-year US Treasury yield spread (1982 to 2009) or future bond returns (1947 to 2009). Data source: Federal Reserve Bank of St. Louis.
4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.
5. Clifford S. Assness, John M. Liew, and Ross L. Stevens, “Parallels between the Cross-Sectional Predictability of Stock and Country Returns,” Journal of Business 79, no. 1 (March 1996): 429–451. Their research uncovered strong parallels between the explanatory power of aggregate book-to-market and aggregate earnings-to-price ratios for country stock markets.
6. Another common assumption is that current account deficits and currency appreciation are related. (The current account balance is the difference between a country’s receipts and payments to the world. This account is composed mostly of the balance of trade, with net income and foreign aid playing a smaller role.) Academic research yields equivocal results on whether this relationship holds.
7. Richard A. Meese and Kenneth Rogoff, “Empirical exchange rate models of the seventies: Do they fit out of sample?” Journal of International Economics 14, no. 1 (February 1983): 3–24. Kenneth Rogoff and Vania Stavrakeva, “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting” (National Bureau of Economic Research working paper No. 14071, June 2008).
Disclaimer
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.
Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.
Keep your Credit in Check
From the Denver District Attorney’s Office:
Economic uncertainty influences our behavior, particularly how we spend, save and borrow. As tax season draws to a close, now might be the time to run a check on your credit “health”. Here are some safeguards to consider if you’ve gotten off track with good credit practices, or simply want to keep your credit in good standing:
Guard against identity theft. ID theft can destroy credit, so prevention is the key. Limit other’s access to information such as credit cards, checks, bank accounts (PIN and passwords) and Social Security number. Keep financial information safely locked up, and check monthly credit card/bank statements for any unauthorized expenditures. Immediately report anything suspicious to the credit card company or bank.
Run credit checks three times a year. This is a free, once-a-year service provided by each of the three reporting agencies. Take advantage of this service by running a credit report through a different reporting agency every four months:
- Equifax (www.equifax.com) or 1-800-685-1111
- Experian (www.experian.com) or 1-888-397-3742
- Trans Union (www.transunion.com) or 1-888-4213
Keep credit card statements for seven years. Once receipts are checked against monthly credit card statements, receipts can be shredded. Statements should be saved for seven years.
Consider a debt-restructuring plan if you fall behind on payments. Immediately call your creditors to negotiate a workable re-payment plan. Note that it is illegal for credit repair companies to charge an up-front fee for their service. NO service can repair bad credit. This takes time to rebuild, starting with paying bills on time. Consumer Credit Counseling Service is one agency that provides this service for free (303-750-2228).
For information from the Colorado Attorney General’s Office on credit reports, click here:
www.coloradoattorneygeneral.gov/departments/consumer_protection/uccc_cab/uccc/credit_reports
Denver DA’s Fraud Line: 720-913-9179
What’s “New” about a New Normal?
The 2008 global market crisis and the struggling economy have left many investors fatigued. Despite two years of strong equity returns, some investors have been slow to regain market confidence. Many are accepting the talk about a “new normal” in which stocks offer lower returns in the future.1
The concept of a new normal is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.
Let’s look at other periods when investors had strong reasons to give up on stocks, and consider the parallels to today:
1932: The US stock market had just experienced four consecutive years of negative returns. A 1929 dollar invested in stocks was worth only 31 cents by the end of 1932. Hopes were sinking during the Great Depression, and many people felt as though the economy had permanently changed. Many investors left the market, and some would not return for a generation. Amidst what is considered the roughest economic time in US history, the markets looked ahead to recovery.
1941: World War II was raging, and the US had just entered the conflict. The US stock market had experienced two consecutive years of negative performance, and the economy had shown signs of sliding back into depression. Although conversion to a wartime economy would revive industrial production and boost employment, investors struggled to see beyond the conflict. Many expected rationing, price controls, directed production, and other government measures to limit private sector performance.
1974: Investors had just experienced the worst two-year market decline since the early 1930s, and the economy was entering its second year of recession. The Middle East war had triggered the Arab oil embargo in late 1973, which drove crude oil prices to record levels and resulted in price controls and gas lines. Consumers feared that other shortages would develop. President Nixon had resigned from office in August over the Watergate scandal. Annual inflation in 1974 averaged 11%, and with mortgage rates at 10%, the housing market was experiencing its worst slump in decades. With prices and unemployment rising, consumer confidence was weak and many economists were predicting another depression.
1981: The stock market had delivered strong positive returns in five of the last seven calendar years, and the two negative years (1977 and 1981) were only moderately negative. Despite these results, investors were weary from stagflation, which was characterized by high annual inflation, anemic GDP growth, and unemployment, and from fears of another economic downturn. In late 1980, gold climbed to a record $873 per ounce—or $2,457 in 2010 dollars. (By comparison, spot gold reached $1,256 per ounce in 2010.) Memories of the 1973–74 bear market lingered. A 1979 BusinessWeek cover story titled “The Death of Equities” claimed inflation was destroying the stock market and that stocks were no longer a good long-term investment.
1987: On “Black Monday” (October 19, 1987), the Dow Jones Industrial Average plummeted 508 points, losing over 22% of its value during the worst single day in market history. The plunge marked the end of a five-year bull market. But in the wake of the crash, the market began a relatively steady climb and recovered within two years. The effects of the crash were mostly limited to the financial sector, but the event shook investor confidence and raised concerns that destabilized markets would increase the odds of recession.
2002: By the end of 2002, investors had experienced the stress of the dot-com crash in March 2000, the shock of the September 11 attacks, and the early stages of wars in Afghanistan and Iraq. Although October 9, 2002, would ultimately mark the market’s low point, investors had endured three years of negative performance and an estimated $5 trillion in lost market value. A younger generation of investors had experienced its first taste of old-world risk in the “new economy.”
2008–Today: The market slide that began in 2008 reversed in February 2009—gaining 83.3% from March 2009 through 2010. Despite two years of strong stock market returns, memories of the 2008 bear market and talk of the “lost decade” have led many investors to question stocks as a long-term investment. But earlier generations of investors faced similar worries—and today’s headlines echo the past with stories about government spending, surging inflation, deflationary threats, rising oil prices, economic stagnation, high unemployment, and market volatility.
Of course, no one knows what the future holds, which brings the concept of “normal” into question. What exactly is the status quo in the markets?
The chart below shows the annual performance of the US market, as defined by CRSP deciles 1–10. Since 1926, there have been only four periods when the stock market had two or more consecutive years of negative returns. In addition, annual returns are rarely in line with the market’s 9.67% long-term average (annualized). The most obvious normal may be that, over time, stocks offer expected returns reflecting the uncertainty and risk that investors must bear.
What’s new about that?
End Notes
1. Adam Shell, “‘New Normal’ Argues for Investor Caution,” USA Today, August, 16, 2010. The term “new normal” originally referred to a post-global financial crisis environment characterized by several years of sluggish economic growth, below-average equity returns in developed markets, high market volatility and risk, high unemployment, and a world in which the range of possible financial outcomes is wider than normal and wealth dynamics are moving from developed to emerging economies.
2. Returns for all periods of the CRSP 1–10 Index are annualized. Data provided by the Center for Research in Securities Prices, University of Chicago. Data includes indices of securities in each decile as well as other segments of NYSE securities (plus AMEX equivalents since July 1962 and NASDAQ equivalents since 1973). Additionally, includes US Treasury constant maturity indices.
Disclaimers
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.
Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor registered with the Securities and Exchange Commission. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.
© 2011 Dimensional Fund Advisors LP. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this material is prohibited.
Lottery Scams Take on a Bold, New Tone
From the Denver District Attorney’s Office:
The Denver District Attorney’s Office is alerting people that bolder, and more elaborate lottery scams are being perpetrated over the telephone. Last month, an elderly couple in Denver fell victim to just such a scam. The couple was called repeatedly over the course of a week and instructed to wire money for ‘incidental fees’ before their winning check of $3.5 million could be released. The couple wired tens of thousands of dollars before realizing it was a scam. The Denver District Attorney’s Office alerted the victims bank, which was able to issue ‘stop-payments’ on some of the checks, but the victims lost $23,000 that will never be recovered.
And the scam didn’t end there! Realizing authorities were on to his scam, the con artist contacted his victims, this time posing as an “investigator” with the Federal Trade Commission. He tried, unsuccessfully, to swindle the couple out of more money, claiming the ‘suspect’ could not be prosecuted unless they contributed funds.
Warning signs:
- Be suspicious of any notification that you have won a lottery, especially if you haven’t paid to play. In order to win, you must first purchase a ticket. Winners contact the gaming agent, and use their ticket as verification that they have won.
- It is illegal in Colorado to collect “fees” on any lottery winnings.
- Any solicitation that asks to wire money should be a red flag. Once the money is sent and picked up on the other end, it cannot be tracked.
- It is illegal in the United States to play foreign lotteries! Many scams originate out of Nigeria. Take this into consideration if the caller has a foreign accent.
Denver DA’s Fraud Line: 720-913-9179
Does Monetary Expansion Stoke Inflation?
Since the financial crisis hit in late 2008, the US monetary base has more than doubled, from about $800 billion in mid-2008 to about $2 trillion in November 2010.1 When the Federal Reserve announced a second round of quantitative easing (QE2), it raised investor concerns that such actions would stoke inflation.
The chart below shows that the US monetary base has spiked since 2009. While inflation has fluctuated considerably, it has not tracked the changes in the monetary base. Although no one can reliably forecast inflation, we think markets do a pretty good job of sorting through all the macroeconomic data. At present (mid December), the markets do not appear to reflect expectations of runaway inflation in the near future.2
US Monetary Policy since 2000
Source: Federal Reserve Board
Nevertheless, investors may be growing anxious in response to media coverage of the Fed’s continuing expansionary policy. For those who are certain QE2 will be inflationary, perhaps the recent example of Sweden’s monetary base run-up will offer some reassurance.
In the 1990s, Sweden’s central bank, the Riksbank, more than doubled the country’s monetary base during the Nordic banking crisis, but inflation remained moderate during and after the expansionary period. The graph below documents that even as the monetary base jumped from 1994 to late 1996, inflation did not follow suit, and in fact, remained flat before falling in 1996.
Swedish Monetary Policy in the 1990s
Source: Sveriges Riksbank
Sweden’s monetary base expansion is one of several international examples of quantitative easing over the past two decades. These case studies, which include past expansionary periods in the UK, Switzerland, Japan, Australia, New Zealand, and Iceland, are discussed in a recent Federal Reserve Bank of St. Louis review.3 The researchers concluded that doubling or tripling a country’s monetary base does not lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy.
Of course, many factors may come into play, and we cannot know whether the US will share the same fortune. But at least we know that quantitative easing has occurred without triggering high inflation.
Endnotes
1. Monetary base is the total amount of the liquid currencies circulating in the hands of the public, deposits in financial institutions, and the deposits of the commercial banks in the central bank of the respective country.
2. One indicator of expected future inflation is the difference in rates between US Treasury bonds and Treasury Inflation Protected Securities (TIPS), also known as the TIPS spread. As of December 16, the 10-year zero-coupon TIPS spread was 2.35% (http://www.federalreserve.gov/econresdata/researchdata.htm). Consider, however, that the spread also includes an inflation risk premium, so the spread is not an exact measure of the market’s inflation expectations.
3. Richard G. Anderson, Charles S. Cascon, and Yang Liu, “Doubling Your Monetary Base and Surviving: Some International Experience,” Federal Reserve Bank of St. Louis Review 92, no. 6 (November/December 2010): 481-505.
Disclaimers
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.
Past performance is no guarantee of future results. This article is provided for informational purposes only and should not be construed as an offer, solicitation, or a recommendation from Dimensional Fund Advisors. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission.
©2010 Dimensional Fund Advisors
Cyber Scams: Beware When Posting Personal Information
From the Denver District Attorney’s Office:
Be careful of what you post on social networking websites. The popularity of sites such as Facebook or Myspace is also becoming the primary data source for fraudsters. Although these sites are resourceful ways of keeping friends and family informed, much of what is posted reveals the kind of information criminals are looking for in order to carry out more sophisticated and personal scams. Details one should be wary about posting include names and birthdates of family members, marital status, hobbies, hangouts, addresses, who’s on vacation or on a military tour, etc. Vigilance is especially important when it comes to protecting the identity of children. Cyber-scams cover all age ranges, cross all social spectrums, and are often up-dated versions of scams that have been around for a long time. The following are examples of common frauds perpetrated on-line or over the phone based on information obtained through social networking sites:
Grandma Scam: An older person gets a frantic call, presumably from a “grandchild” who claims to have been a victim of a crime or an accident, typically in Canada, or overseas. They need money wired immediately to get out of a jam. Posing as the grandchild, the con artist will give plausible reasons as to why the parents must not be told. These scams are often elaborate - another voice, perhaps a “police officer” or “bail bondsman” may get on the line, will ask the grandparent to verify personal information about the grandchild, then will give instructions on where and how the money is to be wired. Panicked grandparents comply, often wiring several thousands of dollars.
One variation of the ‘grandma scam’ is the call from a “grandchild” in the military who wrapped up a tour of duty early and wants to “surprise” the parents by returning home. The “problem” is there’s no money to do so. Delighted to be “in on the scheme”, the grandparents wire the amount that is requested to get the grandchild back home.
Friend in Distress: Yet another and very similar ploy is the “friend in distress”. In this scam, a participant of a social networking site receives a message from a site host “friend” professing to be overseas, and in a terrible mess. They appeal to their network friend(s) to wire them money to get back home. Unbeknownst to the network site host, their website has been hacked and taken over by fraudsters who are carrying out the scam.
Romance or “Sweetheart” Scams: Predators browse social networking sites to seek out on-line “romances”. To lure victims, they post eye-catching, but bogus photographs of themselves. Unlike other on-line frauds, sweetheart scams develop slowly and are relatively long-term. Suddenly, the “suitor” is faced with an awful dilemma and needs cash. Perhaps it’s a sick child, a terrible accident, or a false imprisonment. Sound familiar? The victim is asked to wire money, or to cash a money order and to send back the cash. A couple of distinguishing characteristics of the sweetheart scam is the suitor’s poor use of English grammar, and frequent, overused expressions of love. Many sweetheart scams originate in Nigeria or Angola, and involve third-party accomplices’ in another country, typically England or Canada.
DON’T BECOME A VICTIM!
- Be careful when posting personal information. Keep in mind that prisoners often peruse social networking sites, and can perpetrate a scam from jail.
- Never share detailed information about upcoming trips, military tours of friends or family members, birth dates, addresses, etc.
- Be mindful that photos might reveal too much background information, such as street names or license plates.
- Don’t post the full names of children or their friends.
- Always call a grandchild, friend, parents, etc. to verify that they are in fact, safe.
- Don’t click on any link or respond to any hyperlink on a networking site. Often, this is how malware or viruses are introduced. Promptly delete!
- Change passwords often, and establish separate passwords for individual sites.
- Check privacy settings on network sites and give careful thought about the personal information others can access.
- Keep virus protection software programs updated regularly.
- A WORD ABOUT WIRE TRANSFERS . . . It’s the preferred method used by criminals because money sent over a wire is difficult to trace.
Scams that play on emotions not only result in the loss of substantial money, but are particularly devastating to victims. The inability to stop,or to prove such crimes are all the more reason to take special precautions when sharing personal information with others on-line.
Denver DA’s Fraud Line: 720-913-9179
Navigating Structured Products
In recent years, structured products have gained favor among retail investors in Europe and the US. Investment banks promote these securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.
Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.1 With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.
Basic design
A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula. Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes.2 The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it. Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.
One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset’s gain. Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.3
The following summarizes a few common characteristics of structured products:
- Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.
- Substantial cost: These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.
- Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.
- Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.
- Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver. Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market. To avoid a potential liquidity problem, investors should consider the time horizon of the product and attempt to match its maturity to their anticipated financial need or objective.
- Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).
Who might benefit?
A structured product might help an investor who needs a specific payout at a designated point in the future and who is willing to pay another party to shoulder much of the uncertainty. But this benefit generally comes at the expense of lower yield or limited upside potential.
One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company’s stock (even though this might mean giving up the upside potential of the stock), and at the same time, provide better-diversified exposure to an equity index, such as the S&P 500.
Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent. And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.
Endnotes
1 Larry Light, “Twice Shy on Structured Products?” Wall Street Journal, May 28, 2009.
2 A reverse convertible bond is one example of a yield enhancement tool. It pays investors a higher coupon rate than other comparable bonds due to its higher risk. This risk comes in the form of the issuer having the option to pay off the debt with either cash or a predetermined number of common stock shares. The method of payment at time of maturity will depend on the stock price, and the issuer will pay with common stock when it is advantageous to do so. The reverse convertible bond was popular until the last market crisis, when many investors experienced heavy losses when they were paid off with lower-value stock shares.
3 A call option provides the holder the right to buy the underlying security at a given price at a certain time in the future. A put option provides the holder with rights to sell the underlying security at a pre-specified price on maturity date. (American-style options can be exercised before the maturity date, whereas European-style options can be exercised only on the maturity date.) An option holder will exercise the put or call option only if the payoff is positive.
Disclaimers
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.
Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.
Portfolio Endurance
The need for retirement planning doesn’t end with the onset of retirement. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life—and through different economic and market conditions.
Experts have studied portfolio longevity or endurance to help retired investors reduce the odds of depleting their wealth too soon. The studies evaluate how a portfolio might endure under the stress of changing markets and spending levels. The resulting models estimate portfolio survival in terms of statistical probabilities.1 While the technical details are beyond the scope of this article, the general conclusions are more intuitive.
Three main factors drive portfolio endurance: asset mix, spending level, and investment time frame. Certain aspects of these factors are within an investor’s control while others are not. Let’s briefly consider them.
Asset Mix
Asset mix describes the ratio of stocks to bonds in a portfolio. This determines risk exposure and expected performance, and is one of the most important decisions investors of all ages can make. Historically, stocks have outperformed bonds and outpaced inflation over time. This return premium reflects the higher risk of owning stocks.2 Consequently, the larger the equity allocation, the greater a portfolio’s expected return—and risk.
Keep in mind that risk and return go together. A higher allocation to equities increases the risk of experiencing periods of poor returns during retirement. But if you can handle the risk, having more equity exposure in a portfolio enhances its return potential. Growth can bring higher cash flow, inflation protection, and portfolio endurance over time. This is why most advisors believe that most investors should have an equity component in their portfolios, with actual weighting depending on one’s time frame, risk tolerance, and spending flexibility.
Spending Level
Portfolio withdrawal is typically described in terms of a specified dollar amount (e.g., $50,000 per year) or a percent of annual portfolio value (e.g., 5% of assets each year). Neither method is ideal, however—and for different reasons. Briefly consider each one:
- Specified dollar amount: withdrawing a fixed amount each year and adjusting it for inflation can provide a stable income stream and preserve your living standard over time. But the portfolio may survive only if future withdrawals represent a small proportion of the portfolio’s value. One academic study quantified this amount. It found that a retiree with at least a 60% stock allocation can withdraw up to 4% of initial portfolio value (adjusted for inflation each year), and enjoy a high probability of never running out of wealth.3 Choosing a higher withdrawal amount is not likely to be sustainable, especially if the portfolio faces an extended period of negative returns.
- Percent of annual portfolio value: withdrawing a fixed percentage of assets based on annual asset value makes it unlikely that you will deplete retirement assets because a sudden drop in market value would be accompanied by a proportional decline in spending. But this method can produce wide swings in your living standard when investment returns are volatile.
Retirees who need relatively consistent cash flow may want to combine these two methods. One way is to withdraw cash flow according to a rule that combines past spending (e.g., an average of the past thirty-six months of cash flow) with a payout rate applied to current portfolio value. You can weight these factors to favor your preference for either more stable cash flow or a greater chance of portfolio survival. In effect, you are customizing your withdrawals to smooth out consumption while responding to actual investment performance.
Investment Time Frame
Investment time horizon may be the hardest to estimate, especially if it is the same as your lifespan. In this case, you can only guess how long your portfolio must support spending. If you plan to bequeath assets, your investment time frame may extend beyond your lifetime. This may influence your risk and spending decisions as well.
Time frame forces a tradeoff between the short and long term. Retirees with a longer investment time horizon might choose a higher exposure to equities. But they may have to offset this risk by being more flexible about spending over time. Elderly retirees and others with a short time horizon may choose a less risky allocation or a higher payout rate, although they can experience rising spending levels, too. In any case, retirees should think carefully about equity exposure and avoid taking more risk than they can afford.
Considerations
Planning involves assumptions about the future—assumptions that may not pan out. Although you cannot avoid making assumptions, you can ask whether they are realistic and consider how your lifestyle might change if future economic and financial conditions are much different than projected. For instance, you may assume an average return based on historical performance. But there is no certainty that future portfolio returns will resemble the past, regardless of time frame. Moreover, short-term results may vary drastically, which could force hard financial choices. Investors should think in terms of probability, not history.
Managing asset mix, payout, and time horizon inevitably involves tradeoffs. Exhibit 1 below illustrates the dynamics. For example, a bond-dominated portfolio with a lower expected return may suit investors with a shorter time horizon, or require them to accept a lower payout rate to increase the odds of portfolio survival. A portfolio with a higher allocation to equities may be appropriate for someone with a long time horizon or a strong desire for a high payout rate, but a higher assumption of risk also results in greater uncertainty about future wealth. Retirees who take this route must be able to handle the risk emotionally, and they should be ready to adjust their lifestyle in response to market downturns. In fact, investor flexibility plays a role in all of the tradeoffs.
Exhibit 1: Basic Tradeoffs in Portfolio Survival
Finally, although you cannot fully control these and other factors involved in portfolio endurance in retirement, having more wealth can improve the odds of having a less stressful financial life. A more substantial nest egg might enable you to take fewer risks, enjoy a higher sustainable spending rate, or extend the productive life of your portfolio.
Endnotes
1 Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” AAII Journal 20: 16–21. Also see: Bengen, William P. 1994. “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning 7: 171.
2 From 1926 to 2009, the S&P 500 Index returned an average 9.8% per year compared to 5.4% for long-term government bonds and 3.0% inflation. Sources: Standard & Poor’s Index Services Group for S&P 500 Index; long-term government bonds and inflation provided by Stocks, Bonds, Bill, and Inflation Yearbook™, Ibbotson Associates.
3 Cooley, Hubbard, and Walz, Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” 16–21.
Disclaimers
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Diversification neither assures a profit nor guarantees against loss in a declining market.
Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material is provided for informational and educational purposes only. It should not be considered investment advice or an offer to buy or sell securities.
