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The Independent Investor: Not All Bonds Are the Same

By Bill SchmickiBerkshires Columnist

Bondholders are holding their breath as they wait for the Federal Reserve Bank to begin hiking short-term interest rates. Most investors are expecting all bonds to take a hit at the outset of the country's first rate hike in nine years. What happens after that may surprise you.

Prior to the financial crisis and the stimulus policies instituted by the Fed to solve it, bond investors could count on a fairly predictable pattern of behavior among bond categories as interest rates rose. Historically, the Fed would begin to raise rates when they perceived the economy was growing too quickly. Why?

Because normally, unbridled economic growth will result in higher inflation, which is something no one wants. Higher rates would force the cost of borrowing to go up. That, in turn, would slow investment, spending and ultimately economic growth. The trick is to raise rates just enough to head off inflation while allowing the economy to continue to grow.  

In that kind of environment some bonds do better than others. To understand why, you need to know something about risk. To make it simple, there are two kinds of risk. Interest rate risk occurs when rates rise. That risk affects all bonds. Then there is the risk of bankruptcy.

Generally, U.S. government entities (Federal, state and local) are perceived to have little or no bankruptcy risk. Therefore, the fear of bankruptcy does not enter into the bond investor's calculations. Corporate bonds, on the other hand, do have this additional risk factor.

It is one reason why corporate debt, whether investment grade, convertible bond or high-yield (known as junk bonds), almost always offers a higher rate of interest than government bonds. Since the fortunes of most corporations are tied to the fate of the economy, when the country is doing poorly, the risk of corporate bankruptcy rises. Corporate bond prices fall and the interest rate they offer goes up. The opposite occurs when the economy is growing.

In today's growing economy, the most likely outcome of a moderate rise in interest rates (interest rate risk) on corporate bonds would be neutral to positive. Better prospects for companies in a growing economy would lessen bankruptcy risk. That will hopefully negate some or all of the losses incurred by rising rates overall.  

Corporate bonds of all kinds have performed well over the last few years, maybe too well. It may be why bonds overall will have a knee-jerk negative first reaction to the end of an era of easy money. But corporate debt should continue to do well at least until the Fed hikes interest rates to a level that tips the economy into recession. That could be years from now.

Various Fed spokesmen have reiterated over and over again that the pace of interest rate increases in the future will be slow and moderate.   

The moral of this tale is that in the future corporate bonds should do better than government bonds. My advice to investors who continue to insist on keeping the majority of their money in the bond market is to switch from governments to corporates at your earliest opportunity.

Bill Schmick is registered as an investment adviser representative with Berkshire Money Management. Bill’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquires to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.

     

The Independent Investor: The Risk of Rising Rates

By Bill SchmickiBerkshires Columnist

Conservative investors are becoming increasingly concerned that their bond holdings may be at risk. If and when the Federal Reserve Bank hikes interest rates this year, will bond holders be caught holding the bag?

It depends. The short answer would be that when interest rates rise, bond prices fall, if all else remains equal. That's because bonds have two sources of returns: changes in price and interest payments that move in opposite directions. If you hold your bond investment until the date it matures (whether that is a few months or as long as thirty years), you receive all the interest payments the bond pays out plus your original investment money back  at maturity providing you purchased it at par (the price it was initially offered).

For those of you who plan to hold your bonds to maturity and are happy with your present rate of interest, then there is nothing to worry about. Rates can rise all they want but why should you care?

The problem for many elderly, fixed income investors is that they are not sure they can wait the five, 10, 20 (and certainly not 30 years) necessary to cash in their bonds at par. Secondly, most retired investors acknowledge that at the present rate of interest income received, they can't make ends meet. So rising interest rates for them is a double-edged sword. It means that in the future the stream in interest income from bonds will improve, but bonds they hold now will go down in price at the same time.

If we focus on individual bonds in the short-term, when interest rates move up, basic bond math indicates that prices generally will decline. Price history also indicates that the longer the maturity of your bond, the steeper the decline. Therefore long-dated, low-interest individual bonds are the most risky investments you can hold in a rising rate environment.

On the other hand, bond funds usually decline less (but they still decline). Bond funds have a wide array of short, medium and long-term bond holdings that mature during different times with different rates of interest. That lessens the impact of interest rate increases over time.

Remember, too, that despite rising rates (or even because of them), governments and corporations must continue to raise money in the debt markets. Plants still need to be built, roads paved, and government programs financed but now the cost of borrowing is higher. There is usually a ready market for these higher yielding bonds depending on the quality of the issuer.  

As interest rates rise, bond buyers, including bond fund managers, are always buying and selling lower yielding bonds for higher yielding bonds. That tends to lessen the price depreciation they suffer over time. As long as interest rates do not rise too fast, most managers can stay ahead of the curve. They can offset price declines in their portfolio of bonds by buying bonds with higher interest payments over a longer period of time.

In summary, individual bonds are riskier than bond funds generally speaking. In our next column we will discuss the risks of different types of bonds and strategies to reduce that risk going forward.

Bill Schmick is registered as an investment adviser representative with Berkshire Money Management. Bill’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquires to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.

     

The Independent Investor: Boomers' Kids Don't Want Your Stuff

By Bill SchmickiBerkshires Columnist

You saved all your life, acquiring all sorts of assets that you now want to leave to your children. Today, more and more Baby Boomers are finding that their kids just don't want that antique auto or that original oil painting.

Too many of us fail to recognize that the Millennial generation has grown up with an entirely different view of the world, their possessions, one's life style and even value system. This may come as a shock. It did to me. As readers may recall, my wife and I have been downsizing for three years now. During the course of this process, we have offered our thirtysomething daughter and her husband all sorts of stuff that they didn't want. From snowboards to unopened Tiffany wedding gifts, they politely and gently declined our largesse. This includes larger assets as well.

We have, for example, the luxury of owning two homes, a weekend place and another dwelling close to the office. Although my daughter loves to visit and has a real sentimental attachment to the "country" home, she really has no interest in inheriting the old homestead.

"I just couldn't afford the upkeep and maintenance," she says. "It wouldn't be feasible."

If you haven't had this discussion with your kids, maybe you should.  I have learned that there is a major difference between how my generation (and my parent's generation) spent their time, versus today's Millennials. Previous generations spent most of their lives in pursuit of stuff. We worked to acquire stuff and spent most of our time buying, collecting, storing and enjoying our possessions. Any spare time we had was devoted to maintaining and repairing these symbols of our success. Many of us prided ourselves by measuring our self-worth by how many possessions we acquired.

When asked why we needed two houses, four cars and 11 wide-screen televisions, we answered "why, to leave to the kids and the grandchildren of course." We assumed our future generations would value, maintain and accumulate even more antique rugs, dining room sets, golf clubs etc. Brother, it's time to face the truth. They don't want our junk, no matter how valuable we think it is.

For one thing, they don't have room for it. I recently wrote a column on the growing trend by Millennials towards living in smaller houses, apartments and even trailers. My daughter has no room for my teakwood bookcase full of thousands of DVDs and CDs that I have painstakingly collected through the years. She shakes her head quietly while grinning at me, wondering why in the world I still own those things when all of these media products can be easily and simply obtained on the internet and stored/streamed through the Cloud.

In addition, most of our kids value mobility, adventure and experience far more than we did. Given the choice between spending $20,000 on a new car, or a three-week African safari, most of them would choose Africa. The argument that the automobile would last years longer than that safari doesn't faze them in the least.

To them, stuff has to have a purpose. It must be a means to an end, not the end itself. If something new accomplishes a purpose more efficiently, they dump the old and embrace the new. That may sound unsentimental or even ungrateful but it isn't. It's just different.

My daughter still wants to keep certain objects that evoke memories of our past together. Usually, they are small and hardly the most valuable objects. But they are valuable to her and in the end that's what counts. As for the rest of that stuff, my advice is to sell it, give it away, or dump it and spare your children that chore.

Bill Schmick is registered as an investment adviser representative with Berkshire Money Management. Bill’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquires to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.

     

@theMarket: Month-End Musings

By Bill SchmickiBerkshires Columnist

While the summer months are usually the slowest season on Wall Street, July has proven to be anything but. As we enter the month of August, can we expect the same?

Whether we focus on overseas markets or review our own, it is clear that volatility remained and will remain elevated. Overseas markets in Asia took it on the chin, while the United States was trapped in a trading range that will continue in the month ahead. The good news is that this range appears to have an upward bias, so we can expect some minor new highs as time passes.

For the month, the S&P 500 Index managed to stay above water with a 2.2 percent gain bringing the year's total to an unsatisfying 2.4 percent. Large cap stocks beat small cap stocks, which are down 1.7 percent (but still up 2.2 percent for the year). China, on the other hand, one of my favorite overseas investments, saw its largest monthly loss in six years with the Shanghai market down 14.3 percent. European shares (another recent recommendation) gained 4 percent for the month after plunging earlier as the Greece bailout debacle roiled those markets. The U.S. dollar rose 2 percent but most traders expect the greenback to continue to consolidate in a trading range after experiencing big gains last year.

The commodities markets were where the largest declines occurred in July. Oil dropped 15 percent. Precious metals also declined, led by gold, which was down 7 percent. King copper (off 9 percent) led other base metals and materials lower. The agricultural commodity sector also felt the heat with wheat dropping by 18 percent, corn by 10 percent and soybeans 9 percent.

Investors blame the commodity decline on a perceived slowing of the world's economies led by China. Although the macroeconomic evidence is murky at best, most traders would rather sell first and find out the truth later.

"Is this a buying opportunity," asked one California client recently?

 "Not yet," I answered, and here's why.

While I suspect the commodity space is experiencing the kind of wholesale massacre one looks for when the end of a cycle is in sight that does not mean it is time to buy.

To me, commodities are an asset class that experiences boom and bust periods that sometimes will last for several years or more. The latest boom was a decade long and could now be followed by declines that can last an equal amount of time, depending upon the global economy, the inflation rate and industry specific factors like new and more efficient methods of mining, growing etc. For the most part, commodity prices also tend to under and over shoot their fundamental value and that's what makes investing in them somewhat speculative.

Let's take gold as an example. Gold began its latest run back in 2002. It climbed from $279/ounce to above $1,900/ounce by 2012. That 10-year run has been followed by a decline to its present price of around $1,090 today. I have been looking for a further decline to under $1,000/ounce. Assuming that's the bottom for this precious metal, that does not necessarily mean you should buy gold or any other commodity at that point.

Many commodities will usually take several years after that to "base," once they have made a low. During that further consolidation period, any investments you might make will be dead money. Dead money means your investments go nowhere. In the case of commodities, since none of them pay dividends or interest, the opportunity cost of buying and holding them could be severe. Better to wait until the beginning of the next bull market before committing money to this asset class. That could be another two years from now. I'll let you know.

Bill Schmick is registered as an investment adviser representative with Berkshire Money Management. Bill’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquires to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.

     

The Independent Investor: Supermarkets Evolve to Survive

By Bill SchmickiBerkshires Columnist

We take our local supermarkets for granted. Like gas stations, there seems to one on almost every corner, at least in suburbia. With competition from a variety of sources, supermarkets have been forced to reinvent themselves and are doing a good job doing just that.

Historically, supermarkets are a low-margin business, barely eking out 1-2 percent profit margins annually. Even the "hot" areas of the grocery market, like natural. organic and gourmet food emporiums only command 3 percent to 6 percent margins but to the big store chains that's an attractive option.

In addition, the supermarkets industry is highly fragmented with the top 10 chains only accounting for 35 percent of the total number of grocery stores (although they account for over 68 percent of total industry sales in this country). In order to increase profitability, supermarkets are reinventing themselves and benefiting the consumer in the process.

Given that I'm the cook and grocery shopper in my family, I have some firsthand experience in shopping through this transition and so far I like what I see. Clearly your local megastore is going after the natural and organic food shopper. Most readers already know that you pay more for those items, substantially more in some cases. Have you also noticed that you are seeing more "local vegetables" right alongside those that are shipped in from elsewhere? If you are price conscious (like me) you might also notice the price difference. You could be paying as much as 50 cents more per pound for that locally grown spinach or kale but its fresh and you are supporting local farmers, right?

Supermarkets are adding other products and services where profits are far higher than that box of mac and cheese on sale every other week. Look for those "specials" to continue since middle and low-income shoppers account for 70 percent of grocery sales. Most shoppers tend to be price conscious and will switch if they feel that one chain’s prices are better than another's. In fact, super stores are marketing their weekly special flyers with renewed effort. The name of that game is to get the shopper into their stores.

Since food shopping is essentially a sensory experience, the grocery store is hoping that once in the door the consumer will be susceptible to the siren call of other more high-priced items that promise a variety of convenience, culinary and even educational experiences.

More and more markets are adding pharmacies, bakeries, coffee shops as well as salad bars, chef-prepared entrees, brunch stations and gelato bars. And God forbid if you go shopping hungry. I fully acknowledge that the sushi bar or an impulse order of hot wings at the grocery store has replaced my occasional visit to a fast-food burger chain or restaurant. All of that adds meat to the supermarket's net profits.

Since I, like 92 percent of American adults, believe that eating at home is healthier (and cheaper) than eating out, my main objective in the supermarket is still shopping for fresh food. However, I'm frequently drawn to the seafood or butcher's counter where the slicing, dicing, marinating and stuffing has been done for me by the store's "sous chef."

These wily grocers are also bundling together other meal components right next to the meats and fish, which are easy to prepare and taste almost as good as my own, with a few finishing touches.  I admit that on busy weeknights, going this route makes fixing dinner for two an easier and faster affair. Granted, I'm paying up for the pork roast with cranberry stuffing but still paying less than I would going out to eat. The supermarket’s profit is much higher as a result.

I'm still not using the online applications that stores are offering. There are well over 1,000 apps offered by my iPhone right now and that number is growing exponentially each day. More and more establishments are offering lessons in everything from basic cooking to preparing for your next Super Bowl party. Healthy eating for you and the family, educational courses and advice in weight loss management, heart, diabetes, food allergies and even family mealtime management are now offered along with countess recipes and food guides.

The bottom line seems to me that we are all paying more while the supermarkets are making more as a result, but the added services and products seem to be a fair trade. That's a win-win for everyone.

Bill Schmick is registered as an investment adviser representative with Berkshire Money Management. Bill’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquires to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.

     
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