Warren Ward Associates

Money for Nothing

My articles tend to be at least somewhat topical, often attempting to answer a question from the headlines or being asked by our clients. Today’s deals with interest rates, as have several in the past. I am readdressing the topic because current rates may tempt investors to take risks they don’t understand in order to earn a little extra income.

The title of this article was borrowed from a Mark Knopfler song describing that fact that he loves playing music so much that he feels as if he’s able to make his living doing something he’d willingly do free. That’s a very rare situation indeed. Most individuals and institutions earn their income for doing at least some amount of work. Considering risk and reward instead of work and pay, people can be thought of as earning their money by accepting a range of risks. Quite appropriately, the safest investments pay the lowest rates. Towards the end of 2009, treasury bills moved to a negative interest rate, as buyers overwhelmed sellers and paid more than face value to get those extremely safe bonds into their portfolios by year-end.

With rates sitting near historical lows, we are again hearing about investment strategies that promise to deliver above-market rates of return while assuming little or no additional risk. Of course, this is virtually impossible to achieve. We only need to look 18 months into the past at the government agency-backed bonds which were popularly deemed failsafe, at least until banks began to close.

In my 2006 article The Quest for Yield, I described some interest-paying investments I thought made sense for that time and others that didn’t. Toward the end of that article, I pointed out that our recommendations change over time, as well as being tailored to each individual client’s situation. As an update to those comments, here are some thoughts for your consideration.

We do not recommend these investments for anyone today:

Fixed annuities   These CD-like investments are sold by insurance agents. Typically, the first year rate is guaranteed (and usually enticing) but subsequent year’s rates often are not. Since there is usually a multi-year period during which a penalty for early withdrawal is in effect, we are not comfortable having future interest rates governed by a company’s generosity.

Bond mutual funds   Open-end bond funds have provided good performance over the past 18 months and we see many of them being sold to investors on that basis. Unfortunately, if the falling rates which helped past performance are replaced by rising rates, investors will face loss of principal value instead of experiencing growth. We would stay away.

Reverse Convertible Notes  These are another class of “manufactured” investments like the mortgage-backed bonds which got our economy into so much trouble in 2008. These are also extremely complex. While forecasting the income stream is fairly easy, determining the amount of principal which will be returned is quite difficult. Please avoid these too.

We believe these investments are currently worthy of consideration:

Dividend-paying stocks   Although stocks can certainly be risky and are always subject to fluctuation in value, over the long-term they have been a sound investment. In addition, they are the only investment of which we’re aware that offers the potential for a rising income stream. Like any stock investment, these must be chosen carefully but this can be a very rewarding approach.

Floating-rate funds   Each of these is backed by the loans which businesses take out to meet their day-to-day cash flow needs. Typically, these loans are very short term (almost always less than a year) and rates are readjusted at the end of each term. This makes them a reasonable choice should interest rates rise. We feel that whatever additional risk comes from investing in these smaller businesses is offset by the large number of companies in each portfolio and the higher rates they are charged.

There have been times, and probably will be again, when we recommend both annuities and bond mutual funds, although I doubt we’ll ever become comfortable with Reverse Convertibles. Likewise, the time may come when we don’t think dividend paying stocks or floating rate funds make sense. We always offer investing advice in the context of individual situations, considering the current economy. We don't believe there is any practical way to “set and forget” an investment portfolio.

Getting back to the author of today’s title, in addition to receiving “money for nothing”, Knopfler’s song goes on to extol the value of being famous when it comes to meeting women. He describes them as a side-benefit which accrues “for free”. As rock stars and sports figures are constantly re-learning, nothing in life is truly free, whether an improved social life or higher interest rates.

Beware of Greeks bearing...

The Dow Jones Industrial Average briefly fell below 10,000 in February of 2010. Most commentators blamed the drop on the potential default by the Greek government on its “sovereign debt”, i.e. its government bonds. A bit later, Germany (and more reluctantly, France) committed to help their economically weaker Euro-zone neighbor and global markets rebounded.

Higher interest rates are the price issuers pay for falling credit quality. Investors apparently assumed that any additional risk with Greece’s bonds was being compensated for through higher interest rates. This situation is quite similar to the credit bubble which caused the current US recession. In our case, unusually high rates of return were offered on what were described as investment grade bonds but in neither case did the rating agencies do a good job of assessing risk. Donald MacKenzie, Ph.D. from the University of Edinburgh has published an interesting paper in which he considers the recent credit crisis as a problem in Sociology. Here’s a chart excerpted from it (page 92 of PDF), comparing the anticipated bond default rates in the US mortgage financing market with the actual results. As you can see, the best estimate the agencies made was off by a factor of more than 10, the worst by a factor of over 300.

The rating agencies provided little or no warning of Greece’s credit problems although they did scurry to downgrade those bonds after the bad news came out. Speaking strictly for myself, I’d prefer that a rating agency be ahead of the curve, not behind it. However, these agencies are paid by the issuers of the bonds, so perhaps we shouldn’t be surprised that they tend to be a bit generous in their ratings.

In the fall of 2009, you could look anywhere in the financial press and find an article about the weakness of the dollar and the idea that it might lose its status as the world’s reserve currency. That concept ran counter to our thinking at Warren Ward Associates. We believe that currencies, just like market sectors, tend to move within ranges. With that in mind, it was our expectation that the dollar would strengthen again and that its position as the world’s favorite currency was never in serious jeopardy. Based on that premise, we oriented our clients’ portfolios to prepare for that outcome and were rewarded for doing so.

Did we anticipate the problems in the Greek bond market? No, we absolutely did not. However we did anticipate that something would happen and we find that most somethings can be hedged against.

According to Virgil’s Aeneid, a huge hollow horse was employed by the Greeks to sneak 30 soldiers into the city of Troy. Perhaps its best known line, uttered when the horse was discovered outside the city’s gates, is: “I fear Greeks, even those bearing gifts”. Lower quality bonds can be a gift when an investor understands the underlying credit situation and is fairly compensated for assuming the additional risk. However, being blindsided by a wholesale misreading of the risks or an issuer who simply does not tell the truth, affirms the need for diversification regardless of the asset category.