Grok's Tip #10: Get Real (Returns)!- the 3% solution

[grok87]

Grok's Tip #10: Get Real (Returns)!- the 3% solution.

Investing is risky. In 2008 the S&P 500 lost 37% and Emerging Markets lost more than 50%. From mid 1980 to mid 1981 the 10 year treasury rose 400 bps- a move like that today would cause losses to 10 year treasuries of around 30%. During 1980 the price of Gold was cut in half from $800 to around $400. But at least for bearing all these risks investors can look forward to the prospect of good future expected real (i.e. after inflation) returns, right? Hmmm…maybe NOT!

1) Let’s start with the Vanguard Inflation Protected Securities Fund (VIPSX). It currently has a real yield of -0.32%. Similarly the nominal yield on the Vanguard Intermediate treasury fund is just 0.96%. Year-over-year inflation (August) is currently running at 3.6% and Break-even inflation is around 2%, so the expected real return for the treasury fund looks to be -1% or worse.

2) Now let’s look at the S&P 500. Stock returns have 3 components: dividend yield, dividend growth, and multiple expansion. Let’s take the last component first- Professor Shiller’s irrational exuberance website ( http://irrationalexuberance.com/ )
shows the S&P 500 to have a PE10 multiple of over 20 vs. a long term average of around 16. So the S&P 500 looks fairly richly valued already and future multiple expansion seems unlikely. Turning now to dividend yield, the Vanguard S&P 500 Index (VFINX) has a yield of 2.2%. As far as dividend growth, historically real dividend growth has averaged a bit over 1% (over the last 50 years it’s 1.06%). So a reasonable guess for the future expected real return of the S&P 500 is dividend yield + dividend growth = 2.2% + 1.05% = 3.25%.

3) So if you had 50/50 stock/bond portfolio using these 3 funds you might expect a future real return of about 1.3%- not very enticing compensation for all those investing risks…Let’s see if we can perhaps do a bit better…

4) I Bonds and 30 year TIPs: Instead of VIPSX why not use a combination of IBonds and 30 year TIPs? IBonds have real yield of 0% which is at least not negative. 30 year TIPs are yielding 1.05%. So using a 50/50 mix of these would result in a real yield of 0.53%. Plus IBonds have a nice “Put option” feature. If real rates rise both VIPSX and 30 year TIPs will take a hit (30 year TIPs will get hit more as they have a higher duration). But with I-Bonds you can cash in at par and reinvest at the higher rates. Newly issued TIPs have some optionality as well- they have a "deflation put". What this means is that TIPs will always guarantee you your full return of nominal principal even if there has been net deflation over the period from their issue date to their maturity date. It's hard to place a value on these put options embedded in Ibonds and Tips but let's say for the sake of argument it is worth 25 bps (0.25%). That brings the real return for the Ibonds/Tips mix to 0.78%


5) Similarly instead of the Vanguard Treasury fund yielding less than 1%, why not invest in 7 year PenFed CDs yielding 2.75%?
https://www.penfed.org/productsAndRates ... icates.asp
7 year break-even inflation is about 1.80%, so that’s a real yield of 0.95%. And similar to Ibonds you get a valuable put option. If rates rise you can cash in early (losing just 1 years interest) and reinvest at the higher rates. Again, For the sake off argument let's assume the put option is worth 0.25% bringing the real yield to 1.2%

6) European equities: Many people are quite negative on Europe right now. Perhaps because of this European stock markets seem to offer better future expected returns than the S&P 500. According to the Economist, the PE10 for European markets is about 12, much lower than the 20 for the S&P 500. Dividend yields are higher as well. VGK, the Vanguard Europe Stock ETF currently yields 5.2%
http://www.google.com/finance?client=ob&q=NYSE:VGK
So to sum up you have the possibility of multiple expansion and a better dividend yield. Even if dividend growth in Europe is weak, future expected real returns for European Stocks might be 6% or so.

7) Now I wouldn’t advise putting all your equity allocation in Europe. But if one did a 50/50 mix of the US and Europe that would boost the average expected real stock return to 4.625%. And if you use Ibonds, 30 year Tips and CDs for your bond money they should have a positive real return of about 1% bringing the real return figure for the 50/50 portfolio up to 2.8% or more than double the 1.3% we started out with in 3) above.

And finally since your equity portfolio is now a bit better diversified, arguably one could shift ones asset allocation a bit more towards equities with their higher real returns. I think one should be a bit cautious with this line of reasoning- in 2008 international diversification didn't really pay off. But perhaps one might shift 5% points from bonds to equities. With a 55/45 stock/bond mix, with equities split between US and Europe, and bonds in the Ibonds/30 year TIPs & CD mix the expected real rate of return rises to 3%.

In this world of low expected returns and turbulent markets 3% real return is good enough for me!
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Note: this tip is part of a series of investing tips- the complete list can be found here:

viewtopic.php?t=72045&highlight=

cheers,

[xerty24]

It's also worth thinking about the effect of taxes on your real returns, and this is especially true for bonds/CDs where taxes are applied every year (EE/I bonds being a rare exception with a tax deferral option). Obviously this depends on the details of your circumstances, but the 2.75% CD cited will only bring home just over 2% after 25% taxes (essentially breakeven vs expected inflation), or only 1.80% at 35% tax (slightly negative).

It's worth noting that while everyone's taxes are different, in general taxes on "inflationary gains" are worse when nominal rates are high. In the above example, a taxpayer might be losing 0.75 to 1% of returns to taxes. If inflation was 7% and the CD paid 7.75% (the same 0.75% in excess of expected inflation), the taxpayer would be losing 1.9-2.6% and be looking at an expected real loss of 1-2% per year.

At least the Fed's ZIRP isn't taxing us quite as much on our illusionary gains as usual.

[stratton]

TIPS and Ibonds are your friend.

Paul

[fredflinstone]

"According to the Economist, the PE10 for European markets is about 12."

I read this on another thread, but am reluctant to base investing decisions on information provided by some writer at the Economist. Can anyone provide a second citation for this factoid?

[neverknow]

Grok's Tip #10: Get Real (Returns)!
...
cheers,

You have described my allocation, pretty closely. Except perhaps, I didn't go out quite as long with my CD's and run a 4 tier 2 year ladder -- roll over and forget it. I do have one 6 year CD at 3.2% I'm chock full of I Bonds - my TIPs are 2032 and 2040. In addition to European Index (VEUSX), I also own a tad of the utilities etf XLU (I own a few other equity funds, but overall - equities are only a smidge of my allocation).

I would like real returns, but if I can just pace inflation - that would be my goal. If I could just pace inflation after taxes, that would be really nice.

It is the way of the turtle. It is the way of compounding.

Everyone needs to decide for themselves. What is the allocation that won't make me cry in my soup when the markets rocket higher without me, or make me cry in my soup as the markets tank with me?

And then stay the course.
neverknow

[BlueEars]

...(snip)...
6) European equities: Many people are quite negative on Europe right now. Perhaps because of this European stock markets seem to offer better future expected returns than the S&P 500. According to the Economist, the PE10 for European markets is about 12, much lower than the 20 for the S&P 500. Dividend yields are higher as well. VGK, the Vanguard Europe Stock ETF currently yields 5.2%
http://www.google.com/finance?client=ob&q=NYSE:VGK
So to sum up you have the possibility of multiple expansion and a better dividend yield. Even if dividend growth in Europe is weak, future expected real returns for European Stocks might be 6% or so.

7) Now I wouldn’t advise putting all your equity allocation in Europe. But if one did a 50/50 mix of the US and Europe that would boost the average expected real stock return to 4.625%. ...

What about currency risk? As I recall the Euro has been very overvalued measured on a PPP basis. That can apparently go on for years and then maybe there is a sudden market change ...

[Bongleur]

iBonds are just pocket change. You can't buy enough to make up a significant part of an AA. Well, maybe for an early accumulator.

T Rowe Price Euro fund lost about 25% in the 3rd quarter.

[Mitchell777]

Grok's Tip #10: Get Real (Returns)!
...
cheers,

You have described my allocation, pretty closely. Except perhaps, I didn't go out quite as long with my CD's and run a 4 tier 2 year ladder -- roll over and forget it. neverknow

How does a "4 tier 2 year ladder" work? Thanks

[neverknow]

Grok's Tip #10: Get Real (Returns)!
...
cheers,

You have described my allocation, pretty closely. Except perhaps, I didn't go out quite as long with my CD's and run a 4 tier 2 year ladder -- roll over and forget it. neverknow

How does a "4 tier 2 year ladder" work? Thanks

4 CD's, every 6 months (6 month, 12 month or one year, 18 month, 24 month or 2 years) - makes a 4 tier 2 year ladder. I began, just as I laid out - lump sum divided into 4 parts, but as they matured, they each then get rolled over into a 2 year CD -- forever. I thus, have built a 4 tier 2 year ladder that will receive 2 year rates, renewing every 6 months (which presently, has just resulted in lower rates, but if rates ever should rise again, I will catch the rise). A set it and forget it approach. I chose brick and mortar institutions, I can drive up to and speak to a human, whom lend to my community. I remain within the FDIC limits.

The way of the turtle (from the tortoise and the hare).
neverknow

[neverknow]

iBonds are just pocket change. You can't buy enough to make up a significant part of an AA. Well, maybe for an early accumulator.

T Rowe Price Euro fund lost about 25% in the 3rd quarter.

I Bonds are 10% of my allocation. I didn't necessarily mean for this to happen, but as each year passed and I bought some -- they accumulate.

My Vanguard European Index is my biggest loser. As it is no more then 3% of my total allocation -- it just doesn't matter a whole lot. European equities appear to be value priced and pay dividends for you to own the equity of these International companies. Yes, there is currency risk. Again, at 3% of my total allocation -- it just doesn't matter.
neverknow

[Mian]

Thanks for #10 Grok! Actually, thanks for all of the Investing Tips!

[nbatt]

GROK

How about a Vanguard managed stable value fund yielding over 3%?

[natureexplorer]

Really? The bottom line is that a 3 percent real return is not possible without taking substantial risk.

[neverknow]

Really? The bottom line is that a 3 percent real return is not possible without taking substantial risk.

I have no idea what was meant in the title of this thread. I have a 3% nominal return. Today. And I am pretty happy with that. Could be better. Could be worse.
neverknow

[Noobvestor]

Why no long-term Treasuries? ~4% yield to maturity on EDV at Vanguard - average duration/maturity ~25 years, and bonus flight-to-safety benefits (albeit since we're currently IN something of a flight to safety, these are a bit pricey compared to a few months back!)

[abuss368]

Buy the TIPS fund even for a taxable account.

Too good to pass up!

[neverknow]

Why no long-term Treasuries? ~4% yield to maturity on EDV at Vanguard - average duration/maturity ~25 years, and bonus flight-to-safety benefits (albeit since we're currently IN something of a flight to safety, these are a bit pricey compared to a few months back!)

3.2% is the long term historical inflation rate in the US. In my opinion (it is my opinion only) -- something is wrong, when the 30 year yields less then long term historical inflation. I am not smart enough to know what that something is, but I don't want to own long dated treasuries when something is wrong (whatever that something is). I sold all that I owned - last sale was Sept 22 2011. I'm not saying I would never own them again, but I am not interested right now. Let someone else smarter then me figure it out.
neverknow

[grok87]

It's also worth thinking about the effect of taxes on your real returns, and this is especially true for bonds/CDs where taxes are applied every year (EE/I bonds being a rare exception with a tax deferral option). Obviously this depends on the details of your circumstances, but the 2.75% CD cited will only bring home just over 2% after 25% taxes (essentially breakeven vs expected inflation), or only 1.80% at 35% tax (slightly negative).

It's worth noting that while everyone's taxes are different, in general taxes on "inflationary gains" are worse when nominal rates are high. In the above example, a taxpayer might be losing 0.75 to 1% of returns to taxes. If inflation was 7% and the CD paid 7.75% (the same 0.75% in excess of expected inflation), the taxpayer would be losing 1.9-2.6% and be looking at an expected real loss of 1-2% per year.

At least the Fed's ZIRP isn't taxing us quite as much on our illusionary gains as usual.

Agree, i think generally one would want to put the TIPs and CDs in tax-advantaged space. The other consideration is to not let your CDs be more than $250k which is the FDIC limit

[grok87]

TIPS and Ibonds are your friend.

Paul

well longer dated TIPs I guess. It's disappointing that TIPs yields are negative out to about 7 years!
cheers,

[grok87]

"According to the Economist, the PE10 for European markets is about 12."

I read this on another thread, but am reluctant to base investing decisions on information provided by some writer at the Economist. Can anyone provide a second citation for this factoid?

Hi fred,
I think perhaps this link might be helpful.

http://mrmarket.eu/?p=4
cheers,

[grok87]

Grok's Tip #10: Get Real (Returns)!
...
cheers,

You have described my allocation, pretty closely. Except perhaps, I didn't go out quite as long with my CD's and run a 4 tier 2 year ladder -- roll over and forget it. I do have one 6 year CD at 3.2% I'm chock full of I Bonds - my TIPs are 2032 and 2040. In addition to European Index (VEUSX), I also own a tad of the utilities etf XLU (I own a few other equity funds, but overall - equities are only a smidge of my allocation).

I would like real returns, but if I can just pace inflation - that would be my goal. If I could just pace inflation after taxes, that would be really nice.

It is the way of the turtle. It is the way of compounding.

Everyone needs to decide for themselves. What is the allocation that won't make me cry in my soup when the markets rocket higher without me, or make me cry in my soup as the markets tank with me?

And then stay the course.
neverknow

agree.
Re the longer CDs, some banks have fine print where they can refuse to let you cash them in early. PenFed doesn't have fine print like that. I think their fine print says something like they reserve the right to require a written communication that you want to cash in early 60 days in advance.
So the point is, if one is careful and reads the fine print, one can buy the longer dated cds with their higher yields and just cash them in early if one need the money or one just wants to roll them over early to take advantage of higher rates.
The idea is further discussed in this thread
viewtopic.php?t=44081&highlight=
cheers,

[grok87]

...(snip)...
6) European equities: Many people are quite negative on Europe right now. Perhaps because of this European stock markets seem to offer better future expected returns than the S&P 500. According to the Economist, the PE10 for European markets is about 12, much lower than the 20 for the S&P 500. Dividend yields are higher as well. VGK, the Vanguard Europe Stock ETF currently yields 5.2%
http://www.google.com/finance?client=ob&q=NYSE:VGK
So to sum up you have the possibility of multiple expansion and a better dividend yield. Even if dividend growth in Europe is weak, future expected real returns for European Stocks might be 6% or so.

7) Now I wouldn’t advise putting all your equity allocation in Europe. But if one did a 50/50 mix of the US and Europe that would boost the average expected real stock return to 4.625%. ...

What about currency risk? As I recall the Euro has been very overvalued measured on a PPP basis. That can apparently go on for years and then maybe there is a sudden market change ...

Good point about the currency risk. That is a bit of a wildcard right now for Europe- what if the euro breaks up etc.
In general though sometimes when a country's currency devalues it can help the country's stock market out- their exporters do better, etc.
cheers,

[grok87]

iBonds are just pocket change. You can't buy enough to make up a significant part of an AA. Well, maybe for an early accumulator.

T Rowe Price Euro fund lost about 25% in the 3rd quarter.

Yeah I think the point is to start early with Ibonds. A married couple can buy $20 k per year- will be $10k per year next year i think.
I bonds make up only 11.25% of the portfolio I am suggesting. So as long as you are contributing 90k or less per year, you should be able to buy enough for that year's portfolio contribution, even with the $10k limit.
cheers,

[grok87]

Thanks for #10 Grok! Actually, thanks for all of the Investing Tips!

your welcome!

[grok87]

GROK

How about a Vanguard managed stable value fund yielding over 3%?

Well I'm not an expert on stable value funds. But in general I'd be cautious with them. People have lost money in them unexpectedly already-chrysler motor, see this link
http://www.reuters.com/article/2009/04/ ... 2520090403

So if we get to a real financial crisis all bets are off. The problem is that the funds use insurance companies to wrap the bonds in the fund- i.e. provide protection against interest rate fluctuations. But those wraps are only as good as the insurance company guarantees. In 2008/09 life insurance companies were really on the ropes- look a this chart for genworth for example

http://finance.yahoo.com/q/bc?s=GNW+Basic+Chart&t=5y
cheers,

[grok87]

Why no long-term Treasuries? ~4% yield to maturity on EDV at Vanguard - average duration/maturity ~25 years, and bonus flight-to-safety benefits (albeit since we're currently IN something of a flight to safety, these are a bit pricey compared to a few months back!)

3.2% is the long term historical inflation rate in the US. In my opinion (it is my opinion only) -- something is wrong, when the 30 year yields less then long term historical inflation. I am not smart enough to know what that something is, but I don't want to own long dated treasuries when something is wrong (whatever that something is). I sold all that I owned - last sale was Sept 22 2011. I'm not saying I would never own them again, but I am not interested right now. Let someone else smarter then me figure it out.
neverknow

agree

[grok87]

Why no long-term Treasuries? ~4% yield to maturity on EDV at Vanguard - average duration/maturity ~25 years, and bonus flight-to-safety benefits (albeit since we're currently IN something of a flight to safety, these are a bit pricey compared to a few months back!)

I think there can be a role for long term treasuries. But if one is looking for real returns, long term treasuries can be risky. During the 70s for example long term treasuries got killed by high inflation.
Also I agree with your parenthetical comment.
cheers,

[grok87]

Buy the TIPS fund even for a taxable account.

Too good to pass up!

wouldn't work out too well in a high inflation scenario. See xerty's post above.
in a high inflation scenario you're really going to wish they were in a tax sheltered account.
cheers,

[A Devout Indexer]

Personally, I don't think the future will be as bleak. Agree bond yields are low and returns will be muted, but investors can own the Vanguard ST Investment Grade fund as the low risk/liquidity part of their portfolio and expect to earn a positive real return even before we consider the possibility of rising rates.

Further, looking at the p/b values of large/small and growth/value stocks from Ken French's website through early 2011, we entered the year at valuations only modestly above the '73-'10 average (over which time we saw 10% to 16% annualized returns on total stock, large value, small, and small value), and with the recent downturn have returned to almost exactly the average levels over the '73-'10 period. So average to above average returns going forward are very likely. And I don't see any reason why Europe/Asia isn't in a similar situation.

[Mitchell777]

Grok's Tip #10: Get Real (Returns)!
...
cheers,

You have described my allocation, pretty closely. Except perhaps, I didn't go out quite as long with my CD's and run a 4 tier 2 year ladder -- roll over and forget it. neverknow

How does a "4 tier 2 year ladder" work? Thanks

4 CD's, every 6 months (6 month, 12 month or one year, 18 month, 24 month or 2 years) - makes a 4 tier 2 year ladder. I began, just as I laid out - lump sum divided into 4 parts, but as they matured, they each then get rolled over into a 2 year CD -- forever. I thus, have built a 4 tier 2 year ladder that will receive 2 year rates, renewing every 6 months (which presently, has just resulted in lower rates, but if rates ever should rise again, I will catch the rise). A set it and forget it approach. I chose brick and mortar institutions, I can drive up to and speak to a human, whom lend to my community. I remain within the FDIC limits.

The way of the turtle (from the tortoise and the hare).
neverknow

Interesting approach to me as I near retirement. May I ask, do you spend the interest or just keep rolling the interest into the next CD?

[neverknow]

Grok's Tip #10: Get Real (Returns)!
...
cheers,

You have described my allocation, pretty closely. Except perhaps, I didn't go out quite as long with my CD's and run a 4 tier 2 year ladder -- roll over and forget it. neverknow

How does a "4 tier 2 year ladder" work? Thanks

4 CD's, every 6 months (6 month, 12 month or one year, 18 month, 24 month or 2 years) - makes a 4 tier 2 year ladder. I began, just as I laid out - lump sum divided into 4 parts, but as they matured, they each then get rolled over into a 2 year CD -- forever. I thus, have built a 4 tier 2 year ladder that will receive 2 year rates, renewing every 6 months (which presently, has just resulted in lower rates, but if rates ever should rise again, I will catch the rise). A set it and forget it approach. I chose brick and mortar institutions, I can drive up to and speak to a human, whom lend to my community. I remain within the FDIC limits.

The way of the turtle (from the tortoise and the hare).
neverknow

Interesting approach to me as I near retirement. May I ask, do you spend the interest or just keep rolling the interest into the next CD?

For now, I am compounding the interest. However, as each 6 month period date comes up - the option is there to scrape off what I need. I have just gone to another bank (staying within FDIC limits) with the intent to set up another ladder. The current ladder matures in March & Sept. This new one I'll set up for Dec and June. This ladder I believe, looking forward to my future and the money coming out of tax deferred savings ... I'll be adding to, on the 6 month increments. -- What I'm looking for is the possibility of liquidity, in case of the need for a largish lump sum (such as un expected medical bills). Thus, the 2 ladders, will give me 4 points during the year to scrape off, or add too.

I don't go in for all the complexity of whether you can redeem them early, as grok87 is discussing. My life is complex enough. I'm not institution shopping for the best rates. In opening an account and making the commitment - I am looking for a banking partner in which to build a community. It is my turn to lend, not to borrow.

I do not see the world as bleak. I see the world a bit what might be considered old fashioned today. Spend less then you earn. The way of the turtle. Compounding is a good thing. If you earn 1-2% real, you are doing good. I used to be far more risk taking. But having ones nest egg gyrate by a whole years expenses, daily -- is no way to run a retirement! Or that is what I think. This is how I dampened that kind of volatility. I'm not sure I would know what to do with a 4% SWR. A 2% SWR is plenty. Or it looks that way to me now. This is not a bleakness. It is the way of the turtle.
neverknow

[Angst]

Hi Grok,

Would you give your 2 cents on buying 1.10% series EE Savings Bonds with the intent of holding for 20 years, raising that rate to 3.50%?
I'm already in I Bonds and the TIPS fund; I don't really want to go out 30 years on new TIPS issues. Thanks!

Angie

[magellan]

The other consideration is to not let your CDs be more than $250k which is the FDIC limit

For anyone at risk of going over the limit at a single institution, this FDIC link does a nice job of explaining how most families can increase the limit up to two or three million by titling accounts jointly, using multiple beneficiaries, and holding multiple accounts with different ownership types.

For a couple, insuring $1m is requires only three accounts (two single and one joint). For higher limits, payable on death (POD) accounts can be used with multiple beneficiaries.

The mix and match account registration rules can get a little complicated, but the website lays everything out pretty clearly.

Jim

[magellan]

5) Similarly instead of the Vanguard Treasury fund yielding less than 1%, why not invest in 7 year PenFed CDs yielding 2.75%?

I'm a big fan of this approach and have been using it for a while. I have a ladder of 5yr CDs and I roll the maturing CD each year into a new 5yr.

I count the CDs in my bond allocation. Taking the low credit risk of the ladder into account, I recently switched out of total bond market in favor of the Intermediate term investment grade fund. This is a bit of a market timing move, but my logic is that the CD ladder is nearly 50% of my bond allocation and has zero credit risk, so taking investment grade risk at the longer end of the curve isn't too risky and it lets me grab some extra yield from the unusually high credit spreads.

If these were normal times, I'd add an allocation to a long term bond fund to offset the short duration of the CD ladder and get a blended duration closer to total bond market, but for now I'm ok with a slight tilt to the short side.

As an aside, I know grok isn't keen on IG corporates, but I think investors will ultimately get paid for taking credit risk. Also, despite historical results, I don't think credit risk and equity risk are exactly the same thing and IMO it's very possible that they could be rewarded differently in the future.

Jim

(edited to fix typo)

[neverknow]

I these were normal times ...

I'm pretty sure I have no idea whether these are normal times -- or not. It is different then the 70's, the 80', the 90's, the -- what do you call the next 10 years? It is always different, but NOT different this time.

This is what changed my thinking. Pretty much, my entire lifetime of investing, and peaking ... it was like take all the risk you can, earn all you can, the least taxes, the most efficient, maximize profit etc. What happens if I turn that entire mindset upside down, and take as little risk as is necessary to meet my goals? The effect on me was nothing short of startling. I had never thought about that before. It had always been more, more, more. What if beginning right now, it is enough. Then what? What do I need to invest in to pace inflation, hopefully to pace inflation after taxes. The least risk, rather then the most I can tolerate.

I am showing I have 17% in equities, today (all index's of some sort). It's actually a bit more then I want, but just like my CD's - they are squirreled away in unobtrusive places - so that it matters very little whether they are screaming higher or lower (the equity market seems to only have these 2 speeds these days, radically higher or lower). As with everything else -- if you manage the downside, the upside takes care of itself.

FWIW
neverknow

[fredflinstone]

"According to the Economist, the PE10 for European markets is about 12."

I read this on another thread, but am reluctant to base investing decisions on information provided by some writer at the Economist. Can anyone provide a second citation for this factoid?

Hi fred,
I think perhaps this link might be helpful.

http://mrmarket.eu/?p=4
cheers,

Great, thanks!

[grok87]

Hi Grok,

Would you give your 2 cents on buying 1.10% series EE Savings Bonds with the intent of holding for 20 years, raising that rate to 3.50%?
I'm already in I Bonds and the TIPS fund; I don't really want to go out 30 years on new TIPS issues. Thanks!

Angie

Hi Angie,
I'm not really a fan of EE Savings Bonds I'm afraid, at least not in their current fixed rate form. I have some of the older ones that pay a variable rate. Those I think could be a nice hedge against higher interest rates- i.e. if interest rates rise my other bond investments will take a hit but those variable rate EE bonds will start to shine...


Let's go over some of the features of EE bonds and how they might compare to an FDIC insured savings account.

1) 1.1% fixed rate
2) tax deferred
3) can't cash in for one year, for first 5 years can cash in and lose 3 months interest, after that can cash in without penalty
4) double in value if held for 20 years which works out to a 3.5% rate of interest

Let's take these features in turn
1) similar rates are available form online savings account. See this list for instance
http://www.depositaccounts.com/savings/
and of course these rates may go up in the future whereas with EE bonds you are stuck with that same 1.1% rate forever (unless you cash in early- more on that below).

2) with a rate that low the tax deferral isn't worth very much. Let's look at a holding period of 10 years. If you start with 10,000 and compound tax deferred at 1.1% and then cash after 10 years then you will have $10,867 assuming a 25% tax bracket. That works out to an after tax annual rate of return of 0.835%. If instead you have a taxable savings account with the same 1.1% rate then you will compound at a lower rate of 0.825% and end up with $10,856- basically the same, just $11 dollars less or a dollar per year!

3) to me the one year freeze and early withdrawal penalties are more important. FDIC savings accounts don't have any of these issues. Why encumber your savings with restrictions and penalties for an extra $1 per year on $10,000 of savings.

4) Now we get to the real point of your question- the doubling after 20 years. The problem is that's a long time to tie up your money. Who knows what might happen in that 20 year period. Let me paint for you the sort of scenario I worry about with this sort of thing:

a) you buy a EE savings bond yielding 1.1% but plan to hold for 20 years to get the 3.5%

b) a couple of years down the road the economy recovers, savings accounts start paying 2-3%

c) you're tempted to cash in your EE savings bonds and switch to a savings account. But you're still lured by the promise of that 3.5% after 20 years. So you don't.

d) then 10 years later rate really take off. savings accounts are now paying 6% or so. You're really tempted to cash in the EE bonds to grab that 6% rate. But then someone points out to you that if you cash in now (after earning 1.1% for 10 years) then you will need to get 6% for the next 10 years to average out to the 3.5% rate from holding the EE bonds for the 20 year doubling period. So you do nothing.

e) 5 years later rates really take off again. There is high inflation, a repeat of the 70s and savings accounts are yielding 10%. You can see where I'm heading with this now right? THe same guy points out to you that if you cash in those EE bonds now, after earning 1.1% for 15 years, then you will need savings accounts rates to stay at 10% for the next 5 years to average out to that 3.5% rate holding the EE bonds for the 20 year doubling period. So you do nothing.

f) then a few years later something bad happens. You die and your husband cashes in the bonds early. Or you get sick or laid off and need the money so you cash in early. The 3.5% goes up in smoke. And you missed out on all those higher savings rates, the 2-3% rates, the 6% rates and the 10% rates.

All this is a long winded way of saying that optionality is really important. You want products that have good optionality, like mortgages you can pay off early, or CDs you can cash in early with cheap penalties so you can invest at higher rates if you want to. You don't want the negative optionality that comes from having to hold EE bonds for 20 years to get that 3.5% rate,

hope that wasn't too longwinded
cheers,

[grok87]

i bonds
for those interested I believe current total rate is attractive, may want to buy in the next week or so before it changes...

[Angst]

hi grok,

thanks for your reply re: "20-year" series EE savings bonds - i really appreciated it and found it very comprehensive, not "longwinded"! i am most interested though in the context of making a 20-year commitment. i guess i asked b/c i look at the nominal and real rates on 20 year treasuries and TIPS (which one can hold to maturity to gain the term premium) in comparison to the EE's 20-year 3.5%, and it leads me to wonder if people who understand bonds better than I might currently find a place for EE savings bonds in this context, for the LT end of one's barbell, so to speak. i'm probably being swayed by the effect (i think livesoft, or nisi... or mel? described it) where one is blinded by the desire to take advantage of a perceived limited opportunity (who knows when the 20-year EE doubling feature will be dropped, given the current rates environment). it sounds like i ought to forget about the EE's. thank you!

angie.

(btw, i was surprised how much i missed scanning through the forum the last 2 days. glad to see it back.)

[grok87]

hi grok,

thanks for your reply re: "20-year" series EE savings bonds - i really appreciated it and found it very comprehensive, not "longwinded"! i am most interested though in the context of making a 20-year commitment. i guess i asked b/c i look at the nominal and real rates on 20 year treasuries and TIPS (which one can hold to maturity to gain the term premium) in comparison to the EE's 20-year 3.5%, and it leads me to wonder if people who understand bonds better than I might currently find a place for EE savings bonds in this context, for the LT end of one's barbell, so to speak. i'm probably being swayed by the effect (i think livesoft, or nisi... or mel? described it) where one is blinded by the desire to take advantage of a perceived limited opportunity (who knows when the 20-year EE doubling feature will be dropped, given the current rates environment). it sounds like i ought to forget about the EE's. thank you!

angie.

(btw, i was surprised how much i missed scanning through the forum the last 2 days. glad to see it back.)

Angie,
No problem. If you have some tax-deferred money avaible (rollover ira etc.) you might consider the penfed 7 year cds yielding 2.75%. As discussed above you can cash in early and just lose 1 years interest- if rates rise that will be a valuable option to have. If not you are earning 2.75% (not 3.5% but close) and you don't have to tie up your money for 20 years.
cheers,

[Angst]

Angie,
No problem. If you have some tax-deferred money avaible (rollover ira etc.) you might consider the penfed 7 year cds yielding 2.75%. As discussed above you can cash in early and just lose 1 years interest- if rates rise that will be a valuable option to have. If not you are earning 2.75% (not 3.5% but close) and you don't have to tie up your money for 20 years.
cheers,

Thanks again, Grok. I might do just that.
Angie

[Lbill]

Me, I'm figuring my retirement income based on just managing to match inflation, or gather a 1% real return at most. If I were an optimist, I'd bet on a 50/50 portfolio of LC equities and TBM to return 4.5% real annually like it did from 1972-2010 (on average). But then you were able to earn 5.6% nominal on T-bills (1.2% real) over that time period also. And they used to make buggy whips too. I hope we can get 3% real going forward, but I'm not planning on it.

[market timer]

All this is a long winded way of saying that optionality is really important. You want products that have good optionality, like mortgages you can pay off early, or CDs you can cash in early with cheap penalties so you can invest at higher rates if you want to. You don't want the negative optionality that comes from having to hold EE bonds for 20 years to get that 3.5% rate,

Grok, I think you offer some good advice here, especially with regard to shopping around for cash equivalents. However, you should be more precise in your terminology. Negative optionality is a confusing term (do you mean short an option? do you actually mean illiquidity?). An EE bond holder can choose to earn the short term rate of 1.1% or long term rate of 3.5% if held for 20 years. The EE bond holder has optionality. The government is short the redemption option.

You also describe an interest rate scenario where rates follow the path that makes the EE bond holder indifferent between cashing in the bond vs. earning the remaining yield-to-maturity. It is an interesting exercise but worth noting that this scenario can be hedged. If a bond holder is bearish on rates, he could still lock in the above-market EE bond YTM and monetize the value of the redemption option by selling call options on bond funds.

[grok87]

Me, I'm figuring my retirement income based on just managing to match inflation, or gather a 1% real return at most. If I were an optimist, I'd bet on a 50/50 portfolio of LC equities and TBM to return 4.5% real annually like it did from 1972-2010 (on average). But then you were able to earn 5.6% nominal on T-bills (1.2% real) over that time period also. And they used to make buggy whips too. I hope we can get 3% real going forward, but I'm not planning on it.

30 year tips might be the ticket for you, depending on your age etc..

[grok87]

All this is a long winded way of saying that optionality is really important. You want products that have good optionality, like mortgages you can pay off early, or CDs you can cash in early with cheap penalties so you can invest at higher rates if you want to. You don't want the negative optionality that comes from having to hold EE bonds for 20 years to get that 3.5% rate,

Grok, I think you offer some good advice here, especially with regard to shopping around for cash equivalents. However, you should be more precise in your terminology. Negative optionality is a confusing term (do you mean short an option? do you actually mean illiquidity?). An EE bond holder can choose to earn the short term rate of 1.1% or long term rate of 3.5% if held for 20 years. The EE bond holder has optionality. The government is short the redemption option.

You also describe an interest rate scenario where rates follow the path that makes the EE bond holder indifferent between cashing in the bond vs. earning the remaining yield-to-maturity. It is an interesting exercise but worth noting that this scenario can be hedged. If a bond holder is bearish on rates, he could still lock in the above-market EE bond YTM and monetize the value of the redemption option by selling call options on bond funds.

thanks
i agree "negative optionality" is probably the wrong phrase.
here's what I was trying to say

consider two people:
person a) buys a $1000 worth of 20 year zero coupon treasury at the current yield of 3.2% (assume he has enough room to hold in tax deferred)
person b) buys $1000 worth of EE bonds (i.e. $2000 of face) with the intent to hold for 20 years, when they double in value so yield is 3.5%

now it might seem that person b) is better off since the rate is higher. But remember he has to hold for 20 years to get that 3.5% rate. person a) can sell at any time at fair market value. Say for example that after 10 years have gone by, 10 year zero coupon treasuries are yielding 2% but 10 year CDs are yielding 3.2%.
He can cash in his treasuries at their market value of $1540 and buy the CDs. Then 10 years later he will have $2,111- i.e. more than person a)- i.e. in this (not unrealistic) scenario person b) was able to compound at a higher rate than person b) due to the fact that he had more options (options in the plain english sense of he word not the financial sense) available to him due to the marketability of his treasuries (i.e. ability to sell whenever he wants at fair market value)

person b)'s options in contrast are limited by the big hit he will take if he cashes in early (relative to his goal of getting the 3.5% rate). For instance if he cashes in early after 10 years he will only get $1116 no matter what. There are of course scenarios where person a) will be worse off than that if he were to cash out after 10 years. But they are fairly extreme ones- tbe 10 year zero coupon treasury at that point in time would need to be yielding more than 6%.

can you explain a bit more about selling options on bond funds to monetize the value of the redemption option?
cheers,

[market timer]

OK, now I understand your point here. Since EE bonds are not marketable securities, investors cannot realize any benefit from a decline in interest rates until maturity. So, you are criticizing EE bonds for their illiquidity. This could make rebalancing cumbersome or, even worse, force investors to redeem at a below-market price if they experience a liquidity shock such as job loss.

Investors can monetize the EE redemption option by selling calls on bonds of similar duration to EE bonds. For example, buy an EE bond and sell a call on a long term bond fund at a strike price corresponding to 3.5% yield. If interest rates rise in the next year, the investor picks up 1.1% plus the option premium (worth around 10%). If rates stay where they are or fall, the investor picks up the mark-to-model gain on the EE bond (subject to the illiquidity caveats above), which more than offsets the loss on the option, and then repeats the process next year with a slightly lower strike (corresponding to the now-higher YTM for the EE bond).

[Lbill]

I have a TIPS ladder for retirement income. When built, the average real YTM was in the neighborhood of 2%, which was quite satisfactory to me. Now, of course, most of that yield has already been realized as interest rates have declined and the market value of the bonds has increased. Starting from now - the average real YTM of the ladder is in the neighborhood of nada. I'm trying to get my head around that. That's the thing about returns - they are very lumpy and not nice and smooth like you were visualizing.

[Bongleur]

I have a TIPS ladder for retirement income. When built, the average real YTM was in the neighborhood of 2%, which was quite satisfactory to me. Now, of course, most of that yield has already been realized as interest rates have declined and the market value of the bonds has increased. Starting from now - the average real YTM of the ladder is in the neighborhood of nada. I'm trying to get my head around that. That's the thing about returns - they are very lumpy and not nice and smooth like you were visualizing.

So how do you calculate if it is time to sell them, paying capital gains now instead of income tax over time, and re-invest in current TIPS paying zero real (which will protect your gains) ?

[grok87]

I have a TIPS ladder for retirement income. When built, the average real YTM was in the neighborhood of 2%, which was quite satisfactory to me. Now, of course, most of that yield has already been realized as interest rates have declined and the market value of the bonds has increased. Starting from now - the average real YTM of the ladder is in the neighborhood of nada. I'm trying to get my head around that. That's the thing about returns - they are very lumpy and not nice and smooth like you were visualizing.

Hi Lbill,
You may want to consider selling some of the shorter term tips and buying IBonds and 7 year PenFed CDs.
Lumpy upside returns are a nice problem to have!

cheers,

[jimkinny]

Nice post grok. Nice replies to responses.

Jim