The Case for High Yield Bonds
In the 1970’s and 80’s, if you wanted to buy a low-quality company’s bond, you would in essence be buying a “junk” bond. There was a certain stigma associated with these types of bonds, mainly because no one wants to own “junk.” In a brilliant marketing strategy developed by Wallstreet, the category was re-branded in the early 1990’s to “High Yield” Bonds.
High yield bonds are bonds issued by lower credit quality companies, that pay a higher interest rate than their quality counterparts. High yield bonds carry more risk than investment grade or quality bonds, because they inevitably have a higher default rate and lower credit rating. They also historically carry less risk than stocks because they have lower volatility and are higher up the repayment schedule.
As with any investment, there are good and bad times to be an investor of high yield bonds. One of the many aspects the Strategic Income Group Investment Committee tracks in determining the right time of owning these types of bonds is the “spread.”
The spread is simply the difference between what high quality/ government bond pays and what a high yield or junk bond pays. On average, the difference is roughly 500 basis points (5%). That means that if a quality bond is paying 2% annually, you would expect a high yield bond to pay approximately 7% over that same time.
Whenever things are going well in the economy and markets, the spread level decreases. This happens mainly because during good times, investors tend to ignore the amount of risk they are taking on so fewer quality companies can issue bonds for a lower interest rate. In times like these it is not conducive for investors to purchase high yield bonds because they are not being compensated enough for the amount of risk they are assuming.
On the flipside of the good, whenever things are not going so well, or there is distress in the economy or markets (Coronavirus anyone), the spread level tends to widen out. The widening of the spread levels is due to investors not wanting to take additional risks and the fear of defaults in high yield bonds during these periods.
As illustrated in the chart below, high yield bonds have outperformed quality bonds over the past 20 years, regardless of spread levels.
The Coronavirus pandemic currently taking place has caused unprecedented market volatility and economic uncertainty spreading beyond the financial markets. With the uncertainty caused by the virus, high yield spreads briefly surpassed 1000 basis points (10%), and remain today at elevated levels not seen in a decade.
When investing in the high yield space during times of heightened credit spreads, the return of high yield bonds has historically been stellar. The chart below indicates that when investing into high yield during times of elevated spread levels, an investor has achieved positive returns after 3 years 100% of the time (past performance is no guarantee of future results, which can and will vary). To summarize, wider spreads coupled with longer time horizons have resulted in attractive returns in the high yield market.
Source: ICE Indices, Morningstar Dec 31, 1999 – February 29, 2020.
While high yield bonds are fixed income investments, the return profile during times of elevated spreads appear more similar to the return of stocks. Usually these extremely elevated spread levels do not remain for long and revert back to the normal levels, causing high yield bonds to appreciate in a relatively quick time frame.
Knowing that high yield bonds typically perform very well during times of elevated spread levels, we also wanted to look at their performance relative to stocks during times that spread levels begin to tighten back to normal. As the chart below illustrates, when spread levels have gotten extremely wide, high yield bonds have not only outperformed stocks, but they have done so by a significant margin.
Source: ICE Indices, Morningstar, 12/31/1999 – 2/29/2020 High yield represented by the ICE
BofA US High Yield Index. Stocks represented by the S&P 500 Index.
As part of the recent stimulus package that was rolled out by the Federal Government and Federal Reserve, in an unprecedented move, the Federal Reserve is committed to buying high yield bonds (up to 10% of the high yield market). The Federal Reserve is purchasing these bonds to keep liquidity flowing in the high yield market and prevent what could be a large default rate due to the economic shutdown.
With the new assistance from the Feds, this serves as somewhat of a backstop to the high yield market, making it that much more attractive of an investment going forward.
The high yield bond markets currently present an attractive investment opportunity for some portfolios due to the unusually wide spreads that exist. Couple that with the feds stepping in and committing to purchase the asset class in a big way, and taking into account historical data, the high yield bond market could produce a return that is greater than normal in the near future.
Remember, discipline is the key to success.
Strategic Income Group Investment Committee
Chad Manberg, CFP, Michael Gauthier, CFP, Bob Stamm, CFP, Laurie Simons, CFP
*This article is for education purposes and does not represent a solicitation of investments. All investment advice given is based on a client’s financial plan. Past performance is not indicative of future performance. Investment advice offered through Strategic Income Group, an SEC registered investment advisor.
There’s a question that has been around ever since mortgages existed.
It’s widely debated – a hot topic – and your answer to the question can profoundly affect your financial situation.
What’s the question? It’s simple:
“Should I pay off my mortgage early?”
You might have a gut reaction to that question. You might think that you already know the answer. You’re not alone. If you have a mortgage, you’ve probably thought about this question before.
You may reason that paying off your mortgage early is a good idea, because it means you’ll pay less in interest and have more money in the future to invest at a later date.
On the other hand, you may reason that paying off your mortgage is a bad idea, because it means you’ll miss out on the home mortgage interest tax deduction and you won’t be able to put as much money into investments right away as you would be able to otherwise.
These are the most common thoughts and concerns. But there are more.
What about future unknown tax advantages to having a mortgage? What about future unknown stock market fluctuations? What about future unknown tax rates on investments?
These are all important questions. The trouble is, the future is uncertain. Nobody can see past the present time. However, we can make some assumptions based on historical data.
Should you pay off your mortgage early? Let’s dig in.
The Two Couples
In the book The New Rules of Money, there’s a great example of two hypothetical couples. We’ve adapted that example into what you’re going to read below.
Couple “A” – the Jones couple – believes in “the old way” of paying off the mortgage as soon as possible. Couple “B” – the Smith couple – believes in “the new way” of carrying a big, long-term mortgage.
Which couple do you think will be more financially fit at the end of our example? Place your bets, and read on to find out.
The Jones Couple
The Jones couple decides to get a 15-year mortgage with a 6.38% APR. They figure that the short-term mortgage will force them to pay off the mortgage faster – which is most certainly true.
They also decide to put down a huge down payment of $40,000 – which represents their entire savings account. They don’t have any money left to invest in the stock market, and no money left for emergencies, either.
The bank takes their information and calculates a monthly payment of $1,383. This is a little high for them, but they can manage. Because they’ll be getting the home mortgage interest tax deduction, 56% of their monthly payment will be tax deductible the first year, with a 33% average tax deduction over time. Their monthly net after-tax cost, therefore, is $1,227.
Because they want to eliminate their mortgage as soon as possible, they decide to send an extra $100 to their lender every month. They’re focused on their goal!
Now what will happen after five years? 15 years? 30 years? Let’s find out.
After five years they will have received $14,216 in tax savings. Not bad. But, they’ll have $0 in savings and investments. Hopefully they don’t have an emergency!
After 15 years, they’ll have received $25,080 in tax savings. They’ll also have $30,421 in savings and investments. Plus, they will have achieved their goal of owning their home outright.
After 30 years, they won’t have any more tax savings than they did 15 years prior, and will still be at $25,080. However, they’ll have $613,858 in savings and investments. Finally, they’ll still own the home outright.
Alright, the Jones couple didn’t do so bad. Will the Smith couple do any better?
The Smith Couple
The Smith couple, as you recall, believes in carrying a big, long-term mortgage. Some of their friends advised that it’s a bad idea to stay in debt that long. Let’s see if their friends are right.
The Smith couple gets a 30-year mortgage with an interest rate of 7.42% APR – certainly higher than the Jones couple’s interest rate. Additionally, they only decide to put down $10,000 toward the down payment.
However, this leaves the Smith couple with $30,000 left to invest. Will they invest this money?
The bank calculates the Smith couple’s monthly payment as $1,175. This is a little more affordable than the Jones couple’s payment. Oh, and by the way, 100% of their payment is tax deductible during the first 15 years, with an average of a 364%. Whoa. That means their monthly net after-tax cost is only $799.
The Smith couple decides that instead of sending $100 to the bank to pay off their mortgage early, they’ll invest the money into an account that earns an 8% rate of return. They also decided to throw their monthly payment savings of $428 into this investment account as well.
Now what will happen after five years? 15 years? 30 years?
After five years, the Smith couple will have received $22,557 in tax savings – much more than the Jones couple who only received $14,216.
And, unlike the Jones couple, the Smith couple will have $83,513 in savings and investments. The Jones couple has nothing as this point.
Okay, what about after 15 years? The Smith couple will have received $67,670 in tax savings and have $282,019 in savings and investments which is enough to pay off their mortgage and still have $92,019. Isn’t that amazing?
After 30 years, the Smith couple will have received $107,826 in tax savings, have over 1.1 million dollars in savings and investments, and will own their home outright.
What Happens if Both Couples Lose Their Income After Five Years?
If the Jones couple suddenly lost their income after five years, they would have no savings to get them through the crisis. They wouldn’t be able to get a loan because they don’t have an income, they’d have to sell their home or face foreclosure because they can’t make mortgage payments, and they must pay real estate commissions.
The Smith couple, on the other hand, would have $83,513 to tide them over, wouldn’t need a loan, and they could easily make their mortgage payments even if they are without an income for years. No panic.
The Smith couple came out ahead and had more options throughout the years, even though they had the long-term mortgage. This example goes to show you that it’s not always wise to pay off your mortgage early – as long as you make the appropriate investment choices.
We made a great PDF of the story you just read, and it’s our gift to you free of charge. Take a look, hand them out to friends, and help us educate others on how different mortgage options may work.
Strategic Income Group employs a number of strategies to help you get the most out of your investments.
One of those strategies – one that sets us apart from many other firms – includes the use of Strategic Reserve Accounts.
To understand how our Strategic Reserve Accounts work and their purpose, it’s important to familiarize yourself with a concept called dollar- and reverse dollar-cost averaging (follow the link to learn more).
Once you understand how dollar-cost averaging and reverse dollar cost averaging works, continue to learn how our unique Strategic Reserve Accounts may help you keep more of your money.
While what you’re about to read points out the downsides of reverse dollar-cost averaging and what we can do about it, it’s important to remember that dollar-cost averaging when investing for retirement can have a positive outcome.
For example, instead of paying off your mortgage early, you could use those dollars to invest and potentially come out ahead – but everyone’s situation is different (if you’re interested in this, check out The Tale of Two Couples).
But because reverse dollar-cost averaging works against you in retirement, our Strategic Reserve Accounts are available and may help you keep more of your money.
Strategic Reserve Accounts
Let’s say you’d like to withdraw $1,000 per month from your retirement account. Take a look at this typical retirement strategy:
Under typical circumstances, your investment manager will sell $1,000 worth of investments to ensure they can deposit the money into your checking account on time every month. If the value of the investment falls you are forced to sell more shares.
Thankfully, we have a plan to counteract the potential harmful effects of reverse dollar-cost averaging. Namely, Strategic Reserve Accounts. Strategic Reserve Accounts work as a buffer between you and the potential losses incurred by having to sell investments at a low price.
Take a look at how our Strategic Reserve Accounts work:
We recommend our clients start a Strategic Reserve Account – an interest producing money market account – with Strategic Income Group. When we start your Strategic Reserve Account we would fund it with 3 and 12 months’ worth of withdrawals. This account will maintain a balance of 3 and 12 months’ worth of withdrawals.
Should the markets drop, instead of selling your investments at a lower price to meet your withdrawal requirement, we would simply pull money from your Strategic Reserve Account instead and replenish it when the markets are higher. We are able to replenish the Strategic Reserve Accounts from interest, dividends, and the sale of the shares of the investments.
This allows us to strategically control the flow of money from your investment accounts to your checking account, which may result in better returns. No longer will we be forced to sell investments at a lower price because you need a certain amount of retirement account income every month. With a Strategic Reserve Account, we can attempt to sell at a higher price while at the same time pushing to allow you to take your monthly withdrawals.
At Strategic Income Group, we have a fiduciary responsibility to do the very best thing for our clients – and Strategic Reserve Accounts help us accomplish that goal.
To learn more about Strategic Reserve Accounts or to start one today, contact us. We’re happy to further explain the benefits and answer any of your questions. Strategic Reserve Accounts are just one way we can help our clients get the most out of their investment dollars!
At Strategic Income Group, we pay close attention to the effects of dollar-cost averaging and reverse dollar-cost averaging. Why? Great question!
The bottom line is that these realities have the power to increase or decrease the performance of your investments. In a moment, we’ll explain how.
We don’t stop at paying attention to these important factors, we take action on behalf of our clients utilizing our very own Strategic Reserve Accounts (follow the link to learn more).
To understand dollar-cost averaging and reverse dollar-cost averaging, and to learn how Strategic Reserve Accounts may help you keep more of your money, read on.
So, what is dollar-cost averaging?
Dollar-Cost Averaging: The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. (Source: Investopedia)
The problem with investing a lump sum of money is that should the price per share drop dramatically, the entire lump sum will be greatly reduced in value. Dollar-cost averaging helps protect against this possibility by dividing up a lump sum and investing the portions over time.
Let’s take a look at an example of dollar-cost averaging at work:
As you can see, there was a nice gain thanks in part to dollar-cost averaging.
That’s why we recommend that you invest on a regular schedule during Phase II: The Accumulating Wealth Phase. Investing on a regular schedule lowers your risk due to the power of dollar-cost averaging.
Reverse Dollar-Cost Averaging
Now, let’s say you’re retired and instead of investing money on a regular basis, you’re withdrawing money on a regular basis. This should occur during Phase III: The Strategic Income Phase.
If investments are being sold on a regular basis to fund your retirement lifestyle, reverse dollar-cost averaging takes place and forces you to sell your investments regardless of the price per share. If share values are low, you will have to sell more shares to get your predetermined withdrawal amount than when share values are high.
As you’re aware, it’s important to buy when share values are low and sell when share values are high. Selling regardless of market conditions is not wise.
During Phase III: The Strategic Income Phase, it’s important to be strategic with your withdrawals and take advantage of certain market conditions. While timing the market isn’t generally recommended when you’re putting money into investments, timing the market when you’re withdrawing from investments isn’t only helpful, it’s many times necessary.
Let’s take a look at how reverse dollar-cost averaging can negatively affect an investor who is in retirement and taking withdrawals. Let’s suppose the investor starts with $300,000 or 30,000 shares. The investor plans to take $1,000 from their retirement account every month. Let’s see how this breaks down over the course of a year in the table below:
As you can see, while the investor’s withdrawal rate remains the same, the price per share fluctuates and therefore requires a variable number of shares to be sold every month. Sometimes the price per share is high, other times, the price per share is low.
How did reverse dollar-cost averaging affect the investor? Negatively. Here’s the break down . . . .
The fund, unsurprisingly, lost 30% of its value with a total withdrawal of $12,000. There were 1,888 shares sold and 28,112 shares remaining. The ending value of the account was $196,784. This means there was a $91,216 loss which translates to a 31.67% loss.
As you can see from the example, withdrawing money on a regular basis during volatile and negative markets not only reduces the account value, it also reduces it even further due to the negative affects of reverse dollar-cost averaging.
Strategic Reserve Accounts
How do we help our clients avoid some of the effects of reserve dollar-cost averaging? Through Strategic Reserve Accounts. They allow us to better time withdrawals and gives us the opportunity to reduce being necessarily subject to negative market performance.
Read more about Strategic Reserve Accounts and learn how they may help you keep more money in your retirement account for use at a later time.
Should you or your spouse pass away, would your family have the means to continue to make the mortgage payment or even put dinner on the table?
When breadwinners pass away, many families not only have to deal with the grief of their loss, they unfortunately have to figure out how to continue to pay their bills.
Term Life Insurance
That’s where life insurance can truly make a difference. Term life insurance – the type we recommend at Strategic Income Group – provides a lump sum of money to the beneficiaries of a policyholder should the policyholder pass away. Keep in mind that this benefit is only paid out if the policyholder passes away during the term. There are a wide variety of terms to choose from; for example, if you’re a 35-year-old man you might pay a monthly premium of $223.56 for a 30-year, $2,500,000 level-term policy.
The lump sum of money (in this case, $2,500,000) can be used for paying off debt, investing, or anything else the beneficiaries wish to do with the money. The Tale of Two Couples goes over whether or not paying off the mortgage early might be a good idea – be sure to take a look.
$2,500,000 should be enough money to replace an annual income of $100,000 if it’s in investments (I’m also adjusting for inflation). At the retirement age of 65, there should no longer be a need for this insurance as there should be retirement portfolios with enough money to provide income going forward.
There’s one more great strategy when it comes to purchasing term life insurance . . . .
Let’s take the same example above – a 35-year-old man who wants enough insurance to last up until retirement – and see how “stacking policies” works.
Instead of purchasing one 30-year policy, he could purchase five policies with different terms and premiums:
- $500,000 10-year policy for $21.88 per month
- $500,000 15-year policy for $26.69 per month
- $500,000 20-year policy for $32.38 per month
- $500,000 25-year policy for $43.75 per month
- $500,000 30-year policy for $48.56 per month
For 10 years, there would still be $2,500,000 of coverage after which it would be reduced by $500,000 and again by the same amount every five years. Over time, the coverage would drop, but so would his premiums.
In fact, starting out, the policies would only cost a total of $173.26 per month. This is cheaper than first example by $50.30 – this money could be used toward other financial goals.
Assuming that this man has completed Phase I: The Foundation Phase, he could start investing the savings and probably get an 8% return every year. We completed the calculations and found that at this rate of return after 30 years, the investment balance would be $102,009.78. Not only would he still have adequate – albeit less – insurance over 30 years, he would have a nice nest egg as well (something that buying a 30-year term only wouldn’t provide).
Let Us Shop Insurance Companies for You
We would like to help you shop insurance companies. We typically quote 20 of the best and highest rated insurance companies so we can get the best deal for clients. We are independent life insurance agents and can customize the appropriate amounts and terms to fit your needs.
Term Life insurance
Simply fill out the form and we’ll contact you with more information. We’re excited to show you how you can cover your family and save money at the same time.