In what follows, I work broadly, rather than in depth. I want to see how far I can push an idea on paper before I do real-world testing. The experiment hinges on the following distinction: A Saver has different goals, and operates by different rules, than an Investor. The former does not accept risk to nominal principal. The latter will. Therefore, the pangs of envy that a Saver might experience over the larger yields obtained by an Investor are a foolishness that comes from not understanding his own discipline. And, conversely, the better yields that he might be achieving by fully understanding his own discipline and by acting according to self-made rules are not to be dismissed as “sour grapes”. Those yields were within reach and should have been achieved. There is such a thing as being “too safe”. Obviously, the distinction between Saver and Investor is a purely analytic one. There is no investment a Saver can buy that can truly assure the safety of principal. Banks fail; governments fail; whole civilizations fail. In time and over the long haul, all comes to financial ruin. But in the here-and-now, investments can be ranked with respect to risk to nominal principal, and under “normal circumstances” some investments can be considered safe with regard to the return of nominal principal, and some can be considered risky. Treasury bills and CD's are pointed to as examples of the former. Stocks and corporate bonds, especially spec-grade corporate bonds, are considered examples of the latter.But what about an intermediate case, such as insured municipal bonds? Nominal principal is assured, but the assurance depends on both the issuer continuing to pay for the insurance and the insurer remaining solvent enough to pay claims. What of triple-AAA rated corporate bonds? How likely, really, is a triple-AAA rated issuer to default on its obligation to pay interest and return principal? What about Agency bonds? Although they are currently rated triple-AAA, either on their own merits and/or because of the implied guarantees of the US government, they could be downgraded as their material circumstances changed. Not a likely event, but a possibility. So, to some extent, the difference between “safe” and “risky” is quantitative rather than qualitative, and determining the borders, boundaries, and thresholds between the two is a matter of informed judgment. A literalist will protest that claim, saying that there really is a difference between a bank-issued, FICA-backed CD and a corporation-issued debenture. But does the difference really matter? Very nearly the same circumstances under which an AAA-rated corporation will default in the short term will be the same circumstances that will cause the CD to fail, namely a total collapse of the whole economic system. In such an event, no one's promises or guarantees will have much cash value. Thus, what a Saver is faced with, as he or she scrambles to obtain yield, is something like the following: “This investment will pay interest and return principal, God willing and the creeks don't rise." Such a viewpoint creates a broader investing universe than most Savers permit themselves and, possibly, creates an opportunity to enhance yields. So let's explore it a bit along two dimensions: tax-equivalent returns and guestimated risk rankings.CD's state their yields in terms of APY's (Annual Percentage Yields). T-Bill's state their yields in terms of Discount and Investment Yields, which are different and lower than APY's. Corporates and munis are typically talked about in terms of YTM (Yield to Maturity, which is roughly a measure of both their accumulated current yields and their potential for capital gains.) Additionally, the direct obligations of the US government (and most municipal debt) are tax-advantaged. Determining the equivalencies between tax-advantaged yields and fully taxable ones is a straightforward math problem that is well–described in plenty of places and doesn't presently concern me. The math has to be done, but the task is trivial (and will be written up in a separate post, eventually). Instead, I want to look at a subtler problem: the increasing risk from default (and, thus, the potential loss of nominal principal) as the income stream is received over an increasingly longer time frame. (An even subtler problem, the effect of inflation as the income stream is received over increasingly longer time --or deferred until maturity-- will be dealt with in another post). So, let's talk a bit about time frames. Currently, Treasury bills, notes, and bonds are issued with the following maturities: 4-, 13-, and 26-week; 2-, 3-, 5, 10, 20, and 30-year. Using BankRate's listings of CD's as a representative guideline, CD's seem to be issued with in a wider variety of holding periods at the short end of the yield curve, but top out around 5 years. Municipal and corporate bonds are typically issued with maturities ranging from 5 to 30 years but can, in rare instances, be as long as 100 or even “perpetual”. So, arbitrarily, let's call maturities of 3 years or less very short term; 3-6 years, short term; 7-12 years, medium term; 13-17, medium to long term; and 18-30, long term. That schema can be quibbled with, but it's good enough for present purposes, which is merely to suggest that the passage of time changes expectation and likelihood. Historical default rates are typically reported –-when you can find the information-- in terms of 1-year rates or 5-, 10-, 15- and 20-year rates. I say, “when you can find the information”, because the studies used to be few and hard to find. Things have improved recently, as a quick Google search suggests, and an easily-found study that is worth digging into is an 84 page PFD file by Moody's Investors Services entitled “Historical Default Rates of Corporate Bond Issuers, 1920-1999”, in particular, Exhibit 14, “One-Year Default rates by Alpha-Numerical Ratings, 1983-1999, which suggests that ratings even as far down as Baa1 aren't going to default. But as Exhibit 16 suggests, over longer time frames, even Aaa-rated issuers evince measurable rates of default (on the order of ~0.6% over 5 years and ~2.4% over 20 years, if I'm scaling from their graph accurately).What this suggests to me is that if a would-be Saver keeps maturities very short, he can go quite a way down the credit spectrum before incurring untoward risk. But as holding periods approach 5 years and go beyond that, then the Savor has begun to take on risks that are characteristic of an Investor. What this also suggests to me is that it might be possible for a Saver to identify a broader and more flexible investing universe than they are currently working with. Instead of restricting themselves to CD's and Treasuries, they might be able to access the yield opportunities of Agencies, Munis and Corporates as well. Not all of them, but a significant enough fraction of them that they might be able to make more informed decisions about where to put their money. Deciding the Where's and When's and How Much's will require building some tools and decision procedures which need not be any more elaborate than two dimensional matrixes which embed the implied equation: “If X, then Y.” Let's work through an example. Normally, the huge attraction of municipal bonds for most investors is the fact that the interest received is exempt from Federal taxes. Depending one one's individual situation, a muni with fairly low coupon can beat the achieved yield of a CD with a much higher coupon. If the muni was issued by one's own state and is also state-tax exempt, then the achieved yield goes even higher. Not every municipal bond qualifies for tax exemption, and my guess --though I'll freely confess to not knowing the muni market well-- is that these bonds receive scant attention from investors on something like the following reasoning: “Why mess with a taxable muni for which it will be very difficult to do responsible credit analysis when I can buy a corporate bond with an equivalent rating, an equivalent or higher yield, and much better access to financial statements? In fact, a good bond search engine will allow the exclusion of taxable munis as part of its feature set.But there is one small exception which might be of interest to dedicated Savers: if the muni is issued by one's own state and is state tax-exempt, then an insured muni –-which is always given a triple-AAA rating-- begins to approach a T-Bill in terms of terms of possible achieved yields at equivalent levels of safety. I'm not going to grind through the math of the situation. I'll simply invite you to look for yourself. And while you're doing so, also run your numbers on agency bonds, some of which also are state-tax exempt. It looks to me as if the bond books have overlooked a yield situation that should be of interest to Savers. Determining whether that is so, and when it is so, will require building yield conversion charts and making shrewd decisions about cutoff points so that safety of nominal principal is not compromised. Remember, you are attempting to construct game rules as a Saver, not as an Investor, whose your risk parameters are much narrower. I also think the same strategy can be applied to upper-tier corporates, as long as maturities are kept well within historical guidelines with regard of default patterns. A further caveat: if a person is dealing with a small amount of money and the decision is a one-time decision rather than an attempt to create a systematic program whose longevity might be 20 to 80 years worth of making decisions about money, then chasing a few basis point of yield is foolishness. Go for what is most assuredly safe and most obviously easy. But if one has the temperament and desire to be a Saver, and the total dollars involved over many years of investing will cumulatively and collectively be significant, then it would behoove one to look carefully at the features of CD's that give them their putative reputation for safety and attempt to discover the presence of those structural features in as broad as range of debt instruments as possible. I suggested a few alternatives. No doubt others can be discovered. Admittedly, implementing such a program won't be without its risks and certainly will take some work to set up. But my suspicion is that the risks of straying beyond CD's are more a product of unwarranted fears than anything else and are abetted by the industries that create CD's. Of course, the CD industry doesn't want to lose customers. That would mean losing a source of cheap money, which also isn't to say that CD's should be avoided or can always be beaten with other products. Sometimes, they are the best deal in town and should be bought by the truckload. But how does a person know they are temporary a good deal unless he is constantly doing comparison shopping? And how can he comparison shop quickly and easily unless he has built shopping tools? That is one of the chief reasons for constantly re-evaluating ends and means, assumptions and goals, and always trying to make improvements. Just because something worked yesterday or because everyone else is doing it doesn't mean it is necessarily a good idea today. Markets change, opportunities come and go. A good Saver, a good Investor, a good Trader changes himself as he needs to. One last caveat: no matter how much money one is making, somebody will always be making more, and the money they are making will always look easy in hindsight. That money will look like “missed money”, and there will always be the temptation to reproach oneself with woulda/coulda/shoulda. I don't care how well you know yourself or how careful you have been to fit your investing plans to your abilities and personality, the envy will be there at times. You're human. It's going to happen. You can try to fight it or try to deny it, but envy will rear its ugly head. But the minute you depart from your knitting, the minute you depart from your carefully constructed plans and constraints, you have taken on risks that you have not prepared yourself to take on, and you are jeopardizing all your prior achievement. Don't go there. Treat the envy as mere “money chatter of the mind” and let it go. As Peter Kaplan writes in this month's issue of “SFO”:In accepting the inevitability of missed money, we choose one mild form of pain on a regular basis and prevent a far grater pain down the road. We recognize the fact there will always be the discomfort of restraining ourselves in [investing]. The question is, will it be the discomfort of restraining ourselves or the agony caused by our recklessness?On the other hand, don't be afraid of your own shadow. If one has determined that a portion of one's financial activities should be governed by rules proper to Savers, that doesn't mean that the rules have to be the most narrow and the most restrictive of all sensible rules there could be. If it can be argued on the basis of carefully considered evidence that the yields were within the reach of Savers, then those yields should be reached for. That means knowing the difference between exaggerated fears and recklessness. The Saver's path can be a noble one, and its yields aren't to be despised. But choose the path for its challenges, and not out of fear. Charlie
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