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I know Jim and others here have expressed interest in preferred stocks. So here is an article by the anonymous guy at Philosophical Economics - a very thorough analysis as usual for him. It is a pretty long read, so I also included his conclusion below.

http://www.philosophicaleconomics.com/2017/03/a-value-opport...

"In conclusion, preferred stocks are reasonably valued relative to the rest of the market and relative to their own past history, especially when their special tax advantages are taken into consideration. Within the preferred stock space, two unique and poorly-understood securities–$WFC-L and $BAC-L–represent very attractive value propositions: 6.15% yields (tax-equivalent to 7.26% and 8.28% for 28% and top bracket earners, respectively), very little credit risk, no call risk, meaningful price appreciation potential, and decades worth of dividends still to pay. In an investment environment like the one we’re living in, where almost everything looks terrible, you have to take what you can get."
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Funny, I've followed this board for a number of years now (thanks), but this non-BRK post finally prompted me to join.

Bumping for mungofitch.
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Bumping for mungofitch.

Hmm, sounds rude.

It's a very nice article. I think the section about supply determining the price should be ignored, but the rest is very useful.
I'm not a fan of preferred shares in general as an asset class, but very fond of that WFC/PL issue specifically, for much the same reasons he cites.
I didn't previously know about the "equivalent" BAC issue, which also looks interesting.
No reason to prefer it, though.

One thing he doesn't emphasize as a downside is the erosion from inflation.
It's not a very big problem these days, and probably not for a long time, but eventually it matters.
The market price of the shares and the coupon will both be worth less in real terms as time goes on.
Just something to keep in mind.
Assuming you sell far down the road at the same nominal price at which you bought, your real total
return will be the initial after-tax yield minus the average rate of inflation during your hold.
Actually the math is a bit non intuitive, and the result is a bit worse than that.
You lose purchasing power on the market value of the stock, as well as on the coupons.

At the topmost level, I see no case for fixed income in a portfolio these days, only a mix of cash and equities makes sense.
But, a possible refinement of that is a bit of preferred which could be thought of as a yield-enhancing "long end" of the cash allocation.
Only cash is cash, but one often holds some of it for use a medium length of time down the road.
e.g., one might replace a portfolio of 60% equities and 40% cash with one of 55% equities, 30% cash, and 15% WFC/PL.
Cash for immediate use, equities for longer time frame, preferred as a middle time frame and as a yield enhancer for the cash section.
I also recommended it for my father-in-law's retirement income account (Canadian RIF), for which it worked very well.
For tax reasons, there was a minimum withdrawal amount required but terrible tax situation, so it
wasn't the place you wanted to keep the things which might pay off in a big way. Those were better held in his TFSA, which is always tax free.

Unfortunately for me, US preferreds are tax disadvantaged, I pay 30% on the coupons versus 0% on capital gains.
So my net yield of 4.35% is low enough that equities are just that much more attractive, especially non dividend payers.
If I expect 2% inflation and no change in the price of the preferred, that's a real 2.35%.
Anything with a P/E under 42 (and earnings not falling in real terms) should in theory do that for me, though of course with irregular timing.

But I do have an unusually large cash allocation at the moment which is costing me a little money each month, so I have been considering buying at chunk to reduce that sting.
(I'm losing on cash partly from inflation, and partly from a loan that I don't choose to pay off which is in effect funding some of the cash pile)

As an exercise for the alert reader:
Let's say you are comfortable that there isn't much price risk in WFC/PL. If the price falls, it will bounce back in a time frame you're happy to wait out.
Let's say you own some Berkshire shares.
Which would you go for
(a) Just keep your Berkshire shares
(b) Sell some fraction of your Berkshire shares.
Use half the proceeds to buy 2:1 leverage Berkshire calls with in implied interest rate of 2.6%, so your Berkshire holding stays the same size.
For example, yesterday you could have bought Jan 2018 $90 calls for about $86.95 and sold B stock at about $175.
Use the other half of the cash proceeds to buy WFC/PL yielding 6.2%...
(note, I'm not recommending this, but it's an interesting thought experiment, depending on your tax situation)

Jim
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One thing he doesn't emphasize as a downside is the erosion from inflation.
It's not a very big problem these days, and probably not for a long time, but eventually it matters.
The market price of the shares and the coupon will both be worth less in real terms as time goes on.
Just something to keep in mind.
Assuming you sell far down the road at the same nominal price at which you bought, your real total
return will be the initial after-tax yield minus the average rate of inflation during your hold.
Actually the math is a bit non intuitive, and the result is a bit worse than that.
You lose purchasing power on the market value of the stock, as well as on the coupons.


I pretty much agree, but I do not agree with the headline inflation rate usually provided by the US government and published by the main-stream media. I prefer the numbers provided by John Williams at shadowstats.com. I realize many people disagree with his statistics, but for me and my expenses (including taxes, especially property taxes), they are closer to my experience than the other ones.

Depending on the baseline used, he gets a 10% inflation rate (1980) or a 6% inflation rate (1990) for the end of January 2017. The headline rate is around 2.5%
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I pretty much agree, but I do not agree with the headline inflation rate usually provided by the
US government and published by the main-stream media. I prefer the numbers provided by John
Williams at shadowstats.com. I realize many people disagree with his statistics, but for me and my
expenses (including taxes, especially property taxes), they are closer to my experience than the other ones.


I do indeed hold the position that the shadowstats figures are meaningless.
The CPI matches the billion prices project figures pretty well, see http://bpp.mit.edu/usa/
The main difference between headline CPI and the confirmation from "billion prices" seems to be that
(a) the billion prices project has a tilt towards goods relative to services, combined with
(b) the inflation rate on US services has been slightly higher than that on US goods lately.
The gap has been 0.15%/year in the first ~7 years of the billion prices project, roughly 1.2%/year for BPP versus 1.35%/year for CPI.

Rather than shadowstats, if you don't find CPI or monetary inflation figures match your expense profile,
you are much better off building your own inflation series with a mix of (say) CPI, beer, property taxes and medical insurance.
Or whatever are your few biggest expenditure categories.
These can be pulled from the government web site, I believe...CPI-all-urban is just one of a jillion figures they provide.
The shadowstats figures are not right for anybody.

But hey, that's just my own position on the matter.

To estimate the real total return on a financial asset, consider only true monetary inflation.
FWIW, I define "monetary inflation" as a measure of the rate of erosion of the purchasing power of a currency, not any *specific* basket of goods purchased by any given consumer.
That's the amount of inflation that is "real"; all else is mere changes in the relative prices of different
goods and services which may make up disproportionately large or small parts of the cost profiles of any given person.
If you happen to spend a lot on interest charges, computers, telecoms, and air fares (like me), your personal basket is probably cheaper than it was 15 years ago.
If you spend a lot on health care, property taxes, gold and classic cars, your basket is rising in price rapidly.
Neither of those situations says anything useful about the purchasing power of a dollar, only about price changes on the specific things you choose/need to spend your money on.
If your own costs are rising rapidly, just realize that that's the case, don't go looking for a weird measure of real inflation.
The true monetary purchasing power value of a US dollar is a very substantial fraction of what it was a decade ago. Around 80%, maybe more.
Unless you spend it on something that happened to get more expensive.

Jim
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I can't add much, if anything, to the above post because I have looked at the bpp in the past and arrived at the conclusion that the cpi was 'close enough for government work'.

I do have some wacky anecdotal inflation indicators - such as a folder full of restaurant menus dating back 17 years. My Farouk's Indian Buffet appears to have risen from $6.99 to $9.99 over the last 15 years for one personal example - a little less than 2.5%/year. Our house was worth about $330,000 when we bought it 17 years ago and now is worth roughly $450,000 - that comes out to maybe 2%/year. That may be a good thing since our tax bill is a percentage of our assessment.

Our stocks are up way more than anything else we have owned over the last 30 years.

I have witnessed one form of personal inflation that could be relevant to many of us. Mom and Dad had more than enough money to cover their nursing home bills when they checked themselves in to Westminster Canterbury in 2003 or 4 - about $100,000 to cover about $65-70,000 worth of bills for both of them. By the time Dad died his combined income from investments and SS was in the $70-75,000 range and his bills were in the $80-85,000 range.

There were some reasons - the meltdown on 2008-9 hit right as he was retiring and his dementia may have impeded his ability to act as prudently as he once had. He still had more than enough to care for himself even if he had lived to 117, but it was eye opening to see how different the inflation figures were for Dad in a nursing home as compared to jgcspouse and me in a paid-for home with two jobs.

Longevity inflation is difficult to measure and plan for.
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"Longevity inflation is difficult to measure and plan for. "


Uh oh. Don't get Jim started on longevity insurance. We'll all be forced into considering tontine investing!

(j/k Jim)


-John (a longtime Mungo follower.)
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Warning: off-topic anecdote.

Since I was curious, and since I've been pretty good about tracking all of this in Quicken, I checked our spending going back as far as I have good records, which is around 1996, the last time we moved. In approximately 20 years, our total spending hasn't changed all that much, as long as you back out college expenses for the last 5 years. Generally, we seem to spend around $60-70k/year. What we spend money on has changed over the years. Food, Utilities and Charity have increased. Mortgage interest has gone to zero. While "cash" isn't really a proper category, we spend a lot less cash than we used to. We seem to spend less on entertainment. Home repairs, furniture, vacations, transportation have been lumpy and hard to really see much in the way of a trend.

We are now looking forward to losing the education expense and sending our daughter out on her own.
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The true monetary purchasing power value of a US dollar is a very substantial fraction of what it was a decade ago. Around 80%, maybe more.

Unless you spend it on something that happened to get more expensive.


The main things that have gotten more expensive for me have been property tax (up from $800/year to over $6,000/year now), medical bills after insurance (the copays, deductibles, disallowed items, and (difficult to price): specialists who refuse my insurance), food, communication and utilities. Home maintenance costs have increased considerably (the first time I had to replace my roof was about $2,500 and the most recent time was over twice that), new windows were $12,000, but I now do not need AC, so it is not clear how that balances out. I am no longer allowed to shovel my snow. This tends to cost about $40 per snowfall, more if it is deep. And the fine if my walks are not shovelled is about $35/day until it is done. This year was cheap, but some years were several hundred dollars. Some of these things (such as snow shovelling) are small, but there are a lot of them, and they really add up. I had some very expensive surgery in 2016. The hospital billed the insurance company well over $100,000; But all my copays and deductibles were way over $1,000, and I had some other surgery that billed way over my annual income, but around $1,000 in copays. And something like that happens every few years. The COLA on my Medicare went up something like 0.3% this year, but the insurance premium went up even more than that, so I get less overall.

Natural gas has gotten cheaper, both because I put in a much more efficient home heating system (a bit over $10,000) and removing and remediation of leakage of former oil tank (around $50,000). I do not suppose the change will ever pay for itself, but the environment may appreciate it.
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Uh oh. Don't get Jim started on longevity insurance. We'll all be forced into considering tontine investing!

Now that you mention it (heh heh heh...)

I've been musing on the subject of starting a tontine retirement vehicle as a mutually-owned or non-profit venture.
Longevity risk/annuitization is the glaring problem that Mr Bogle
hasn't addressed, and it is well suited to his "drive the costs down" approach.
Somebody has to do it, I figure.

I think a lot people would be willing to give up perfect constancy of payments
in return for payments for life to any age, a nice high return, and no counterparty risk.
Rising payments are merely a nice bonus.

Jim
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... removing and remediation of leakage of former oil tank (around $50,000).

Oooh, man, that must have hurt.
My deepest condolences.

Jim
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The Times had a recent article on "How to make you money last as long as you do" which has been a topic here as well. They quote a financial planner who has done some Monte Carlo simulations of the possibilities of running out of funds and found that delaying social security until age 70 helped considerably but that adding a single premium immediate annuity reduced the risk of running out of funds to essentially zero. The kicker? For $298k this annuity would generate $12k/year (~4% yield). Our much-discussed WFC/L is currently above 6% yield, so perhaps you could avoid the financial planner and do considerably better?

https://www.nytimes.com/2017/02/18/your-money/retiring-longe...
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My wife and I are both 76.
Soc sec and pension cover our yearly expenses.
Have all our money in cash now.
What would be a good mix for us, using WFC_L BRK-B and other?
All suggestions appreciated.
Thanks



The Times had a recent article on "How to make you money last as long as you do" which has been a topic here as well. They quote a financial planner who has done some Monte Carlo simulations of the possibilities of running out of funds and found that delaying social security until age 70 helped considerably but that adding a single premium immediate annuity reduced the risk of running out of funds to essentially zero. The kicker? For $298k this annuity would generate $12k/year (~4% yield). Our much-discussed WFC/L is currently above 6% yield, so perhaps you could avoid the financial planner and do considerably better?
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The kicker? For $298k this annuity would generate $12k/year (~4% yield). Our much-discussed WFC/L is currently above 6% yield,
so perhaps you could avoid the financial planner and do considerably better?


The difference is far more than it appears in that comparison.
In one case it's a yield, and in the other case it's mostly return of capital.

Let's say you go for one or the other deal today for $298k, inflation is 2%/year, and you croak 20 years from today.
WFC/PL is trading at $1199.60 today. Let's call it $1200, so the $75 coupon is exactly 6.25%.

Between you and your estate, how much do you get from the annuity?
For annuities I believe that only a very small and changing portion of the amount is taxable for Americans. Let's say 5% just so we don't ignore it?
So, you receive $12k payments for 20 years or $240k, which after inflation equates to $190710 in today's money.
After tax, that's around $181794 in today's money, which is 60.8% of your original money.
The other 39.4% of your money (in purchasing power) is lost and gone forever.
Even with zero tax and living to 103, you have had a negative real return on your money after 38 years.
Only in year 39 do you start to come out ahead on the deal, at age 104, and your rate of return at that point is less than 0.1%/year.

If you buy WFC/PL instead, you get 248.33 shares, paying a coupon of $75, total $18625/year pretax.
Let's assume you're US based and a top tax bracket kind of guy and pay 23.8%, so that's net $14192 per year after tax in today's dollars.
So, your real after-tax return after 20 years to your assumed death gets you $225550 in coupons overall in today's money, which is 18% more than the annuity gave you.
But...and here is the kicker...your estate still owns the preferred stock.
Assuming the price is still $1200 in then-current dollars, it's worth $741.77 per share in
today's dollars or $184206. There is no capital gains due if it's sold, as the nominal price hasn't changed.
Losing 2%/year in value to inflation is a lot better than losing it all.

So, after 20 years you (including your estate) end up putting in $298000 and end up with either
* $181794 total back in today's money from the annuity, after taxes and inflation
* $409756 total back in today's money from the WFC/PL, after taxes and inflation

The thing to remember about an annuity is that you are not *investing* that money.
It is an insurance premium expense, and once given over to the insurer, the principal never comes back to you.
Thus the payments are not a yield at all, but little steps back up out of that really big initial hole.
They are priced so badly that you have to live a *really* long time for it to be better than simply running down the pile of cash it would have cost you.
(that $298000, again without inflation protection or any return at all, will obviously last 24.8 years at a $12k/year rundown rate as there is no tax)


A disadvantage of the WFC/PL in these really long scenarios is that it's not perpetual.
There is the likelihood that each WFC/PL that cost you $1200 will get forcibly exchanged for $1300 worth of WFC common stock...eventually. Maybe 16-25 years out?
Your earnings yield is probably going to be a bit lower on the common than than the yield on the preferred, and "payments" will
get irregular (selling bits of stock when the market value of the block rises in real terms above its initial level).
But it does mean that you start getting inflation protection from that point onwards.
Hardly a wipe-out.

Previously I have suggested to people to use a mix of mainly WFC/PL for yield and a little WFC common to "insure" against the forced conversion.
The only scenario that you get the forced conversion is the scenario wherein WFC has gone up by 3.5 from today's price,
so when you eventually lose yield from the WFC/PL you have done wonderfully on the WFC common.
On certain assumptions a portfolio of 1/3 WFC and 2/3 WFC/PL would keep your yield from dropping below
its initial nominal level when the conversion happens, which is 4.90% pretax at current prices and yields.
You also get a material amount of inflation protection on your coupons, though not complete.

Jim
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Mungofitch - what an awesome explanation of an annuity - thank you!


"The thing to remember about an annuity is that you are not *investing* that money.
It is an insurance premium expense, and once given over to the insurer, the principal never comes back to you.
Thus the payments are not a yield at all, but little steps back up out of that really big initial hole.
They are priced so badly that you have to live a *really* long time for it to be better than simply running down the pile of cash it would have cost you."
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I really appreciate your reply, Jim, thank you.

And for your earlier WFC/PL posts too. I've just found them and they've been equally helpful.

I've still an unusually large cash allocation in taxable at the moment (less after buying BAC-L/WFC-L to 5% last week) and am becoming more comfortable with buying to 10%.


One question - I can see why retail investors overlook the opportunity, but why do professionals?

Obscurity can't be the reason and I'd think the Large Outstanding Market Supply would be attractive to the institutional buyer?
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One question - I can see why retail investors overlook the opportunity, but why do professionals?

Obscurity can't be the reason and I'd think the Large Outstanding Market Supply would be attractive to the institutional buyer?


Buffett had some thoughts on this in his latest CNBC interview.

Buffett: That's a very interesting phenomenon. I've talked this way, and people with small amounts of money say, "That sounds good to me," and then they just go and they buy index funds. They keep buying them. And they've done better than the people who have gone to hedge funds. But if I say that, I get asked various pension funds, sometimes they're local. And I've been asked by very big retirement funds, some other states. And I say the same thing to them. And they basically can't stand the idea that their big money won't buy special performance. And , of course, they get called on by these people all the time. You know, and a good salesman will –

Quick: The hedge fund guys, you mean?

Buffett: Yeah, they're going to fall for good salespeople. And what really gets me is sometimes they hire consultants. They say, "Well, I don't know enough to pick good managers, but I know enough to pick a good consultant." I have never quite figured out why they can't figure out who a good manager is, then some guy comes in, says, "Well, I'm a good consultant." So it's really sad, but they're really outclassed, in many cases, by the salespeople. I mean, that's true in a lot of fields. But in investments, you're talking big, big, big money. And somebody's got $1 billion, they want to have a family office, or they want to feel special. And the truth is, you don't need to be special.
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I am still trying to wrap my head around WFC/PL - shouldn't we be concerned about the combination of erosion from inflation and interest rate risk?

When we see interest rate increase one will not be able to sell at the same price as today.

WFC/PL should be exposed to interest rates like a long term bond (its maturity is upon possible forced liquidation, many years from now). This is confirmed when comparing its price chart to long term bond funds. One could see 15% drops from peaks in 2013 and 2016 .
Interest rates are pretty low these days, and we should expect those to go up some day - some believe rate increases will take a while, some believe it will happen sooner. In any event, whoever owns WFC/PL for long term income will probably see a significant rate increase, and a price drop. So one eitehr sells at a principal loss, or stuck with it for many years - where the effect of inflation kicks in.

Clearly this is much better than long term bonds with significantly lower yield, and the price drop could be caught up over time (to some extent erasing the current undervaluation) . Still - shouldn't this be a concern?
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Clearly this is much better than long term bonds with significantly lower yield, and the price drop could be
caught up over time (to some extent erasing the current undervaluation) . Still - shouldn't this be a concern?


I think you've hit the nail on the head. You aren't protected from inflation.
But the risk is mainly simple erosion of capital and principal, not so much pricing (IMO).

It's an unusually attractive proposition...compared to other things in the fixed income world.
But the fixed income world is a place of (generally speaking) no attractions these days, so it's a faint compliment.

Still, I wouldn't worry overmuch.
Over short to medium periods, inflation it won't add up to all that much.

Look at the longer term.
Say you hold till the day the shares get forcibly converted, and inflation is 2.5%/year till then.
Let's say that takes 20 years.
You buy at 1207 today, and end up with $1300 worth of WFC common stock that day.
In today's dollars, you end up getting total $1191 in coupons and $845 worth of stock that you could sell or keep, total $2037.
That's a real total return of 2.65%/year. (ignoring the minor advantage of coupon timing).

Conversely, you could by a 20 year Treasury bond today yielding 2.94% WITHOUT inflation projection.
So you'd be getting a real yield of about 0.44%/year.
Or, you could by 20 years TIPS which have a real yield of 0.88% today.

In that context, 2.65% from WFC/PL looks pretty good.

I personally don't worry too terribly much about the price risk.
Use it for situations that you won't have to sell on short notice. Only cash is cash, and that's what cash is for.
So if you own this and the price is not good for a while, just don't sell at that time.
In any case, the price probably won't spend a lot of time below par and the price risk is therefore mostly reasonably constrained.

If somebody goes in expecting something in the vicinity of the yield at purchase time, minus
the average rate of inflation during the holding period, you'll be close to the mark.
If that's attractive enough, then it can have some uses in a portfolio, maybe wedged between the cash and the equities.
But if you want a higher real total return in scenarios with material inflation, you probably just want more equities.

Jim
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If somebody goes in expecting something in the vicinity of the yield at purchase time, minus
the average rate of inflation during the holding period, you'll be close to the mark.


Yup, an excellent way to frame the concern. Expecting the yield at purchase time while assuming an exit at will - might lead to disappointment.
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Buffett had some thoughts on this in his latest CNBC interview.

If so, then why wouldn’t these preferreds be recommended by consultants to big money, VIIIandXX? They’d be an easy sell, I’d think: sufficiently obscure and allowing one to “invest like Buffett.”


When we see interest rate increase one will not be able to sell at the same price as today.

The author does address a number of ways the risk is at least partially mitigated, sencoman.

And as Jim once posted: if your intended holding period is forever, then the price risk is entirely irrelevant.

http://boards.fool.com/ot-wells-fargo-preferred-l-series-308...


In that context, 2.65% from WFC/PL looks pretty good.

In the context of an overvalued market with depressed expected returns, looks even better. Very little opportunity cost to play it safe.
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At the topmost level, I see no case for fixed income in a portfolio these days, only a mix of cash and equities makes sense.

I'm all Total Bond Market in my 401k, thinking it'll rise if the market corrects.

You'd prefer Stable Value thinking TBM will fall if interest rates rise?

Or is it that TBM cannot rise (much) in any correction given its current low yields?

(Believing the other 401k options [Total Stock Market and Total International Stock Market] overvalued, I think of TBM/Stable Value as dry powder.)

Thanks.
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At the topmost level, I see no case for fixed income in a portfolio these days, only a mix of cash and equities makes sense.

I'm all Total Bond Market in my 401k, thinking it'll rise if the market corrects.

You'd prefer Stable Value thinking TBM will fall if interest rates rise?

Or is it that TBM cannot rise (much) in any correction given its current low yields?

(Believing the other 401k options [Total Stock Market and Total International Stock Market] overvalued, I think of TBM/Stable Value as dry powder.)

Thanks.
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I'm all Total Bond Market in my 401k, thinking it'll rise if the market corrects.
You'd prefer Stable Value thinking TBM will fall if interest rates rise?



Well, my opinions are not always the best way to consider investments.
But that being said, I think the Total Bond Market fund is like walking around with a "Kick me" sign on your back.
With holdings having weighted average yields around 2.5%, it's like buying no-growth stocks at a P/E of 40. And that's before fees.

It contains bonds. I feel about them much the way Mr Buffett does: reward-free risk.
The contents are overpriced and have capped upside and in most cases--the long stuff--potentially huge and permanent downside.
Plus, as a bonus, if I'm not mistaken the total bond market index gives highest weight to the heaviest borrowers, being the weakest big firms.

I still think any mix of cash and equities can be justified better than ANY allocation to bonds at these prices.
If you need more yield that that gives, sell a few shares of something each month.
If you really want bonds, sit on cash for now and buy them the next time there is a panic.

Or, if you really want to reach for yield (at the saner end of the spectrum) and want to get fancy, a covered call strategy might be worth looking into.
These tend to underperform an equity index during long strong bull markets, and outperform the rest of the time: flat, falling, or especially jagged trendless ones.
Since I think the current long strong bull market is likely to die at some point, the advantages at the other times might be good.
As a random pick, have a glance at ETV. It has actually outperformed SPY since 2005, quite a feat.

Jim
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Jim,

Would you be kind enough to explain the advantages and disadvantages of ETV? Dumb readers such as myself need all the learning we can get.

Thanks,

SD
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I not long ago bought NFJ (div stocks, converts, covered calls, global).
Still buyable at a discount to NAV. Downside, distributions are quarterly.
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Thanks, Jim.

I did search your earlier posts but couldn't find it directly addressed.

Stable Value it is!
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I did search your earlier posts but couldn't find it directly addressed.
Stable Value it is!


One thought to bear in mind: only cash is cash. (most Americans seem to consider 3 month T-bills as "close enough").
The great return from cash is its immediacy: it's there when you reach for it, even in the most desperate of times, and can be deployed immediately.

I have no idea what your "stable value" product is, but the rule of thumb is that there is no such thing as a free lunch.
If the yield is higher than cash, then there is almost certainly a catch or two*, and it's probably worthwhile to track those down.
For example, odd "equity wash" rules which prevent you switching from "stable value" to cash. Or simply credit risk, or counterparty risk, or flat-out lack of liquidity.
Maybe it's a good deal, but I would be a skeptic and assume otherwise until doing a lot of digging.

Jim


* In fact, the process used to determine a country's divisia money supply relies on the variation in yields
to *measure* the degree to which a financial security is equivalent to cash. Big difference = big difference.
They take it as an axiom that a higher yield means something not like cash.
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No. of Recommendations: 5
One thought to bear in mind: only cash is cash. (most Americans seem to consider 3 month T-bills as "close enough").

The example of Greece should remind people that cash held by someone on your behalf may not really be cash.
Capital controls were introduced in Greece in June 2015, when Greece's government came to the end of its bailout extension period without having come to an agreement on a further extension with its creditors and the European Central Bank decided not to further increase the level of its Emergency Liquidity Assistance for Greek banks.
As a result, the Greek government was forced to immediately close Greek banks for almost 20 days and to implement controls on bank transfers from Greek banks to foreign banks, and limits on cash withdrawals (only €50 per day permitted), to avoid an uncontrolled bank run and a complete collapse of the Greek banking system.

https://en.wikipedia.org/wiki/Capital_controls_in_Greece
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They take it as an axiom that a higher yield means something not like cash.

Real yield, not nominal yield, one assumes.
Otherwise, in periods of high inflation, they would not count cash in interest-bearing checking accounts as cash. That would be wrong.
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Maybe it's a good deal, but I would be a skeptic and assume otherwise until doing a lot of digging.

I appreciate the caution, but managed by Vanguard, I believe it's a good deal.

Does have a higher ER (.23%) than Vanguard's MM fund (.11%), but yields 1.68% vs .53%.

And does have "equity wash" rules: while I can transfer from Stable Value to TSM, TIM, or TBM (or back to Stable Value) at anytime, I can only transfer to the money market fund from TSM, TIM, or TBM, and only then after 90 days. Only prevents me from taking advantage of interest rate spread between Stable Value and MM fund, not from shifting to equities or bonds.


Interesting:

This analysis concludes that, for moderately and highly risk-averse investors, SV funds are, under reasonable yield curve assumptions, a major component of an optimal portfolio, to the exclusion of money market funds and the near exclusion of intermediate-term bonds.

http://fic.wharton.upenn.edu/fic/papers/11/11-01.pdf
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Does have a higher ER (.24%) than Vanguard's MM fund (.11%), but yields 1.82% vs .53%.

Corrected.
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I have no idea what your "stable value" product is, but the rule of thumb is that there is no such thing as a free lunch.

From Investopedia: "A stable value fund is an investment option available primarily to qualified retirement plans such as a 401(k) plan. It is a managed portfolio of highly rated corporate or government, short-term and intermediate-term bonds with a principal protection wrapper provided by a life insurance company. The objective of the fund is to generate a stable yield while preserving investor principal. Historically, these funds have been able to generate yields that have outperformed the typical money market fund at no greater risk. They do this by managing a portfolio of bonds just like any other bond fund, except any losses of principal resulting from fluctuating bond prices are made up by the insurance company wrapper."

In a 401k portfolio, if the objective is to earn risk free higher-than-money-market returns while you wait for equity prices to come down, I highly recommend using a stable value income fund which most plans offer as an option. The yield generally changes quarterly (in some funds annually) and is posted at the beginning of the period. In one my of 401k portfolios, it's been in the 1.75% - 2% zone for the past several years. Even during the financial crisis, as far as I know, there was no loss of principal in any stable value fund. I believe this does come very close to a free lunch because it is only offered in retirement plans and is strictly regulated by the government. The NAV never goes down! One of the disadvantages of rolling over from a 401k to an IRA account is that you lose access to a fund like this.

In accounts where stable value is not an option, I suggest using a high quality low duration bond fund if you are looking for a parking spot for cash. The Doubleline low duration bond fund is a good example. Most of the assets are in very low duration investment grade and government bonds. The 30 day SEC yield is 2.07% and duration is only 1.1 years. With such a low duration, rising interest rates is not a problem. On the contrary, rising rates are beneficial as money gets reinvested into higher yielding bonds. Annual returns since inception in 2011 has been around 2% for this fund.
http://www.morningstar.com/funds/XNAS/DLSNX/quote.html
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No. of Recommendations: 11
They take it as an axiom that a higher yield means something not like cash.
...
Real yield, not nominal yield, one assumes.
Otherwise, in periods of high inflation, they would not count cash in interest-bearing checking accounts as cash. That would be wrong.


I think they use the difference between a given security's nominal interest rate and the nominal interest rate
of whatever they choose as "interest on a deposit of zero duration". (e.g. demand deposits or zero-duration government bills, I guess).
Since both sides of the subtraction are nominal rates, the gap is kind of unitless and doesn't need to be adjusted for inflation.
But I've never done a divisia calculation myself, that's from reading the theory.


Speaking of the money supply...
As an aside, it's interesting to see that some money is finally getting created in the US.
A lot of those once fearing hyperinflation didn't understand that the Fed's balance sheet simply doesn't matter, what matters is the money supply.
In the really old days, one tended to influence the other pretty directly, so you could get meaning from looking at the Fed's balance sheet,
but not in recent years. Money supply growth pretty much came to a halt for a long time because the money multiplier collapsed.
(The Fed furnace was roaring but the economic house was still cold because the monetary windows were open.
You could no longer use furnace fuel consumption to estimate the house temp, you needed to switch to a thermometer...
even a bad money thermometer now gives a better reading than a precise and wildly wrong Fed fuel consumption measure)

The average M4 divisia money supply in 2014 was only slightly higher than the average in 2009 (up 1.17%/year).
But...that has now changed. The two year rate of change of Divisia M4 is up to 4.5%, up from zero in late 2011.
That seems to have been the "kink" point: -1.5%/year from Dec 2008 to Dec 2011, then average about +3.9%/year since end 2011.
(that still only brings the rate of change since the crunch to about 1.75%/year, measuring 8 years Jan 2009 to Jan 2017).
This recent rise is a very good thing. Assuming the rate never explodes upwards, of course, which seems unlikely.

Jim
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Interesting:
This analysis concludes that, for moderately and highly risk-averse investors, SV funds are, under reasonable yield curve assumptions,
a major component of an optimal portfolio, to the exclusion of money market funds and the near exclusion of intermediate-term bonds.
http://fic.wharton.upenn.edu/fic/papers/11/11-01.pdf


I'm sticking with my theory that there is no such thing as a free lunch.
Under certain *other* reasonable assumptions, it's possible to turn lead into gold, right?
(there is actually a firm doing commercial transmutation using a nuclear reactor, but ironically gold is the input. ha!)

This paper looks at a financial innovation that has existed in its current structured form for only about 20 years.
It looks safe, as it hasn't had a blow up. Yet. That's always a scary line of reasoning, but OK.

Then they do all of their measurements on its "risk"/reward metrics, using short term volatility as a (meaningless) measure of risk,
not realizing that the whole point of a "stable value" fund is that they fake the prices and remove the liquidity.
Price movements in the underlying portfolio are simply smoothed out!

Consider:
I'll buy some shares in Berkshire, hold them in a fund, and offer shares in that fund to you any day you like...with restrictions. I take a fee.
I will ignore the price of Berkshire shares and calculate the trading price of my firm based on the *assumption* of a linear 6.5% return between now and 2022.
Then you proceed to estimate the "risk" of my venture by looking at the volatility of the price I am quoting.
Since the measured risk/reward is way better than that of Berkshire shares, you conclude it's a better deal, despite being the same thing with an extra layer of fees and worse liquidity.
Does that make sense? Neither does the paper.

I'm not saying that "stable value" funds are going to blow up, but that they are no safer than the underlying
portfolio (which typically includes an insurance wrap and counterparty risk), and are in fact a
worse true risk/reward ratio than the underlying securities because of the expenses and liquidity limitations.
So, if one accepts that a medium term bond fund is not a great deal, then this won't be better.

Jim
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not realizing that the whole point of a "stable value" fund is that they fake the prices and remove the liquidity.

At least in the stable value funds that I have a access to, there is no loss of liquidity. Investors can buy or sell any day with no restrictions, minimum holding periods, minimum amounts, etc. However, this may not apply to all SV funds.

At the end of the day, you are correct that true risk is determined by the underlying securities. A high quality low duration bond portfolio run by a skilled manager does not appear too risky to me, but I could be wrong about that.
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The NAV never goes down!

That's only because they lie about the NAV.
They ignore the market prices of the underlying securities, and make up a theoretical price as if
all fixed income securities were held to maturity and traded at par until then with zero defaults.

Most of them are structured products these days, from what I read.
A triumph of marketing that has never gone bad...yet.

The sponsor buys a bunch of securities (which you could have bought yourself), and generally charges a fee and passes only a
fraction of the coupons back to you. They smooth the payments so it looks like a short term stable value portfolio, but it isn't.
When there is a big credit loss event within the portfolio, the NAV can certainly drop.
It's the same problem as happened in money market funds that made impossible promises never to break the buck, but with more duration risk.

I suppose I'm not the only one who has had qualms.
"The crux of the problem for the SEC seems to be how to reconcile the fact that stable-value
funds boast completely stagnant NAVs, even though their underlying bond portfolios change in value every day.
Although the funds' wrapper contracts are the glue meant to hold that scheme together, the SEC seems
to be questioning how they can be valued in such a way as to justify the funds' static NAVs."

That's from a Morningstar article from before the crunch.

I gather the reason they are now available only in 401(k) plans is that they were flat-out banned for other uses about a dozen years ago.
Presumably because of this sort of problem.

The good news: they'll probably be fine.
The bad news: for me, that wouldn't be enough comfort.
If you want an intermediate bond portfolio, just buy one. Don't buy one with added smoke and mirrors (and fees and risk).

The only exception I can see is that they might be attractive at a moment that they are pricing the product artificially low, during a bond panic.
Take advantage of their added price smoothing. But then get out as soon as the prices are close to fair.
But oh yeah...this is so obvious they mostly prohibit it, as you'd likely want to be moving in or out of fixed income which was fairly priced.

Jim
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Would you be kind enough to explain the advantages and disadvantages of ETV? Dumb readers such as myself need all the learning we can get.

I don't know this particular security very well, but it is a buy-write ETF.

What does that mean?

They buy stocks that are representative of their benchmark, and then write near-the-money or out-of-the-money
short term call options against them all the time. Some funds do it security by security, others write calls against their benchmark index.

If, in a given month, a given security goes down a lot, goes down a little, stays flat, or rises a bit this is
more profitable than just holding the same stock because they keep the option premium, or at least some of it.
However if that security goes up a lot, their upside is capped: the person to whom they sold the call exercises it,
and they get only a finite upside rather than the full amount by which the stock jumped in that period.

It's reasonably common for a single security to go up a lot in a given short period, but two things to note:
(a) this isn't true in the majority of individual short time periods. Over time, it's the average that matters.
(b) when you do this across a large number of securities, across the portfolio it really only happens much when the index rises a lot in a short period.
This is why the strategy as a whole tends to underperform in a strong and smooth bull market and outperform in all other situations.

The two situations that make buy-write an outperformer are:
- Stocks aren't rising in value quickly in short term. (or at least, not a large fraction of them at once)
- Option premiums are relatively high. (e.g., VIX is high).
ETV totally crushed SPY in 2015 when SPY was almost perfectly flat for the year.
However recently, neither of these has been true. ETV has underperformed SPY in the last 15 months.
But, this too shall pass. There will always be another bear market, and volatility will come for a visit from time to time.

I haven't done the exercise, but I think you'd probably find ETV is more likely to outperform SPY in months which started with a high VIX, and vice versa.

A buy-write strategy is similar to (but not in the real world the same as) writing cash-backed puts, a hobby of mine.
My crude rule of thumb is that for reasonably selected underlying stocks, over reasonable time periods
the return you get writing repeated puts without leverage is roughly half way between what the stocks would have returned and 10%/year.
Obviously when the stocks go up more than 10%/year, you'll do worse than holding the stocks...but you're still making 10%/year.

Jim
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Couple of random (US-centric) thoughts.

1. Accounting allows you to show bond holdings at par, at least for treasuries, if they are intended to be held till maturity. So technically the SV funds are not lying. Of course if everybody tries to cash out at once this will fail but then so would a bank cd.

2. Just as they talk about the J-factor in bankruptcies, now we have to talk about the G-factor in every bond security. The government will surely ensure that nobody in money market funds or stable value funds loses any money because that's the lesson they learned from the financial crisis.
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No. of Recommendations: 3
If you want an intermediate bond portfolio, just buy one. Don't buy one with added smoke and mirrors (and fees and risk).

The issue here is not that stable value funds are great or that someone badly wants to invest in an intermediate bond portfolio. The crux of the matter is that there is limited choice in a 401k plan.

In most 401ks, you do not have access to individual equities or ETFs. The choices are limited to a list of 20 or so mutual funds most of which are equity funds.

If you decide not to invest in equities at current valuations, then there are only 4 or 5 choices left. A money market fund that yields nothing, a SV fund that yields around 1.75%, an intermediate duration (but not low) bond fund that tracks the barclays aggregate bond index and may be a TIPS bond fund.

TIPS is actually not a bad choice these days with inflation rising. Intermediate duration bond funds typically have a duration of about 6 years which I feel is too high in a rising rate environment. I won't be surprised if the 10 yr crosses 3% this year. As an aside, the 50 YR French govt bond has lost a third of it's value in the last few months. Imagine the headlines if this happened in equities.

So basically you are left with money market (or a govt T bills fund) which yields nothing versus stable value which yields something.
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I'm sticking with my theory that there is no such thing as
a free lunch.


Buying Berkshire a few years back at 1.1 book gets pretty close
though. :)

Regarding the insured bond ("stable value"), at a first
approximation, every investment that I can think of
that has extra management, extra marketing, extra packaging layers,
or insurance, but no actual change to the underling, is a worse
investment than the underlying.

However, possibly not so fast in the case of insurer covering a bond,
in fact I quite like the idea, but for non-trivial reasons.
The reasons are three-fold. Firstly the insurance industry
regularly operates at underwriting loss - to this extent, taking
the insurance gives can provide to you more than you provide
to them. Secondly, cash (other than the pillow format)
is also not cash of course, but just a claim to be able to
extract funds from whichever bank or brokerage is reporting
it at some point in the future. When you borrow from a bank,
the bank does not take it from a reserve as economists are
taught in text books, but rather it just uses double entry
book-keeping to issue the cash and counter balance it with
a debt entry. The bank extends credit, creating deposits
in the process, and they look for reserves later. Similarly,
when your bank reports that you have some cash in your account,
it isn't literally there, and it can disappear (and be repaid
perhaps in part by the government) at some point in the future
just like a bond can default. I'm talking about extremely
unlikely scenarios, but just agreeing with Zzorac about
the insurance backed bond perhaps not being as bad as a
first approximation. Thirdly, I would tend to think that whilst
not everyone is overconfident about bonds never defaulting,
there will always be some sucker who is overconfident - this
sucker can be the insurer that is willing to insure the bond,
even if other insurers won't agree to insure it. Thus in a
real economic sense, the insurer might be providing value
to the bond holder, even if they aren't providing value to
themselves.

- Manlobbi
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I'm sticking with my theory that there is no such thing as a free lunch.

The evidence demonstrates that stable-value funds produced higher returns than short-term instruments and did so with similar risk. They produced returns similar to those of intermediate-term instruments, but with less risk. We can conclude, therefore, that stable-value funds offer unique risk-return characteristics that allow investors to create portfolios that are more efficient at delivering returns for a given level of risk.

https://books.google.com.sa/books?id=9Bd-RVaO5S0C&pg=PA9...


The crux of the matter is that there is limited choice in a 401k plan.

Yup. My choices: MM, Stable Value, or TBM.
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Larry has since changed his mind:

The BIG problem with stable value funds is that it is almost impossible for the average investor to know what is inside. The fund could be taking on FAR TOO MUCH risk and you would not know it.

We even have had a hard time getting information, and straight answers, and we advise on or manage now $13b in assets.

The idea behind the funds is sound and there can be well run funds but there is almost no way to know. And even a long history might not mean much if management changes and you get bigger risk takers running the show.

I did recommend them in my book on alternatives which has a chapter on them. But having spent more time investigating them during the crisis I found things that gave me concerns. Thus I would in general not recommend them, despite the appeal behind the idea.


https://www.bogleheads.org/forum/viewtopic.php?t=66285


I'm still comfortable with my fund (Vanguard Retirement Savings Trust), trusting it to be well run.


I'm sticking with my theory that there is no such thing as a free lunch.

If you'd otherwise pay a "liquidity premium," wouldn't you expect a higher return from the less liquid Stable Value fund?


I gather the reason they are now available only in 401(k) plans is that they were flat-out banned for other uses about a dozen years ago.

Stable Values funds require predictable withdrawals so they can hold bonds to maturity. 401k plans offer this.
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The Vanguard Group recently simulated a stress test on its own stable value fund and concluded that even under “extraordinary conditions” of rapidly rising interest rates, 100% of principal and some yield would be secure.

http://www.forbes.com/sites/janetnovack/2012/11/26/worried-a...
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I've been musing on the subject of starting a tontine retirement vehicle as a mutually-owned or non-profit venture.

Enthusiasts believe modern technology and data-crunching could help overcome the instrument’s shortcomings. Electronic records make it easier to verify whether someone is dead; crowdfunding could help source a tontine pool; and the blockchain, a type of decentralised ledger, could anonymise it (and thus avert any murder plots).

“The eventual disruption will come not from a traditional asset manager, but from a 22-year-old kid in Silicon Valley,” predicts Mr Milevsky, who has seen the number of tontine-related patent applications increase recently. Tontines are a thing of the past. But they may yet come back from the grave.

http://www.google.com.sa/url?sa=t&rct=j&q=&esrc=...
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Death pools can bring financial security for the long-lived (The Economist)

Someone else forwarded that to me.
My fascination with tontines is becoming well known, it seems.

Enthusiasts believe modern technology and data-crunching could help overcome the instrument’s shortcomings.
...
“The eventual disruption will come not from a traditional asset manager, but from a 22-year-old kid in Silicon Valley,” predicts Mr Milevsky,
who has seen the number of tontine-related patent applications increase recently. Tontines are a thing of the past. But they may yet come back from the grave.


Actually one of the things I like about the "mutual inheritance fund" version is its simplicity and LACK of any requirement for actuarial or techno-finance skill.
It automatically adjusts for the mortality curve of its own participants: no member gets anything
(other than dividends) unless and until another member croaks.
If the pool is unusually long-lived, participants just wait a little longer before getting their payouts.
That's a lot better than having the fund go into a deficit of some kind.
In retirement, you can have regular payments till death which are high (embodying a good return),
risk free and low fee because they're fully funded, or payments of a known size and timing.
You can any have two of those. But you can't have all three.
A little bit of uncertainty about the exact amounts seems the best thing to give up.
It does, however, mean that to be fair all participants in a given fund have to be the same sex and
somewhat close to the same age when the fund starts, and the fund can't stay open to new entrants.

If you were to have one elaboration, by far the best is this one.
Each payment is not based solely on your share of the total number of shares of the fund still existing.
It's that, times your share of the aggregate probability that each fund member died the last quarter, based each member's age and sex.
(those are all about the same for all participants in the simplest version above, so the multiplier is 1).
With this adjustment, the same fund can have a mix of people by age. Bigger pool = smoother payment stream, and lower operating fees per participant.
If the mortality curve of the group does not match that of the tables used for the adjustments, it
still does not risk the fully funded nature of the fund, it merely means that the payment size
to some participants was not precisely the "true" fair amount, but a few percentage points off.
The bigger problem is that it is far, far harder for the layman to understand and trust.

Maybe my preference for the simpler version is because I'm closer to the age of being the croaker than to the age of the putative disruptive 22 year old.
As the years go by, I am more and more impressed by the KISS solution to any problem.

Jim
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