It's no secret interest rates are at historical lows. We've experienced a 30 year bond market rally that, when it comes to an end, may be worse than most any stock market decline we've seen.
Many investors have been investing in bond mutual funds – from high yield to U.S. treasuries. Unfortunately, we have been conditioned to think that bonds and bond funds are safe.
However, it depends on how and why you own them. Most investors buy bonds because of their safety and certainty. For example, a 10-year Treasury may pay 2.4% annually and at the end of the term, principal is repaid to the investor. That's pretty straight forward. However, investors investing in bond funds could see a dramatic difference.
Bond funds do not have a maturity; there is no set interest rate (coupon) and no guaranteed return of principal. One more thing, they are accompanied by investment management fees often in excess of 1% or carry a sales commission of nearly 4%. Peter Lynch, the renowned manager of the Fidelity Magellan Fund addressed his concern about bond funds in his book Stocks for the Long Run by saying, "I may lose some friends in the bond-fund department for saying this but their purpose in life eludes me."
An increasing interest rate environment is bad for most bonds and bond funds; they tend to go down in value when rates rise. However, if you own individual bonds you may see them decline in value but if held to maturity you should receive par value. Again, unlike individual bonds, bond funds do not have a stated maturity so you may never receive your principal value back. Moreover, if other investors start to liquidate their shares of the bond fund, the manager may have to sell bonds for a loss (to generate cash). More than likely those bonds would be sold for a loss and will no longer exist in the fund for them to return to par value.
The yield on the bellwether 10-year Treasury note spiked to 2.16% at the end of May from 1.67% the end of April. That rate rise hammered many bond funds: funds that invest in long-term government bonds, fell 6.8% last month, according to Morningstar; emerging markets bonds fell 4.7%. Some funds even use leverage and lost in excess of 20% - in the month of May!
The solution is to invest in a portfolio comprised of mostly individual securities so your returns are not based on other investors' behavior – ie: liquidating their shares of a mutual fund and diminishing your return. If you own an individual bond and it goes down in value, simply hold it to maturity to receive the par value. You also gain something a bond fund doesn't offer: more certainty, safety and predictability: a predictable income (coupon) and a return of principal at maturity (assuming the credit quality of the company can pay it)
If you think rates will be increasing over the next year or two, this is the time to right the ship – before the tsunami. We would be happy to discuss our approach to fixed income investing and how you could benefit. Please do not hesitate to contact us.
Viewpoint: 403(b) Fair—Promoting Greater Transparency for 403(b) Plan Fees
By Anthony Agbay, The Agbay Group
Until recently, the market for 403(b) defined contribution plans—which can be sponsored by public-sector educational institutions, including universities, nonprofit charitable organizations (including many hospitals), Indian tribal organizations and churches—was like the Wild West, where anything goes. Over the past few years, new 403(b) regulations have changed the landscape significantly. While multivendor plans remain an option (unlike single vendor 401(k) plans), the 403(b) regulations require plan sponsors to adopt a written plan document and ensure that the plan operates in accordance with its terms. In addition, new mandatory procedures include limits on contributions and distributions and requiring a third-party administrator to monitor employee eligibility.
When the regulations were being considered, many opined about their likely impact for good or ill. Now that they are in place, actual outcomes can be indentified and discussed.
WASHINGTON 12/23/2011 — Nearly 160 million workers will benefit from the extension of the reduced payroll tax rate that has been in effect for 2011. The Temporary Payroll Tax Cut Continuation Act of 2011 temporarily extends the two percentage point payroll tax cut for employees, continuing the reduction of their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid through Feb. 29, 2012. This reduced Social Security withholding will have no effect on employees’ future Social Security benefits.
Employers should implement the new payroll tax rate as soon as possible in 2012 but not later than Jan. 31, 2012. For any Social Security tax over-withheld during January, employers should make an offsetting adjustment in workers’ pay as soon as possible but not later than March 31, 2012.
Employers and payroll companies will handle the withholding changes, so workers should not need to take any additional action.
Many of the pension plan limitations will change for 2013 because the increase in the cost-of-living index met the statutory thresholds that trigger their adjustment. However, the catch-up contribution for employees age 50 and over remains unchanged. The IRS indexed dollar limits to qualified retirement plans for 2013 are provided in the table below.
Why didn't the age 50 and over catch-up contribution change?
The Consumer Price Index for all Urban Consumers (CPI-U) is the gauge used to determine if limits increase. The inflation rate is measured from the third calendar quarter of the prior year to the third quarter of the current year. This rate will determine the inflation factor to apply to the limit for the following calendar year.
The challenge with the age 50 and over catch-up is the amount is indexed in increments of $500, which is a large percentage of $5,500 (9%). The CPI-U has to increase over 9% for this limit to be raised. Compare that to the 402(g) limit, where the CPI-U only needs to increase by more than 3% ($500 divided by $17,000) for that limit to increase. Since the CPI-U has not increased anywhere near 9% in recent years, a few years must pass before there is an increase in the age-50 catch-up amount.
TDFs are not created equal. Too often, they are comprised of proprietary funds that restrict fiduciary oversight, and proposed DOL regulations will add transparency, but won’t affect a plan’s underlying strategy. Plan sponsors should review their investment options, analyze the "glide paths" of the funds and ensure that the strategy chosen best suits the needs and demographics of plan participants.
Bear markets make for greater scrutiny in the financial markets and, more specifically, financial products. However, just as many regulations seem to come after the damage is done (i.e., the legislation that followed the Enron crisis), the same fate may await target-date funds.