There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.
—Mark Twain, Following the Equator
The distinction between saving (the goal of which is the JL preservation of capital) and investing (the goal of which is the creation of capital) is a crucial issue for investors to under-stand. Savings, because of low risk, and therefore low return, should be accumulated to meet emergency needs, cash flow needs, and short-term spending requirements (e.g., college tuition, purchase of a home or car). Once you have created this safety net, the balance of your capital should be invested.
In this chapter we will focus on fixed-income alternatives that are much more akin to savings than they are to investing. We begin with securities known as commercial paper.
Commercial paper consists of short-term, unsecured promissory notes issued primarily by corporations. The market is huge, with well over $1 trillion outstanding. Corporations issue commercial paper for two reasons—it is generally cheaper than bank loans and it diversifies their sources of funding. Most commercial paper is issued at a discount, paying par at maturity (a small part is interest bearing and pays interest and principal at maturity).
Maturities on commercial paper are usually no longer than 270 days. The reason is that commercial paper is exempt from the ex-pensive SEC registration requirements of the Securities Act of 1933 as long as the maturity is less than 270 days. The maturity of most commercial paper is, however, much shorter—typically from one day to two months. The reason that the average maturity is so short is that in order for a bank (one of the major buyers of commercial paper) to borrow at the Federal Reserve’s discount window it must put up what is called eligible collateral. In order for collateral to be eligible, its maturity cannot exceed fifty days. Because of the demand for eligible collateral, commercial paper trades at a lower yield—which is why corporations issue so much very short-term commercial paper.
Just as is the case with corporate bonds, commercial paper carries a credit rating from agencies such as Moody’s and Standard & Poor’s. At one time only companies with very high credit ratings were able to issue commercial paper. However, this has changed. Companies with lesser credit quality have been able to issue paper by enhancing their own rating with some type of credit support. The support can be in the form of a letter of credit from a highly rated company (typically a financial institution or insurance company), or it can be in the form of collateralization with high-quality assets (e.g., accounts receivable, mortgage-backed securities). For the most part, commercial paper is a very safe investment because the financial situation of a company can easily be predicted over a few months. As a result there have only been a handful of cases where corporations have defaulted on their commercial paper. But caution should still apply. Thus, a good rule of thumb is that you should only consider paper with the highest rating of Al (S&P rating) or PI (Moody’s rating).
Commercial paper is issued in one of two ways. The traditional route has been through broker-dealers. However, some corporations have such large programs that they now issue paper them-selves directly to the investing public.
While there are some issuers that sell commercial paper in denominations of $25,000, it is usually issued in denominations of $100,000 or more. Thus only high-net-worth individuals can even consider this market. Despite the size of the primary market for commercial paper there is very little secondary trading. While a dealer, or the issuer in the case of directly placed commercial paper, will generally repurchase the paper if the need arises, individual investors should only purchase the paper if they plan to buy and hold.
Yields on commercial paper are somewhat higher than they are on Treasury bills. The higher yield results from three factors. First is the increased credit risk. Second is the lower level of liquidity. The liquidity premium, however, is very small because of the very-short-term nature of the paper, and most buyers plan to hold to maturity. And third is the taxing of interest on commercial paper at the state and local level, while this is not true for Treasuries. These are factors that should be considered in evaluating the investment decision. Investors can track the yields on commercial paper very easily. The Wall Street Journal reports on them daily, as does the Federal Reserve at their Web site—federalreserve.gov/releases/cp.
The bottom line is that for high-net-worth individuals, commercial paper can be an attractive alternative, providing an incremental return over Treasury bills. And while investors have incurred very few losses over the past several decades, the basic principle of prudent investing still applies: Don’t put too many eggs in one basket. Thus if your portfolio is not large enough to allow you to diversify across issuers, the best way to access this market is through money-market funds—the next investment vehicle we will discuss.
A money-market fund is an open-end mutual fund that invests only in short-term debt obligations. By SEC regulation such a fund must have a highly diversified portfolio that is composed of the securities of creditworthy corporations, banks, and other financial institutions and federal, state, and local governments. By law, the average maturity of the fund cannot exceed ninety days, though the term of any one instrument can be as long as 397 days. Thus a money-market fund involves almost no interest rate risk. The generally high credit quality of its investments, and the payment of interest on a monthly basis, allows it to maintain a net asset value (NAV) of $1.
There are two distinct categories of money-market funds— taxable and tax-exempt.
Within the category of taxable money-market funds there are three types, general, U.S. government, and Treasury-only. U.S. Treasury funds invest only in direct U.S. Treasury obligations, and thus entail no credit risk. In addition, interest is exempt from state and local taxes. U.S. government funds hold obligations of the U.S. Treasury as well as those of the agencies of the U.S. government. As we have discussed, while agency debt is rated AAA, it does not have the backing of the full faith and credit of the government (only the market’s perception of an implied guarantee). The lack of the backing of the full faith and credit of the government makes agency bonds not as an impeccable a credit as Treasury debt. Agency debt thus carries slightly higher interest rates. The interest on the debt of two of the agencies, the Federal Home Loan Bank and the Federal Farm Credit Bank System, is also exempt from state and local taxes.
The third type of taxable money-market fund is a general fund. It invests in U.S government debt as well as in the short-term debt of large, high-quality corporations and banks in order to try to achieve higher returns.
The second category of money-market funds is known as tax-exempt or municipal money-market funds. They invest in the short-term securities of state and local government agencies, and provide interest income that is tax-free (subject to the limitations imposed by the alternative minimum tax rules, or AMT). There are two types of tax-exempt funds. National tax-exempt funds invest in municipal obligations issued by state and local governments across the country. Such funds provide income that is free of federal income taxes. Most states, however, only provide a tax exemption for interest earned on debt obligations of their own state. Therefore, most of the interest from national tax-exempt funds is generally taxable at the state and local level. This creates the need for single-state funds that only purchase the municipal obligations of a single state. Depending on the state tax rate, a national or single-state fund will be the preferred choice.
While the appeal of the tax exemption is high, sometimes the mathematics show that a taxable fund will actually provide higher after-tax returns. To determine which alternative is best, you need to calculate the tax equivalent yield (TEY) of a municipal money-market fund. As we discussed in chapter 1 the TEY is (approximately) equal to the tax-exempt yield divided by 100 percent minus your tax rate.
TEY = Y /(100% - tax rate)
When doing the math, remember that you also need to consider that interest on Treasury and federal agency debt is exempt from state taxes, while interest on nonlocal municipal debt may be taxable. The potential for the AMT to play a role should also be considered.
The main goal of these funds is the preservation of principal, not high return. Thus money-market funds should be considered savings vehicles, not investments. If return is the goal, there are better alternatives. As we saw in the first chapter, investors have generally been well rewarded for extending term risk beyond the average term of a money-market fund. Short-to-intermediate-term bonds (or bond funds) would be the preference if return were the main objective. Money-market funds should be used to hold funds needed for unanticipated expenses and as a “holding place” for funds that will be invested in the near future.
Most financial planners recommend that investors hold an amount equal to three to six months of living expenses in a money-market fund (or other very short-term fund with a similar high credit quality) for the proverbial rainy day. Given their role, investors should seek funds that invest only in the highest-investment-grade securities. With this restriction, and the limitation on maturity restricting the ability to take interest rate risk, funds should be chosen mainly on the basis of which has the lowest cost. The average money-market fund has expenses of about 0.6 percent, but some funds carry expenses as low as 0.15 percent. Convenience can also come into play. You might be willing to pay somewhat higher expenses for the convenience of check-writing privileges, and also for having all of your investments at one custodian. There are, however, funds with expense ratios well above one percent—and they should be avoided like the plague. That is simply too high a price to pay for any convenience benefit.
When looking at a fund’s operating expense ratio, a word of caution is warranted—sometimes a fund will temporarily waive some of its expenses. Therefore, you should determine whether a fund is gaining its cost advantage by maintaining low expenses over time, or by temporarily waiving fees. This information can be obtained by reviewing the prospectus.
While money-market funds do not provide a guarantee against loss, thanks to the tight restrictions imposed by the SEC, their track record is almost unblemished. For competitive reasons most fund sponsors have maintained a policy of preventing their funds from “breaking the buck” (the NAV falling below $1). If a fund were allowed to break the buck, confidence in the fund would be shattered. There have been several instances where fund sponsors have had to subsidize the fund’s value because of credit losses. High-expense funds might seek to keep their net yield competitive by investing in riskier securities—and sometimes losses will be incurred. In addition, the very low interest rate environment of 2003–04 forced companies to at least temporarily waive some of their fees, or the funds would have provided negative returns.
The convenience and safety of money-market funds have made them extremely popular vehicles. Given their role in the portfolio, investors should seek funds with both a track record of very low expenses and a history of investing only in the strongest credits.
A certificate of deposit (CD) is a short- or medium-term, interest-bearing, FDIC-insured debt instrument offered by banks and savings and loans. FDIC insurance is only provided on accounts of up to $100,000 per social security number, per bank. A CD has a stated interest rate and maturity date, and can be issued in any denomination.
CDs can be either negotiable (marketable) or nonnegotiable. If a CD is nonnegotiable, money removed before maturity is subject to an early withdrawal penalty—and there are no strict guidelines governing the penalty that can be imposed.
CDs of over $100,000 are generally known as “jumbo CDs.” Because of the economies of scale they provide the bank, they generally carry a slightly higher interest rate. Almost all jumbo CDs, as well as some small CDs, are negotiable. Many large brokerage firms now market CDs. They will also act as custodian, simplifying the paperwork. Some firms even provide marketability by standing ready to buy back CDs prior to maturity. There are also many Web sites that list current offerings, allowing investors to shop the market nationwide.
Banks have become very creative in the types of CDs that they offer. For example, CDs can be either fixed or floating (a variable CD). They can also have call or put (the investor has the right to early redemption) features. CDs can even have a “step-down” feature—the investor might be offered a higher initial rate but the rate is subject to downward revision should a benchmark (e.g., Treasury bill or Eurodollar) rate fall. They can also have a “step-up” feature. And they can even be tied to the performance of the stock market. While most of the offerings favor the banks (especially the ones tied to the performance of the stock market— those should almost certainly be avoided), at times the marketing departments of banks create products that favor the investor (probably because the marketing staffs, and possibly even the finance staffs, don’t fully understand the risks). Thus while most of the time CDs may not provide the best investment choice, there are occasions when they are definitely worth considering—for example, if a bank offered a long-term CD with a put option, allowing the investor to redeem early should rates rise, but hold to maturity if they remain stable or fall. As is always the case, prudence dictates that you don’t invest in anything where you don’t fully understand the nature of the pricing and the risks.
There is another type of CD that we need to cover— dollar-denominated CDs issued by foreign banks. Dollar-denominated CDs issued by foreign banks abroad are known as Eurodollar CDs, or Euro CDs. CDs issued by U.S. branches of foreign banks are known as Yankee CDs. Euro and Yankee CDs need to provide a higher rate of interest because they lack FDIC insurance. The issuer is also able to offer a higher rate because it has lower reserve requirement costs (the Federal Reserve requires U.S. bank deposits to be backed by reserves). Since the issuer will earn less on the funds raised in the U.S. (because of the reserve requirements it cannot lend out the full amount) it has to offer a lower rate of interest on U.S. deposits than it can on Euro CDs. A third reason for their higher rate is the “sovereign” (country) risk the investor accepts. The size of the risk premium a Euro or Yankee CD will provide will depend on the credit rating of the bank, the specific sovereign risk perceived by the market, and the confidence in the global banking system in general. A fourth reason for the yield premium is their reduced liquidity (even if they are marketable).
Yields on CDs are generally somewhat higher than they are on Treasury instruments. However, taxable investors must consider the exemption from state and local taxes that Treasuries enjoy and CDs do not. This is irrelevant for tax-exempt or tax-deferred accounts. Once the tax differential is considered, for taxable investors Treasuries might provide the higher after-tax rate of return. Investors should also consider that Treasuries have no credit risk, they are more marketable, and there are no prepayment penalties.
The yield on a bank CD is influenced by the credit rating of the bank, even when FDIC insurance applies. Before purchasing any CD, investors should determine the risk involved by checking the issuer’s credit rating. There are several rating services, including Duff & Phelps, Fitch, Moody’s, and Standard & Poor’s. Credit risk is not much of an issue for amounts of $100,000 or less since FDIC insurance is available. For amounts greater than $100,000 diversification of credit risk becomes important, especially if a bank is not a highly rated one. Investors should note that while the FDIC does insure that no losses will occur, it does not guarantee the timely payment of interest and principal. If a bank fails, CD holders will eventually have their funds returned, but it may not be at maturity.
CDs (at least those that carry FDIC insurance) are generally safe investments and worth considering for a portion of a fixed-income portfolio, especially for tax-deferred or tax-exempt accounts.
As we ended the first quarter of 2004, money market accounts, a traditional safe harbor for investors, were yielding less than 1 percent, the lowest level in decades. Even ten-year Treasury bonds were yielding less than 4 percent. If interest rates rose, longer-term bond prices would fall dramatically. Investors who are un-willing to, unable to, or have no need to take the risks of equity ownership search for vehicles that can provide higher than money-market yields without taking either significant credit or price and term risk. Stable-value investment vehicles (also called interest-income, principal-preservation, or guaranteed-interest funds) just might fit the bill. Well-designed vehicles can provide investors with higher yields without exposing them to significant credit or price risk.
Stable-value investments are fixed-income investment vehicles offered through defined-contribution savings plans and individual retirement accounts (IRAs). The assets in stable-value funds are generally very high quality bonds and insurance contracts, purchased directly from banks and insurance companies, that guarantee to maintain the value of the principal and all accumulated interest. They deliver safety and stability by preserving principal and accumulated earnings. In that respect, they are similar to money-market funds but offer higher returns.
Stable-value options in participant-directed defined-contribution plans allow participants access to their accounts at full value for withdrawals and transfers as permitted by the defined-contribution plan. However, since they are often purchased within retirement plans, the plan itself may have withdrawal restrictions (and the stable-value fund itself may impose other restrictions, which will be discussed below).
The higher returns offered by stable-value investments make them comparable to intermediate bonds without the volatility. In that respect they offer unique risk-return characteristics—perhaps explaining why they are included in two-thirds of employee-directed 401 (k) and 403(b) plans, representing over 33 percent of assets that according to the Stable Value Investment Association total in excess of $300 billion in value ( www.stablevalue.org). In order to gain an understanding of these vehicles we will look at the types of investments they make and how they are able to offer stability of value yet provide attractive returns.
Until recently, most stable-value vehicles were structured as guaranteed investment contracts (GICs). These are contracts issued by financial institutions—typically a highly rated insurance company, though it could also be a bank—guaranteeing investors a fixed rate of return. In the 1980s, however, several insurers (Executive Life, Mutual Benefit Life, and Confederation Life), financed by high-yield bonds, sold GICs to retirement plans and then went under.
The result is that today most stable-value assets are structured as “synthetic GICs,” also known as “wrapped bonds.” Synthetic GICs are created by purchasing short-term to intermediate-term bonds, including U.S. government and agency bonds, mortgages, and asset-backed securities. The bonds purchased are generally of the highest investment grade ratings (AAA and AA). Some vehicles include a provision for a very limited allocation to lower-rated paper (e.g., 10 percent). In addition, provisions are often made for the portfolio to invest in futures, options, and forward currency contracts (see glossary). The portfolio is then protected from fluctuation in value by the purchase of insurance “wrappers.” If the market value of a stable-value portfolio falls below the book value of the portfolio, the insurer pays the difference, keeping the fund’s value stable. On the other hand, if the portfolio’s market value exceeds its book value, the fund pays the insurer the difference. The wrapper allows the stable-value vehicle to fix its net asset value at, say, $10 a share (i.e., like a money-market fund). However, a stable-value fund is not a money-market fund and there can be no assurance that the fund will be able to maintain a stable value over time. Also note that if a fund holds derivative positions they can be more volatile and less liquid than traditional securities. The greater volatility of these instruments could lead to additional sources of market losses. Typically the wrapper will cost the vehicle from 15 to 25 basis points, depending on the credit quality of the portfolio, the structure of the wrapper and supply-demand conditions of the market for this type of portfolio insurance. because of the insurance wrapper, the returns for the funds come solely from their yield. Thus there is no potential for capital gains, and very little risk of loss to consider (unless the credit rating of the insurer and the underlying instruments are not of the highest investment grades). Additionally, the stable-value vehicle may hold insurance company-issued GICs, or similar instruments, as well as cash equivalents.
Stable-value funds appear to be a good deal for investors, providing returns similar to those of high-grade intermediate-term bonds with the volatility of a money market account. However, while the risks are minimal, the investments are not risk-free. The earnings of stable-value vehicles can be outpaced by inflation, their yields typically lag the market, and unlike money-market funds that invest solely in U.S. government securities they are not entirely immune to a credit blowup among the issuers of the bonds they hold. Although the insurers put their financial weight behind stabilizing the fund’s net asset value—“guaranteeing” that investors will never experience a loss in their invested capital— they do not shield the fund from credit problems. Although credit blowups do not impact the NAV, credit problems do result in lower future yields for a stable-value fund. In addition, investors accept the credit risk of the insurance provider. Thus it is important to analyze both the risk profile (credit rating, maturity, individual bond structure, and liquidity) of the individual securities held in the portfolio and the credit rating of the insurance providers. Many stable investment vehicles diversify (but do not eliminate) the credit risk of the insurance provider by purchasing contracts from several providers.
If the characteristics of stable-value funds are of interest to you, be sure to keep a particularly close eye on costs, as you should with any investment vehicle. Within defined-contribution plans such as 401 (k)s and 403(b)s, such annual expenses average less than 0.5 percent, but in an IRA the fees are likely to be as high as 1.0 percent, according to the Stable Value Investment Association.
Most stable-value offerings place restrictions on when or how often you can withdraw cash from their funds. For example, they may limit the number of withdrawals that can be made during a specified time period. Consequently, they typically don’t offer the same degree of liquidity, or ready access to one’s cash, as do money-market funds. (Note that the liquidity restrictions allow them to invest in less liquid and higher-yielding investments.) In addition, some plans will force investors to move their withdrawal amount into an equity fund, instead of another fixed-income investment (preventing investors from shifting their stable-value assets into the bond market whenever it looks as though interest rates may decline or into money-market funds whenever it looks as though interest rates may rise). Also, if the investment vehicle is inside of a retirement plan it will be subject to the rules of that plan.
Despite purchasing bonds that fluctuate in value, stable-value investment vehicles produce very stable returns. They are able to do so because of the insurance wrapper that they purchase. The insurance wrapper allows them to use “book value” accounting instead of market value accounting. Book value accounting means that the fund is valued based on what it paid for each contract, not on what each contract might be worth at any given time if it were sold on the open market. Book value accounting keeps the price of stable-value funds steady despite changes in the market value of the underlying securities. This makes it possible for the fund to pay interest rates similar to bonds, with minimal fluctuations in share prices.
A stable-value investment vehicle contains a number of GICs and individual bonds. Each time a contract or bond matures, the principal sum is paid back to the fund and the fund must then reinvest it in a new contract or bond at whatever interest rate is prevailing at the time. If rates are going down, the current rate will be lower than the rate that was being earned previously, and the return to the stable-value fund will gradually decline. Similarly, if current rates are higher than the rate on the matured contract, the stable-value fund’s return will gradually increase. Most stable-value managers ladder, or diversify, the maturities of the contracts held within the stable-value fund to smooth these changes. Because book value accounting returns are much more stable and the correlation of stable-value funds to equity holdings is lower than it is for bond funds, stable-value vehicles are excellent diversification tools for a portfolio.
If large sums of money flow into a stable-value fund when interest rates are high, and small sums of money flow into a stable-value fund when interest rates are low, everyone in the fund enjoys higher than average returns because more money is invested in contracts that continue to pay high rates until their maturity date. The reverse is also true.
The timing of the cash flows is typically the main concern for the manager of the stable-value fund. Without the ability to accurately forecast contributions and withdrawals, managing the fund for stable value would become very difficult. In addition, the cost of the insurance wrappers would certainly increase (withdrawals would rise whenever interest rates increased and losses would be incurred). This is why stable-value funds are only available in tax-exempt or tax-deferred account environments with heavy withdrawal restrictions. The complete investment freedom of a taxable account environment has proven to be too great a hurdle for the economics to overcome.
Stable-value funds can be considered for a portion of one’s fixed-income allocation. With that in mind, the following suggestions are offered:
An example of a stable-value product that should be considered is the TIAA Traditional Annuity, available in many 403(b) accounts and in the TIAA-CREF IRA. This product is backed by the claims-paying ability of TIAA, a very highly rated (AAA) insurance company. The product carries no sales or surrender charges.
We have now completed our review of the world of short-term fixed-income securities. The next category of fixed-income instruments that we will cover is corporate securities.