This week on Money For the Rest of Us Plus I answer Hub member questions regarding investing large lump sums and whether bank loans (i.e. floating rate bonds) are a good substitute for investment grade bonds in order to protect against rising interest rates.
The episode length is 16 minutes.
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Welcome to Money For The Rest of Us Plus, this is the companion episode to Episode 87, Is This Normal? It is Friday December 18th 2015, I am back in Idaho. Very snowy, hopefully we’ll be able to go out and do some cross country skiing today. Actually, if I’m in Idaho, I love that there’s snow because that way … I usually bike during the summer and I cross country ski during the winter and in between periods I take walks and feel guilty for not exercising very much, because I really, really hate treadmills and stationary bikes so, going to ski.
Today’s episode, I wanted to answer a couple questions from two Hub members, and they’re somewhat related, and they also follow up to the mid-month strategy update that I published just today where I discussed non-investment grade bonds. Let me read the first question and then I’ll read the second question, and I’ll kind of answer them together. The first member talked about his taxable portfolio is invested in the Vanguard Total Bond Market Index Fund, and he’s considering switching to a floating rate exchange traded fund, or a short term bond fund protected against short term losses.
And so, he’s looked at some floating rate funds as potential options and, his question is, “Is there a set and forget it solution to protect against the risk of rising interest rates while minimizing the credit risk? ‘Because I’m heavily invested in equities as it is.” And he had sent off a piece from the Wall Street Journal as well as from Vanguard that talked about some of the risk with bank loans or floating rate funds. Now when I talk about … He mentions floating rate funds, there’s a number of different names for it but there’s a floating rate fund, some types are called leverage loan funds, on the Hub I’ve called them bank loans in terms of the asset class, so that’s his question. He’s really asking about these floating rate bond funds, whether they’re a substitute for the Vanguard fund.
These floating rate funds are, because they’re floating rate, they don’t have duration risk because the rates are tied to LIBOR, to short-term interest rates. So with the Fed raising rates yesterday, if they continue to raise rates, the yield on those individual bonds, those loans essentially will go up in tandem. So you don’t have the price falling as interest rates rise with these funds. I’ll return to that in a minute.
The second question, or the second email is from another Plus member and he writes, “I’ve studied your asset allocation strategies a bit and I’ve listened to the episode on dollar cost averaging, I understand history says I should invest all at once but with oil, high-yield troubles, volatility, et cetera. If it were your money would you sit out a bit to let things shake out?” And earlier in his email he talked about, he gets a large percentage of his pay each year at the end of the year, similar to me. And so he’s sitting on this large sum and wants to know whether he should invest it right away or dollar cost averaging.
He says, “I’m not seeking investment advice,” which is good because I don’t provide it, but he’s just curious how I would evaluate the various factors if it was my money. And his second was, his thoughts are, “To avoid high-yield indefinitely until the energy woes flush through. Does that seem too conservative or would you seek an actively managed situation that is ex-energy as possible.” Those are two somewhat complicated questions to answer, let me focus back on the floating rate funds.
The bank loan funds are non-investment grade credits. They are not substitutes for a fund like the Vanguard Total Bond Market Index Fund, which is an investment grade fund overall. So you’re essentially going from an investment grade to a non-investment grade fund. Now, you’re protected against rising interest rate but there’s clearly credit risk. And the bank loans have sold off this year and because there’s this concern regarding energy that I mentioned some data yesterday on the mid-month strategy update where the spread for energy related high-yield bonds is about 12%. And you’re seeing that in the space for bank loans or these floating rate bond funds. So for example right now the bank loan funds on Money For the Rest of Us Plus, I assumed an expected return over the next ten years of 5%. And that assumed about a 3% default rate and 80% recovery. So at the time that those assumptions were put together the bank loans were yielding 5.9% and then once you factor in the default rate that brought it down and the recovery to about 5%.
Now bank loans are yielding 6.87%, so you’ve had about a one percentage point increase in the bank loan. So as the rates go up, and by rates it’s not the underlying original bond, that’s still paying the same yield tied the LIBOR, but the price has fallen. So the prices have fallen 10% or so as there’s been more concern regarding the credit risk. And so the expected defaults, the actual defaults will probably go up. Now it is concentrated in the higher risk credits, as I mentioned just going back to the high-yield situation the yield on the lowest rate, the non-investment grade bonds, the spread to treasure’s about 15%. The highest rated, the double B credits are yielding 4.5% over Treasures. So you’ve had a huge ballooning out of the speculative-grade credits.
So, first off, if you’re worried about interest rates rising don’t substitute directly bank loans or high-yield bonds. Particularly bank loans because you’re thinking of the reduced interest rate risk, because the credit risk is high and as I’ve mentioned I have about 7% of my bond portfolio in non-investment grade bonds and about 2% in bank loans. And those both come through some closed-end fund exposure I have through a Blackrock fund and a DoubleLine fund. And I’m not aggressively positioned in either one because, back to that second question, I am a little wary of investing in non-investment grade bonds including bank loans when you have spreads widening until we get some type of settle down in terms of the oil prices. And to kind of see what the default situation is going be. Now there are assumptions there on Money For the Rest of Us Plus for ten years so maybe some of you have made that allocation, I think those assumptions are still solid as we look out ten years.
But as we are looking at a shorter-term time horizon, if I don’t have non-investment grade bond exposure I’m not necessarily going in right now until I see those spreads widen to where they’re going be and start to contract. That’s what I did back in the 2008, 2009 period, waited until they got as wide as possible. And then the economy started to recover. And then they narrow. And then you get that capital appreciation. And so, on absolute yield basis high-yield bonds are actually very attractive right now. Yielding almost 9% if default rates only come in at 4.5% as Fitch is estimating next year. If they come in higher than that then maybe those yields are justified, the yields are assuming about a 12% default rate right now, which is pretty fascinating.
So, to answer the first question then, it’s not a great substitute to use bank loans and with rates down really, really low there really isn’t a substitute. If you’re worried about rising interest rates then you essentially have to cut your yield and own either cash or a very, very short duration bond fund, which essentially are yielding nothing. The alternative is to invest in something like peer to peer lending, like I have done, where you can get 5-6% after the defaults. But it’s not as liquid, it is not a liquid holding. The shortest term you can do is three years on Lending Club unless you buy something in their secondary market through Folio where you can get them for less than that. Because they’re a secondary market they’re seasoned loans. But that’s another option, but generally speaking the yields are what they are and interest rates are really, really low. And there’s not a great substitute and it’s what’s made investing difficult this past six, seven years for retirees to invest that had been dependent on income.
And then to talk about that second question then, “Is avoiding high-yield indefinitely until the energy woes flush through, is that too conservative?” Not necessarily because I don’t necessarily think one should move … Maybe you can tip-toe in, I tend to use, he asked about an actively managed situation. When I invest in non-investment grade bonds, I tend to invest in active managers, I want somebody looking at the individual credits and making a decision. A manager I trust, as opposed to doing it passively through an ETF. So I don’t own any passive non investment-grade bonds, ETF’s. I prefer to have a manager looking at it, so they can avoid if, if a credits getting downgraded and a default looks imminent hopefully they can get out. Hopefully they weren’t in in the first place, they had enough skill to realize they could get out. So I prefer, I’ve used closed-end funds.
Now I use actual funds. I’ve used for example the Loomis Sayles Bond Fund in the past. That’s a fund that does invest largely in non-investment grade bond, that fund’s also had a difficult year, down about 7% year to date. I specifically remember, as an institutional manager we had Loomis Sayles. And we knew Dan Fuss really well. We had it in our portfolio. And with spread started widening, once that fund was down we pulled out. We pulled out when it was selling off dramatically and then once the spreads got really, really wide then we went back in. They weren’t real happy that we were moving in and out of their fund but my preference is, when spreads are widening like we are now, I don’t go heavily into non investment-grade bonds. I haven’t sold, I’ve kept my positions in the two closed-end funds because they’re selling at significant discounts to the net asset value. I trust the managers. The yields are very, very high, they’re yielding 9% or 10% or so and so I’m willing to hold them through. They’re very much a long term holding.
So as I reflect on these two questions, I think I answered them, there is not a simple set and forget solution to protect against the risk of rising interest rates, if you want a competitive yield. If you want a very, very low yield there is. You just essentially hold cash, a very, very short duration bond fund. If you want a higher yield you have to take credit risk and you can do it through a bank loan, recognizing the credit risk are high, or you can do some peer to peer lending. And that will protect you against the duration risk.
Lump Sums and Dollar Cost Averaging
Regarding the second email then, “Should one, if you get a large lump sum at the end of the year should you dollar cost average in? If it were my money what would I do?” I’m a dollar cost averager. I get an annual payment from my former firm. And have typically have averagde in and deployed it into the best opportunities over, I don’t necessarily take an entire year, but certainly take three to four months to get comfortable with the situation. And that’s how I manage the emotions of my investing. And we are humans, we’re emotional, I recognize what the numbers say. If the markets going up it’s better to put it all in at once. And since the market typically goes up it’s better to put it all in at once. I make better investment decisions reflecting on it and putting it in over time.
And so that’s what I do you have to make obviously your own decision regarding that. But it just takes me a while to get used to having that larger dollar amounts, scaling the trades, et cetera. And I don’t like to make any investment moves suddenly, I have always been an incremental investor. I mentioned on the mid-month strategy update this idea that all long time investing is a series of short-term moves. And, now that this particular listener has a sum to invest he’s got to make the short-term decision how to deploy that. This past year, my most recent December payment I put it all in a private investment, so I guess that was an exception. I deployed it into this real estate debt deal that I did. But last year my payment I deployed it over a series of three to four months. I did that the prior year and that’s my typical mode of procedure because I think I make better decisions and am a less emotional investor. And much of investing is controlling our emotions.
So hopefully I answered those two questions from those of you that sent them in. If not you can just follow up with an email and I’ll try to clarify. Any other questions you might have please email me jd@moneyfortherestofus.com. Have a great week.
