Nearly five years after offering its last issue of 30-year bonds to individual and institutional investors—causing some to warn of a bond shortage—the U.S. Treasury has returned to the market place with a $14 billion issue of its longest maturity, perhaps leading you to ask yourself whether you should consider adding some to your portfolio.
The likely answer? Probably not.
To be sure, U.S. Treasury securities have the highest credit quality of all private and public sector U.S. debt issues, given that the Federal Government could always tax or borrow to repay principal and pay interest on time—a meaningful reassurance if you’re lending your money to somebody for as long as 30 years. Moreover, being available in denominations of only $1,000, they are easily affordable for most investors.
But, bearing 4.5 percent coupons, the new bonds provide little compensation in both absolute and relative terms for lending money to the Treasury—or anybody else—until February 2036: Given that yields of debt securities are lowest for those of the highest credit quality—and highest for those of the lowest quality, called “junk bonds”—they pay a bit less than high-quality corporate issues (and nearly 1 percentage point less than the 5-3/8 percent 30-year Treasury bonds issued in February and August 2001). Given that the Treasury’s left hand (Internal Revenue Service) likes to take away at least some of what little the right hand (Bureau of Public Debt) gives, their income is reduced by federal income tax as much as income from corporates securities, even if, unlike corporates, it is exempt from state and local taxes. Given that yields on debt securities of comparable credit quality nowadays differ little from the shortest to the longest maturities, they pay Treasury bond owners locked in for 30 years about the same as Treasury bill owners who risk their money for only 90 days. As if to underscore the point, the $21 billion of 3-year notes and $13 billion of 10-year notes that were also auctioned at February’s $48 billion quarterly refunding also had identical coupon rates of 4.5 percent.
Because marketable bonds’ prices—and thus their yields—fluctuate continually during the maturation process, it is quite possible that those who have to sell them before maturity may lose money on them despite the Treasury’s high credit quality. (As if to underscore that point, interest rates in general crept up slightly before they were a week old—and, thus, their prices drifted slightly lower.)
So why did the Treasury resume issuing 30-year bonds?
To “diversify (its) funding options and expand its investor base”…”finance the government’s borrowing needs at the lowest cost over time”… and ”stabilize the average maturity of the public debt,” it said in statements.
That is to say: To meet demand that it expected after canvassing investors—and that it found at its February 9 auction—such as institutional investors, who worry less about their companies’ mortality than most individuals who regard 30-year investment horizons as a bit long. To lock in relatively low interest rates, which have prevailed in recent times, for the long-term part—albeit, a small part—of the public debt. By locking in low interest rates, Treasury will not be subject to unknown future borrowing costs when shorter-term debt must be rolled over. To address the average length of the marketable interest-bearing public debt held by private investors, which dropped from 6 years 1 month at the end of fiscal 2001 to 4 years 10 months at the end of fiscal 2005. Like individuals, who save toward long-term goals such as college tuition for children and retirement (but who may have more flexibility when taking risks), treasurers of institutions have to be sure that they are always able to meet liabilities when due—whether benefits to life insurance policyholders’ survivors or to pensioners.
Of $4.1 trillion of the Treasury’s total marketable debt held by the public at the end of fiscal 2005, as much as $500 billion was accounted for by long-term bonds. Short-and intermediate-term Treasury notes, ranging from 2 to 10 years, accounted for $2.3 trillion (and about three-fourths of the increase in total publicly held marketable debt from $2.9 trillion at the end of fiscal year 2001). Treasury bills and Treasury inflation-protected securities (TIPS) made up the rest.
Although the Treasury stopped selling new 30-year bonds in 2001, its 30-year issues had not disappeared, as some may have thought last August, when it announced that it would re-introduce them in semi-annual auctions beginning this month. Talk with your financial adviser today about whether 30-year bonds are right for your portfolio.
March 2006— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hillebrand Financial Planning, LLC a local member of the FPA.
The Perplexing World of Social Security and Earnings in Retirement
Launched in 1935 during the Great Depression as a principal component of Franklin D. Roosevelt’s New Deal recovery program, the Social Security System has earned an unquestionable reputation for the reliability of its stream of monthly checks to retirees, the nation’s first comprehensive source of retirement income.
But did the laws that authorized the checks and ensured their reliability also: · Permit the checks—based on your lifetime income —to be large enough to sustain seniors in comfortable retirement? · Require Social Security checks to be taxed too much by the same Treasury Department which issued them? · Reduce the checks too severely for those who needed money before becoming 65. · Enable beneficiaries to get back all of the money they had paid into the system over the years?
While these questions—and the question of the system’s continuing reliability as the ratio of beneficiaries to taxed active workers increases—are debatable and debated by lawmakers, the most baffling for many individual workers as they plan for the approach of retirement is: when do you start receiving Social Security checks?
The answer, partly rooted in changing regulations, is not easy. Nor is it the same for all individuals.
Yet, it is very important. On it depends not only when you start to receive checks, how large your checks will be—the earlier you start, the smaller your checks—and how much you may earn from other work once you start, but also how much net Social Security income you will have left after income taxes.
To understand how these things are determined, you first have to understand the regulatory concept of your “normal retirement age” (also called your “full retirement age”) at which your retirement benefits equal your “primary insurance amount.” For those born in 1937 or earlier, it is 65. For those born in 1960 or later, it is 67. For those born in 1938 through 1959, it is in-between. (Useful tables which spell out this and other relevant regulations appear on the Social Security Administration’s Web site, www.ssa.gov).
If you decide to start withdrawing Social Security before your “normal” retirement age, you may retire as early as age 62, but your benefits may be reduced as much as 30 percent if you were born after 1959 or 25 percent if you became 62 in 2005—a reduction that shrinks your monthly checks permanently.
If you decide to defer getting Social Security past your “normal” retirement age (delayed retirement credits), your benefits may be increased by percentages depending on when you were born: from 3 percent if you were born in 1917-1924 to 8 percent if you were born in 1943 or later. You would receive your largest benefit by retiring at 70.
Whatever the SSA determines you should get monthly (to be further adjusted annually for inflation unlike most private sector pensions) may be (further) reduced if you get work for pay before you reach your “normal” retirement age: $1 in benefits for each $2 you earn above an annual limit. Last year, that limit was $12,000; this year, it’s $12,480. In the year you will reach “normal” retirement age, the reduction is less—$1 in benefits for each $3 you earn above $33,240 in 2006, until you reach the point at which you can earn all you are able to without penalty. This point is reached once the recipient arrives at their normal retirement age.
For example, a retiree with earned income of $25,000 and a Social Security benefit of $1,000 per month would receive just $478 each month after a reduction due to earnings. Done with the SSA, you now emerge on the radar screen of the Internal Revenue Service, which is required to get its share and finds you an especially fertile target if you have substantial income beyond Social Security. A SSA Web site calculator helps you to understand how the earnings test would apply to you.
If you are filing a federal income tax return as an individual and have “provisional income”—defined as adjusted gross income plus nontaxable interest (such as interest from tax-exempt bonds and income dividends from municipal bond mutual funds) plus 50 percent of your Social Security benefits—between $25,000 and $34,000, you may have to pay income tax on that 50 percent. If your combined income exceeds $34,000, up to 85 percent of your benefits may be taxable.
If you file a joint return and you and your spouse have provisional income (as defined above) of between $32,000 and $44,000, you may have to pay tax on 50 percent of your Social Security benefits. However, up to 85 percent of your benefits become taxable when your combined income exceeds $44,000. This is a complex rule, so consider contacting the Social Security Administration or your tax adviser for more information.
March 2006— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hillebrand Financial Planning, LLC a local member of the FPA.
The Trials and Tribulations of Measuring and Comparing Investment Returns
Measuring and comparing investment performance is not an easy task. Consider, for instance, something as simple as the daily comings and going of the stock market. One month the Dow Jones industrial average (DJIA) is up and the next month it’s down. But do those changes really tell the whole story?
Not really. The continuous changes in the DJIA merely represent the change in the market value of the 30 stocks that make up the DJIA. The actual change would reflect not just the change in market value but the income from the dividends from the companies comprising the Dow. And since the DJIA currently has a dividend yield of 2.5 percent, the actual investment performance, or what some refer to as the actual total return of 30 stocks in the Dow, would be different from what is typically reported based only on price changes. In addition, the DJIA is a “price weighted” index, so that higher priced stocks have a higher impact on index performance. Most of the other common indexes are “market weighted,” reflecting the relative market composition of the stocks in the index.
So what then are some of the best ways investors and planners should measure and compare investment performance?
According Herbert Mayo, author of a time-honored textbook on the subject of investments, the simplest way to calculate a return on an investment is by considering the flow of income, such as dividends, plus price gains (or loss) relative to the amount invested for a given holding period. So for example, if a person buys a share of stock for $40, collects a $2 dividend and then sells the stock for $50, the holding period return would be ($50 + $2 - $40) divided by $40. Thus the holding period “total” return would be 30 percent. A shortcoming of holding period returns, however, is the failure to consider how long it took to earn the return. After all, if the difference in time between buying and selling is 10 weeks, then a 30 percent return is great; if it is 10 years, 30 percent is not as impressive.
According to Mayo, this problem is avoided by calculating the so-called internal rate of return. A simple example of internal rate of return is the yield to maturity on a bond. Yield to maturity equates the present value of the cash flows (interest payments and principal repayment) with the present cost of the investment while assuming that interest income as received is reinvested at the same (yet to be determined) yield. Though a tad complicated, the key difference between a holding period return and compound annual return is that the
latter return considers all cash inflows to an investor when they occur and compares them with the cost of the investment. But in comparing portfolio returns where money is being added and subtracted from holdings, we must decide how to weight the returns of the individual holdings. Weighting the performance of each individual investment relative to the size of the investment (a dollar-weighted return) may give predominant weight to recent large investments and may not truly represent portfolio performance over an extended holding period
An alternative to this misrepresentation on the part of a dollar-weighted rate of return is the time-weighted rate of return. Simply computing the average of a series of returns can also be misleading. So, for instance, if an investor buys a stock for $40 and collects a $1 dividend in year one and the stock closes the year at $42, the time-weighted return would be ($42 + $1 - $40) divided by $40, or 7.5 percent. If the investor held that very same stock for another year, closing at $50 and collecting another $1 dividend, the holding period return for that year would be 21.43 percent, or ($50 + $1 - $42) divided by $42. The simple average return would be 7.5 + 21.43 divided by 2 or 14.47 percent.
So which method of calculating is preferred? According to Mayo, there is no absolute right answer. Typically, the investor is concerned with the return earned on all the money invested, making dollar-weighted the more preferred method. However, Mayo says one can make the argument for the use of time-weighted returns to evaluate the performance of portfolio managers. By way of history, a study published in 1968 by what was then called the Bank Administration Institute (BAI) suggested that measurements of performance should be based on asset values measured at market, not at cost; the returns should be “total” returns; that is, they should include both income and changes in market value (realized and unrealized capital appreciation); the returns should be time weighted; and the measurements should include risk as well as return.
No matter the method of calculating investment performance, it’s also especially important that planners and investors compare the investment performance of their portfolios to appropriate benchmarks. Typically, according to The Financial Analyst’s Handbook, there are three useful standards against which portfolios can be measured, including comparison with an absolute goal; comparison with market indexes, and comparison with other portfolios. Of note, financial planners say that dollar-weighted returns compare very poorly against benchmarks when there are large cash flows; time-weighted returns are the only ones that are really appropriate for benchmark comparison purposes.
March 2006— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hillebrand Financial Planning, LLC a local member of the FPA.
