Fixed Income Dilemma

What are we to do about fixed income?  Current yields are low at all maturities, for all except the riskiest issues.  In addition, investors currently holding bonds or bond funds are looking at interest rates that can seemingly only rise, leading to losses in value.

Let’s start by examining why we hold bonds in the first place, and how they have been performing relative to those reasons.  Bond ETFs will be used as a proxy for bond performance.  Investment grade bonds are represented by AGG, which tracks the Barclays US Aggregate Bond Index (data at and  High yield bonds are represented by HYG, which tracks the Markit iBoxx USD High Yield Index (data at and

  1. Low risk.  A core justification for owning investment grade bonds is that they rarely lose value, and when they do, it’s not much.  3 year standard deviation is 2.64%, compared to 6.01% for HYG, and 10.8% for SPY.
  2. Diversification.  The equity beta for AGG vs. the S&P500 is -.03 as of 9/30/2016.  This tells us that AGG is a very good diversifier to stocks.  From a portfolio construction standpoint, this is not to be taken lightly.  On the other hand, HYG has a beta of .40.  Still a diversifier, but as one would expect, more positively correlated with equities.
  3. Income.  Those who are retired, and many advisors, see bonds or fixed income assets as a way to earn money from savings without touching the money that was saved (spend earnings instead of principal).  Since money is fungible, this is really just a behavioral bias (mental accounting).  However, since all of our clients are humans who exhibit these biases, if it makes a client feel terrible to sell 2% of assets that have appreciated 2%, but feel good to take the income from an asset that has 0% return but 2% yield, then that might be a valid reason to use bonds for income.  AGG has been yielding about 2% YTD, and HYG about 3.5%(!).
  4. Regulations.  This is not a small consideration.  New fiduciary rules impact portfolio management, and portfolio managers will need to document extensive research to back up deviations from “standard” portfolios, which might by default include substantial allocations to fixed income for certain types of clients.

What about going forward?  Will these assumptions still hold, given global negative interest rates (see Eric Robbins’ article in this issue) and the historic bond bull market in US Treasuries?  I’m going to focus just on the first item on the list.

Low risk.  Is it possible for bond values to remain elevated, with depressed yields, for any mid- to long-term time frame?  The driving force behind this dynamic since the great recession has been QE.  According to the Fed’s website, approximately $45B of their $4T balance sheet will mature in the next quarter.  Also from the Fed, new mortgages are being issued at a rate of about $100B per quarter, and according to SIFMA, new US Treasury issues have totaled an average of $165B per quarter.  So in order for the Fed to maintain their current balance sheet, they alone are currently consuming nearly 20% of all new Treasury and mortgage debt issued in the US.  Foreign governments are also engaged in QE.  According to the US Treasury, their holdings of US debt have remained fairly constant over the last year at around $6T.  These holdings also mature, so there is implied demand for new issues from foreign buyers as well.

Jeff Gundlach feels that, based on presidential election political rhetoric, a new round of fiscal stimulus is forthcoming, which will overwhelm these buyers and result, along with Fed interest rate changes, in increasing rates (September 8 presentation, available from DoubleLine).  He recommends moving to lower duration securities and cash, right now.  I would add the observation that government spending comes from Congress, not the White House, so it is the congressional makeup that will determine fiscal policy action, or lack thereof.  Fidelity does not share Gundlach’s view (update from Fidelity website).  Bill Irving believes that “yields will remain at historically low levels for some time.”

Another consideration is that we are, historically, past due for a recession.  This typically results not only in large losses in equities, but a flight to quality, supporting  bond prices.  The bottom line:  Rates are not likely to remain at current lows forever.  However, federally backed debt, which comprises 70% of AGG (including agency and implicit government-backed debt), may continue to hold value in the short or even mid term.  If you look at a graph of the Federal funds rate, you will notice that while interest rates drop in huge increments, they only increase in small increments, over time.  These interest rate changes have previously been implemented slowly enough for the average investor to adjust asset allocation before major impairment to asset values can occur.

Corporate debt, according to both Irving and Gundlach, is now trading at historically normal spreads.  John Hussman provides a lot of data showing that today’s equity market is highly overvalued.  These data points together suggest that corporate debt may not be adequately compensating for credit risk.  Instead, corporate bonds have been bought beyond reasonable levels in the quest for yield (adding credit risk).  That strategy may be a greater risk to overall portfolio value than interest rate risk.  In fact, if high yield bonds have been added to a portfolio including US equity, the risk is now even larger since there is positive correlation between those asset classes.  Gundlach suggests emerging market debt in place of high yield domestic corporate bonds.  Foreign bonds add currency risk, but that can be hedged (for a price).

Another option is to make use of actively traded long/short bond funds or SMAs.  Although the exposure will always be to bonds, this is not an asset class that acts like a bond, but instead is an alternative.

So, what to do?  Assess the timeline of your portfolio, and compare it to basic bond management theory.  Can you match duration to reduce interest rate risk?  Can you use a barbell strategy to reduce interest rate risk and still meet your return requirements?  If this doesn’t work, what kind of risk are you willing to take?  Are you willing to live with interest rate risk, at least in high quality US issues?  Are you willing to take credit risk as well as adding to your overall portfolio risk by adding high yield, preferred stock, or foreign bonds?  Does it make sense to reduce your bond exposure and invest in another asset class?  As you look at these trade offs, be sure to determine your criteria for further review and action.   Set a specific interest rate cutoff (and/or whatever other data points you deem valuable), and determine what actions you will take when it is reached.  Set a specific review date, and determine what data you will review at that time.  And last, but far from least, be sure to record your process for compliance.

Disclosure:  Long AGG, SPY



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Jared Dillian wrote a great piece about taxes in the US.  He did not touch on corporate taxes or on tax avoidance, which are also very important, but those issues do not diminish the points he makes:

The US Is Not a Low-Tax Jurisdiction

Trump has been going around running his mouth about how the US is one of the highest-tax countries in the world. This really makes the journalists upset. They say that it’s false. Every time he says this, they have a conniption.

How can it be true? How can we have higher taxes than Sweden1, where taxes are so high that everything is free, there are ponies everywhere, and everyone is happy2?

It depends on how you measure it.

The Wall Street Journal posted a piece about this Monday, offering the statistic (that most journalists have offered) that the US collects about 26% of GDP in taxes, compared to an average of 34.4% for other industrialized countries.

First of all, the fact that we collect 26% percent of GDP in taxes is crazy—for years, even decades, the total take would end up around 20% of GDP, no matter how high or how low the tax rates went. Tax collection has become much more effective in the last 10 years, and a lot of what the IRS would call the “tax gap” has been closed.

But yes, the amount we pay in taxes collectively is lower than most industrialized countries.

But there is another way to look at it.

What about tax rates? Who has the highest tax rates in the world?

The US is close to the top.

The top marginal income tax rate at the federal level is 39.6%.

Now, a lot of economists stop there, and say US taxes are 39.6%, Sweden’s are 59.7%, so the US is a low-tax jurisdiction.

But you have to take into account state income taxes, too. California is the highest, at 13.3%. Some municipalities and counties also have income taxes. When you take into account New York state and city income taxes, it’s also about 13.3%.

So 39.6 + 13.3 = 52.9%.

Catching up to Sweden!

We’re not done yet. We now pay a 3.8% surtax on investment income, which was intended to fund Obamacare. That makes it 56.7%.

Only four countries in the world are higher3. Sweden, Finland, Canada, and Belgium4.

We’re not done yet!

We also pay payroll taxes of 6.2% for the employee and 6.2% for the employer on the first $118,500 of income, plus Medicare taxes of 2.9%, 1.45% for the employee and 1.45% for the employer. Economically speaking, the employee pays both. So add 2.9% to the total, and then you get to 59.6%.

We’re not done yet!

In some localities (like New York), there is something called an “unincorporated business tax,” or UBT, so if you have an LLC or sole proprietorship, you pay another 4% on your net business income.


Not done yet!

We haven’t yet discussed property taxes. In high-tax jurisdictions like New York, New Jersey, Connecticut, or Illinois, you can easily have a tax burden of $20,000 annually on a middle-class home. I have heard that property tax bills of $50,000 to $70,000 are pretty common. Nobody takes this into account in the global comparisons.

Even where I’m from, in the impoverished eastern part of Connecticut, it’s not uncommon to see $4,000 property tax bills on houses that are worth about $130,000.

Now we’re done.

So is the US a high-tax jurisdiction or a low-tax jurisdiction? Or a better question might be: How can we pay so little compared to other countries if our tax rates are so high?

Glad you asked.

The Most Progressive Tax Code in the World

I think if I were an economics PhD student, the topic I would pick for my thesis would be to measure the progressivity of income taxes around the world. Like, how much people in low brackets pay compared to people in high brackets. This is an important question.

A lot of people spout off about taxes without really knowing what they are talking about. So let’s pull up the latest tax table from the IRS:

Source: Tax Foundation

So you might recall the Mitt Romney biff from the last election when he said that half the country pays no income taxes, and people thought this was a very tone-deaf thing to say. If you look at the table above, you can see that everyone pays at least some tax. So what gives?

Two points:

  1. Generally, people in the lower brackets get a lot of deductions and credits (like the EITC) that completely eliminate their tax liability, or even create a negative one. That’s right—not only do a lot of these folks pay no income taxes, they actually receive money from the government.5
  1. People still pay payroll tax, to fund Social Security and Medicare.

Our tax code is very progressive—the effective tax rate for millions of people is zero or negative, while the effective tax rate for rich filers is in the thirties (or much higher when you add in state income taxes and other items that we discussed before).

What about Sweden?

Here are Sweden’s tax brackets, in USD (from Wikipedia):

0%      $0 to $2,690
31%    $2,690 to $62,140
51%    $62,140 to $88,180
56%    $88,180+

So as you can see in Sweden, everyone pays a decent amount of tax. The rates are high, but the tax code is not all that progressive.

And this is how the OECD reports Sweden has a much higher tax burden than the US: the tax code is flatter, and everyone pays. Lower class, middle class, upper class—everyone.

Progressive tax codes are the worst things in the world.


With a progressive tax code, you can divide people into groups and turn them against each other. The rich aren’t paying their fair share. The poor aren’t either. There is a lot of hate and discontent.

A flat tax (or nearly so) solves these problems: everyone has skin in the game, and also, a flat tax is progressive anyway. If there is a flat tax of 20%, if you earn $100,000, you pay $20,000, and if I earn $1 million, I pay $200,000—10 times as much.

But really, it all comes down to incentives. High marginal tax rates create a disincentive to working hard and producing cool stuff.

If Joe Shlabotnik makes $25,000 a year and his marginal tax rate is 15%, he has no disincentive to go to work. He gets to keep 85 cents of every dollar.

But you don’t care about that guy. Actually, you do, but you don’t care about Joe Shlabotnik as much as about Elon Musk.

Elon Musk lives in California, so he pays that 13.3% state income tax, and very likely he faces the 59.6% marginal rate that we discussed earlier. So is the 59.6% marginal rate keeping him from going to work? No.

What if it were 70%, like under Jimmy Carter?

What if it were over 90%, like Bernie Sanders wanted? Would he still go to work then? He might not.

You want guys like Elon Musk to keep going to work6.

Nowhere in this essay have I said that these tax rates are unfair. They may very well be fair. I am not getting into a political discussion here, nor am I complaining about my taxes.

I am saying two things:

  1. That the US is not a low-tax jurisdiction, at least in the way that it counts.
  1. The top marginal rate is the one factor that is most (inversely) correlated to economic success.

I am no fan of Trump. And I’m not sure why he was complaining about high taxes, with all those NOL carryforwards. But as you travel around the world, taxes here are not especially low. The US has this reputation as this Wild West capitalist fantasyland, but nothing could be further from the truth.

1 We don’t, but it’s close.
2 Ranked 58th in suicides.
3 Not counting Aruba.
4 France got rid of their 75% top rate, for reasons you might expect.
5 In other words, a lot of people think they are taxpayers, but they aren’t. They have tax withheld over the course of the year, then get it all back (and then some) as a refund.
6 Musk would probably go to work if his tax rate was 100%, because that’s who he is, but most people aren’t wired like that. Certainly not me.


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Spinal Cord Stem Cell Therapy Success!

This is wonderful news.  From Patrick Cox, via John Mauldin:

USC neuroscientists just announced truly historic news about BioTime’s (BTX) (*see disclosure below) stem cell platform. For the first time, a quadriplegic patient with complete injury to the spinal cord has substantially recovered.

I’ve told you this was coming, but I wanted to get more information to you today as news of this long-awaited breakthrough in neurobiology spreads through the media. In fact, the news is even better than the information released by the Keck Medical Center of USC would indicate… and you should understand why.

A press release of this nature must follow strict conventions enforced by the SEC and FDA as well as traditional scientific guidelines. For example, the news release describes this spinal cord treatment, an injection of stem cells into the area of spinal cord injury, as “a procedure that may improve neurological function.” Watch the following video, however, and the only reasonable conclusion you can make is that the procedure has already done that.

Watch the entire B-roll video that USC has made available to the media. B-roll video isn’t edited as a story, of course. Rather, it’s meant to supply short video snippets for reporters. Nevertheless, most of this material is worth watching as it provides more information than is available in the extremely reserved press release, which is available here.

Note that Charles Liu, MD, PhD, says that this procedure should change the way that scientists and doctors think about spinal cord injury, making it possible to aim for full functional recovery for the first time.

The part of the B-roll that really gets me is seeing Kris Boesen, the 21-year-old man who received the treatment, wipe tears from his eyes while expressing his gratitude toward the scientists who made it possible. Prior to receiving BioTime’s stem cell therapy, Boesen was completely paralyzed from the neck down and couldn’t even lift his hands to his face.

Note also that Boesen mentions that his recovery is ongoing—from the top of the spine downward. We don’t yet know if he will regain use of his lower body, but he reports positive indications.

The critical part of this story that is entirely left out of the press release, however, is that the patient would have made a far better recovery if he had been treated promptly. Boesen was injured on March 6 but could only communicate his desire to participate in the clinical trial through head movements. He had to undergo assisted breathing therapy before he could give verbal consent.

That means that about a month of serious scarification took place before 10 million AST-OPC1 cells were injected into Boesen’s cervical spine. Scarring is the enemy of nerve reattachment and the reason that this procedure is only being administered to patients who have recently suffered spinal cord injuries.

Nevertheless, those stem cells managed to sort out and self-assemble, connecting severed nerves correctly from the upper and lower sides of the injury. This is the true power of regenerative medicine. It doesn’t rely on the surgeon’s skill. It’s the patient’s genome and the biological wisdom inherent in pluripotent stem cells that affect the cure.


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China and the “internet of cars”

From Zachs Investment Management:

The Internet of Vehicles (IoV) just might be the next milestone in the tech zeitgeist, with designs to integrate vehicle-to-vehicle, vehicle-to-roads, vehicle-to-human and vehicle-to-sensor mobile interactions. The internet-based technology is expected to equip vehicle users with better and easier-to-use navigation, road safety and location sharing tools along with other functionalities of their smartphones including entertainment apps, web browsing and (hands free) calls. Sounds like something that should be coming from Silicon Valley, but in actuality it is China that could be emerging as one of the biggest forces at its forefront.

Currently ranking as the largest market for automobiles—with 24.6 million units sold in 2015—along with having the highest number of internet users in the world, China is ripe for securing a hefty slice of the IoV revolution. And it’s already well underway.

Already, several Chinese internet/technology companies have embarked on clinching deals with the biggest automobile firms in the world. Chinese internet behemoth Baidu has managed to get automakers including Hyundai, BMW, Mercedes, Ford, Audi and Volkswagen to install its ‘CarLife’ in their units sold in China. The search engine company also teamed up with an insurer for a usage-based auto insurance project.

In 2014, Alibaba purchased Chinese interactive mapping and navigation firm Autonavi for $1.5 billion, and is looking forward to joining hands with Chinese automaker SAIC. Also, Audi has revealed plans of incorporating Chinese internet company Tencent’s WeChat app into its vehicles to allow location sharing. French automobile maker PSA Peugeot-Citroen will reportedly collaborate with Alibaba for wi-fi features in their cars sold in China, and is also planning to install apps to detect gas usage and vehicle location.

The “connected vehicle” market also spells ample opportunity for mobile service providers. Connectivity features in cars could require more data usage and faster internet speed—meaning more revenue-earning avenues would be available for internet/cellular service providers. To cash-in on this promising market, China Mobile and Deutsche Telecom partnered in October 2014 to provide 4G-based vehicle information services to connected drivers.

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Elon Musk Master Plan, Part Deux

Read the whole thing, here:

And here’s the best part:

What really matters to accelerate a sustainable future is being able to scale up production volume as quickly as possible. That is why Tesla engineering has transitioned to focus heavily on designing the machine that makes the machine — turning the factory itself into a product. A first principles physics analysis of automotive production suggests that somewhere between a 5 to 10 fold improvement is achievable by version 3 on a roughly 2 year iteration cycle. The first Model 3 factory machine should be thought of as version 0.5, with version 1.0 probably in 2018.

In addition to consumer vehicles, there are two other types of electric vehicle needed: heavy-duty trucks and high passenger-density urban transport. Both are in the early stages of development at Tesla and should be ready for unveiling next year. We believe the Tesla Semi will deliver a substantial reduction in the cost of cargo transport, while increasing safety and making it really fun to operate.

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Improvements in dental fillings

It’s about time!

From iflscience:

Every year, dentists fill millions of cavities from teeth that have decayed. Ordinarily, this does its job in protecting the inner pulp from harm, but in around 10 percent of cases they fail. This requires the dentist to perform a root canal and completely remove all the infected tissue from the center of the tooth. But what if there was a way in which to encourage the tooth to repair itself?

Well that is exactly what researchers at the University of Nottingham and Harvard University are trying to achieve. They have developed a new biomaterial that they say allows the damaged pulp to regenerate a protective layer of dentin. This should help the tooth prevent infection of the site, and make for more integrated and long-term fillings, causing a significant shift in the way that dental cavities are treated.

Read the whole article for more details.

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video games suck

Wow, just wow.  From Marginal Revolution:

Here is Erik Hurst, from an excellent piece profiling Erik Hurst:

Right now, I’m gathering facts about the possible mechanisms at play, beginning with a hard look at time-use by young men with less than a four-year degree. In the 2000s, employment rates for this group dropped sharply – more than in any other group. We have determined that, in general, they are not going back to school or switching careers, so what are they doing with their time? The hours that they are not working have been replaced almost one for one with leisure time. Seventy-five percent of this new leisure time falls into one category: video games. The average low-skilled, unemployed man in this group plays video games an average of 12, and sometimes upwards of 30 hours per week. This change marks a relatively major shift that makes me question its effect on their attachment to the labor market.

To answer that question, I researched what fraction of these unemployed gamers from 2000 were also idle the previous year. A staggering 22% – almost one quarter – of unemployed young men did not work the previous year either. These individuals are living with parents or relatives, and happiness surveys actually indicate that they quite content compared to their peers, making it hard to argue that some sort of constraint, like they are miserable because they can’t find a job, is causing them to play video games.

This problem, if that is the right word for it, will not be easily solved.

The post What are young men doing? appeared first on Marginal REVOLUTION.

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