Monthly Archives: October 2016

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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