Financial Jungle

Isn’t the tax-inefficiency of bonds already incorporated into their price? Or rather, wouldn’t any other tax-efficient investment vehicle that you could choose be priced higher (after adjusting for risk)?

Hi Natham - My brain is a little slow today. Can you give me a few examples of what you meant?

I also don’t like bonds in the long run. But, if I know that I am going to have a certain expense up to the next 5 years, I would save all of the money in bonds. I invested in fixed income instruments my earnings from summer jobs, when I was saving for college. Retrospectively speaking, if I had invested my funds in stocks i would have paid for school easily.. But the extra risk was not worth it for me at the time..
If I were planning on retiring in 15 years or beyond I would put as much as possible in stocks. You shoudl look at my retirement account- 95% stocks 5% high yield bonds …

Here, here FJ. Althogh I don’t totally understand your point in #1.

DividendGrowth - I agree. Better stick with bonds if the money is needed within 5 years.

MG - The gist of article is that we should look at the big picture when it comes to asset allocation. For most of us, our investment accounts are *puny* relative to our overall net worth, which includes our educations; 4 years and $100k later… ouch!

I basically treat my employment salary as super bond; the cheque comes every month, and it grows at ~5% annually.

In other words, my overall asset allocation (including education) is too conservative. If anything, there’s a shortage of growth assets.

This is why I can’t afford to overweight more bonds in my portfolio.

Wow, what a great post.

I’ve never thought of my income in terms of a bond although I do recognize that it’s my biggest asset.

mmm…I’m wondering if it’s worth owning bonds if you don’t own a lot - ie if you need the money in the next ten years then equities might be too risky but if the timeline is long enough then who cares about the volatility? What’s the point of owning 20-30% of bonds (if you are still working). I’ll have to ponder this further.

One point I will make is that owning bonds allows you to take advantage of major dips. ie if the markets are going up then slowly buy more bonds and vice versa.

Thanks, Mike (FourPillar).

I was thinking about your last point as well. Even with bonds, the capital isn’t guaranteed unless you plan to hold them till muturity. It’s possible for both bonds and stocks to drop simultaneously. The best place to park money temporarily is in high-interest saving accounts.

Even then, I wouldn’t park 30% in cash.

I should clarify - when I say “bonds” what I really mean is short term bonds or even high interest savings accounts so they don’t change in value.

Mike

I see your point but I think describing your employment income as similar to bond holdings is a stretch.

Literally, employment income has no value. Yes, it might be cash flow, but it is not a hard asset. Also if you were fired or quit your job you don’t get your money back. But really, what is your ‘money’, there is no worth so there is no value (is it one years pay, two years pay, one weeks’ pay etc.). Employment income is not guaranteed, and it is not guaranteed to grow by X% each year.

Employment income is the main cash flow that sustains all working people. Its potential to grow is very variable. It could shrink, or it could double year to year. Doesn’t sound much like bonds to me.

Personally, I think that my job is more like a stock. In Ottawa, there are plenty of engineers who simply gave up looking for tech jobs in the last recession and now work in other fields. One StatsCan survey showed that for people who got laid off and found other jobs, the average pay was 30% lower. Your job isn’t a bond unless you work for the government or a tenured university professor and have close to a guaranteed income stream for life. Another example would be stock brokers whose jobs are already closely tied to the fortunes in the stock market.

It’s difficult to know where to turn these days for a nice balance of income and minimal volatility but I am also in favour of seeking good income opportunities and accepting the markets will dish out volatility. I like COS.UN also and it’s one of my larger holdings. The volatility can also be turned to your advantage in some cases by selling call and put options on income trusts like this, although I don’t do this often.

MG - Employment income stream has no market value, but it sure does have intrinsic value. We can punch in the Discounted Cash Flow calculator and work backward to derive at the present value.

In my original article, I was careful not to use the word “employment” to describe my asset; I used the “ability to earn income”. My current employment may not be guaranteed, but my ability is. At the very least, everyone should protect this valuable asset with disability and term-life insurance.

CC - No no no… You’re not pulling that on me. Employment is nothing like the stock market.

In any given year, the stock market may not fetch the 10% expected return. Worse, you can actually lose money if the time-horizon is short.

With employment, a $70k salaried tech guy is not going to earn a negative salary in his next job. If he earns $49k temporarily, so be it. Since our salaries are progressively taxed based on tax-brackets, a 30% drop in gross income may only equates to an 18% drop after-tax. Even less if you factor in the benefits.

The point is that it doesn’t matter if you earn $70k, $49k or $35k, the intrinsic value of your ability to earn income still towers over the bonds in your portfolio. Why even bother investing, say, $15k in bonds? That only ekes out $600/year pre-tax and pre-inflation, which is not going to make a difference after a 30% salary cut.

Canadian Capitalist wrote: “One StatsCan survey showed that for people who got laid off and found other jobs, the average pay was 30% lower.”

Is this the survey you’re talking about?

If it is, then you may have misinterpreted the findings. According to the article, “For those experiencing a loss, the average loss was nearly 30%; for those experiencing a gain the average increase was just under 26%.”

[…] we dont intend to overweight bonds. Instead, we let the remaining 20% ride a dive source: 4 Reasons Why Our Portfolio Has No Bonds, Financial […]

Hi FJ,

Great post. I agree 100% with most of your post as my portfolio contains a 0% weighting in fixed income. However, I don’t agree that your employment income should be treated as a bond, as employment has absolutely no value. Of course you get a paycheck while you’re working there but if you quit, retire or get laid off it’s worthless. Unlike a bond there’s no face value to your job.

P.S - I completely agree with your 4th point and take that approach with my portfolio.

MCM

By stock, I mean the volatility in income. If you want to nitpick about not being exactly like a stock, it isn’t a bond either. If you have 15K saved in bonds, who says you can’t consume capital?
That’s not the survey I’m referring to. In any case, it was done in 2001, just around the time layoffs were coming in Ottawa.
Even the survey you are referring to, when there is a wage loss, the average is 30%. That’s average, which means there were people who had worse losses. And unfortunately, layoffs become more common in times of economic distress and lousy stock returns.
It’s possible for both bonds and stocks to drop simultaneously.
I suppose anything is possible. But the question is how likely is it? Between 1982 and 2007, the TSX had three losing years of 10% or more. Short bonds had none. In fact, the only losing year for short bonds was 1994 when they lost 1%.

No matter how you view your income stream I personally avoid bonds like the plague for the most part. In my opinion the inflation rate is always understated by the government CPI stats so most fixed income vehicles are losers in the long run. They only make sense if your capital is just being parked temporarily while you look for a better place to put it. In the case of bonds in particular the only time they might make sense is in the rare instance that interest rates are very high and beginning to fall as in the early 1980’s.

MGM - Glad you agreed with most of my points. Regarding the value of employment income, I touched on that a bit in my response to MoneyGardener.

The present value of your ability to earn income is the sum of all the future income discounted to today’s dollar. Say you earn $70k a year for the next 20 years, and growing at the rate of inflation, then the present value is simply $1.4 million ($70k x 20). This is the intrinsic value to you. It doesn’t matter if it has no market value.

Canadian Capitalist -

It’s so hard to draw an accurate conclusion from a survey. Among the people who lost 30+% in income, what percentage are those who milk the system by collecting EI?

I titled my article, “4 Reasons Why Our Portfolio Has No Bonds”. Yes, it is about us; not the people who were surveyed. My wife and I each have a pair of able hands, a reasonably intelligent mind, and the willingness to work. For me, I feel that if I want work bad enough, I’ll find work, and I refuse to use statistics as my excuse.

How much does a typical computer engineer make in Ottawa? $70k at least? Realistically speaking, do you believe you’ll ever earn less than $70k? If so, by how much? 30%? 50%? Even at 50%, discounting $35k over 20 years inflation adjusted is $700k in today’s dollar. This is still a significant overweight on your overall asset allocation - assuming you’re not a millionaire yet. If you have $700k worth of bond-like asset, isn’t it time to catch up on growth assets?

Finally, the probability of me losing more than 50% of my employment income is one in a million, so I won’t bother “protecting” it by buying bonds; bonds will not come close to replacing my income anyhow, and worse, I’m giving up a monsterous amount of opportunity costs by not investing in stocks.

what percentage are people who milk the system by collecting EI?

Are you kidding me? EI is insurance and if you collect then you are not milking anything.

Mike

Mike - please don’t ask me to spell it out. If the EI reference is becoming a distraction to the crux of the discussion, I’m happy to remove it.

FJ: I have no doubt that you know best about your personal situation, your tolerance for risk etc. And yes, I did notice that the post talks about your portfolio. If that’s what we are talking about and not the merits of your arguments that could apply to others, I’ll suggest that this is a pointless exercise… it’s like arguing about tastes.

Canadian Capitalist -

Let me rewrite one of my sentences, “it is about us and others like us; not the people who were surveyed.”

Call me selfish, but I just don’t desire blogging about subjects that don’t matter to me.

For those in a similar boat as mine, I hope you find the discussion fruitful. For those who need bonds to sleep well at night, well, I’m afraid you’re reading the wrong blog.

Being a bond specialist, this is really very difficult for me to beleive. If you don’t want to pay taxes on your bonds, invest in tax free municipal bonds. I have adjustable rate bonds in my clients portfolios that are giving them 60% coupons with government agency backing (AAA Credit). If you look at the overall stock market performance the Dow has no gain since 2000, and the NASDAQ is at a huge loss since 2000. It astonishes me to see how uninformed the public is about bonds due to the lack of media coverage. Yes they are boaring, but they have an agreement to give you all of your money back when they come to maturity. 99.9% of investors out there don’t have any idea about the returns they can make on bonds with a long term investment strategy.

>>”If you don’t want to pay taxes on your bonds, invest in tax free municipal bonds.”

I can’t speak from an American perspective. Are these municipal bonds tax-free for Canadians as well?

>>”I have adjustable rate bonds in my clients portfolios that are giving them 60% coupons with government agency backing (AAA Credit).”

When do they mature? What’s the return when you annualize them?

>>”If you look at the overall stock market performance the Dow has no gain since 2000, and the NASDAQ is at a huge loss since 2000.”

Let’s not cherry pick on a particular time period or index. Long-term investors who diversify outside of Dow and NASDAQ are doing quite well. This is especially true for Americans with unhedged portfolios. I surmise that if you need the money within the next 5 years, then bonds is the way to go.

>>”99.9% of investors out there don’t have any idea about the returns they can make on bonds with a long term investment strategy.”

I’m all ears. What’s the long-term return on bonds?

Sorry my friend I don’t have a clue about Canadian tax law. As far as high returns being available in bonds, I’d be happy to teach you. We’ve been doing this since 1986 and made great annualized returns. Returns on these bonds since 2000 has been a little over 20% per year if you average them. Most of the bonds that were purchased in 2000 have come to maturity since then. Returns have been about the same if you average them since the Mid 80’s. Sorry I have to cherry pick that period because these bonds didn’t exist before then.

The American stock market is a complex beast where most individuals end up losing money if they don’t have professional help. Sorry to say that but I meet them all day long in my profession. Let’s take at Home Depot and Lowes. Both are large home improvement product suppliers to the public and home builders. The United States just went through the largest housing expansion in history. Those of us who bought Lowes stock got a great return. Those of us who bought Home Depot stock ended up with no return because the CEO took almost half a billion dollars in bonuses and a very large severance package. I’m not saying that there are not great opportunities in the stock market,of course there are, but they are risky. You can lose your money if things don’t go your way. In the bond market you can make great returns and there is a set date in the future when you’re going to get all of your money back. Bonds follow a set of rules that apply until the bond matures. As for the bonds that I’m currently making 60% on the rules state: for every 1 point the 1 month U.S. LIBOR drops, the coupon goes up 25 points. For every point the 1 month U.S. LIBOR goes up the coupon drops by 25 points. I bought the bonds with high interest rates on the underlying assets so they will refinance as rates go down and the investors should get most of their principal back before rates go up again. It’s a simple rule that will make people money. I bought the bonds cheap 8 months ago when the coupon was a 0% knowing rates were going to go down soon and I made a big return. In the stock market there are thousands of rules and factors that we have to be right about to make a 60% return and those rules are frequently broken. Look at Enron, people thought it was a gem and they lost their entire life savings. There is one rule to pay attention to in order to get a great return on the bond I discussed with you. Rates go down and investors make money. Send me your e-mail address and I’ll send you the Bloomberg on that particular bond if you’d like to learn about it. Warren Buffet one of the world’s most famous investors, is one of the largest private investors in this type of bond.