Carlos should buy bonds

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May 16, 2007 2:48 pm

[quote=Ashland]Surprised All Reit didn’t suggest to invest in alternative asset classes…[/quote]



REITs/BDC? I love em, But because of the risk to principal they arent part of a traditional fixed income portfolio.



Anyways, inflation is the main reason why nominal bonds are such a
questionable investment. Bondguy will say whatever he wants to say
about that. But inflation will grind away, as a compounding effect.


You have a a 10y @ 4.25 note, and when you have to roll it in 10 years, then the new 10y note and its income stream do not buy as much.This is why TIPS are so much better.



IMHO the main use of fixed income is mostly to diversifiy core equity holdings and other real return assets. The little old lady who owns nothing but muni bonds will eventually be eating cat food.


May 16, 2007 7:28 pm

[quote=Bobby Hull]

[quote=Ashland]Sorry... baby started screaming & I hit the button by mistake.

1 - Ball players retire much before 59 1/2. Last time I looked a VA bought at 30 yrs old locks you into that product type for about 30 yrs. I've got a good idea - let's use an L-share & add the income rider to it!!!

2 - Carlos will have enough money to hire a couple of muni bond managers that will cost him less than the 2 - 3% mark-up we demand on our bond sales. They'll manage the duration of the portfolio & take the appropriate(we hope) interest rate, credit, reinvestment, etc. risk. So, we don't worry so much about 'surrender periods' in bonds. Also, since interest is constantly thrown off, he'll be able to move or $$ to take advantage of opportunities as they present themselves.

3 - Hopefully he chooses a good planner that gives him a budget that he follows on what he can spend today & what he has to put away to have for after he can't play.

4 - Statistically it's less risky to have a component of your $$$ in stocks vs. 100% in bonds. For very conservative investors this may be as little as 5%, but as we all know more is better!

An interesting article:
http://www.efficientfrontier.com/ef/998/hell.htm[/quote]

Corky, you have almond shaped eyes, dont you?

[/quote]

Were you referring to Corky from the show Life Goes On?

May 16, 2007 7:32 pm

[quote=Mike Damone][quote=Bobby Hull]

[quote=Ashland]Sorry... baby started screaming & I hit the button by mistake.

1 - Ball players retire much before 59 1/2. Last time I looked a VA bought at 30 yrs old locks you into that product type for about 30 yrs. I've got a good idea - let's use an L-share & add the income rider to it!!!

2 - Carlos will have enough money to hire a couple of muni bond managers that will cost him less than the 2 - 3% mark-up we demand on our bond sales. They'll manage the duration of the portfolio & take the appropriate(we hope) interest rate, credit, reinvestment, etc. risk. So, we don't worry so much about 'surrender periods' in bonds. Also, since interest is constantly thrown off, he'll be able to move or $$ to take advantage of opportunities as they present themselves.

3 - Hopefully he chooses a good planner that gives him a budget that he follows on what he can spend today & what he has to put away to have for after he can't play.

4 - Statistically it's less risky to have a component of your $$$ in stocks vs. 100% in bonds. For very conservative investors this may be as little as 5%, but as we all know more is better!

An interesting article:
http://www.efficientfrontier.com/ef/998/hell.htm[/quote]

Corky, you have almond shaped eyes, dont you?

[/quote]

Were you referring to Corky from the show Life Goes On?

[/quote]

Yes, I was.

May 17, 2007 12:34 pm

[quote=AllREIT] [quote=Ashland]

IMHO the main use of fixed income is mostly to diversifiy core equity holdings and other real return assets. The little old lady who owns nothing but muni bonds will eventually be eating cat food.

[/quote]

AllREIT, let me see if I've got this straight. The little old lady, typical multi-millionaire muni bond buyer who doesn't need to get rich because she already is rich, will eventually be eating catfood? Just to be clear, is that the little old lady you are talking about?

May 17, 2007 2:24 pm

[quote=BondGuy]

[quote=AllREIT] [quote=Ashland]

IMHO the main use of fixed income is mostly to diversifiy core equity holdings and other real return assets. The little old lady who owns nothing but muni bonds will eventually be eating cat food.

[/quote]

AllREIT, let me see if I've got this straight. The little old lady, typical multi-millionaire muni bond buyer who doesn't need to get rich because she already is rich, will eventually be eating catfood? Just to be clear, is that the little old lady you are talking about?

[/quote]

Did I say the little old lady was a multi-millionaire? Maybe she just an old fashioned single millionaire with $1 million socked away in 4% muni's.

A few years of 10%+ inflation like we had in the Carter years (Does anyone remember this man????) and it's catfood and kerosene for Mrs Daisy.
May 17, 2007 5:20 pm

Sorry, All Reit, You're all wet!

Let's say that the inflation rate is 10% for 5 years straight.

Let's say the 70 YO Little Old Lady has $1,000,000 yielding 4% tax free.

Let's say that she is spending 40,000 per year.

10% Inflation means that it takes 44,000 to buy the same things that 40,000 bought in our base line year.

2nd Yr 48,400

3rd Yr 53,240

4th Yr 58,564

5th Yr 64,400.

Ok? We ageed up to this point?

Well. In today's market, the 4% yield is going to rep[resent an average of a 10 year bond portfolio. Her Bond guy bought her a perfect ladder of $50,000 per year for 20 years so that her rate averages your 4%.

At the end of yr 1 it turns out that she needs 4,000 to make up the shortfall in her accounts. She takes that out of the long end of her ladder and she rolls the maturing 50,000 out to the long end. (Oh, did I mention that interest rates have gone up as inflation hit? Now she's getting 8% on her 20 year munis, like back in the Carter Days, maybe even higher, because tax rates aren't what they were in Carter's day)

She has:

946,000 @ 4% = 37,920

 50,000 @ 8% =  4,000

Total         & nbsp;   =  41,920

Subtract        &nbs p;   48,400 which is what she'll need for the next year

Shortfall         = 6,430

EO 2nd yr

890,[email protected] 4%  = 35,840

100,000 @ 8%  =  8,000

Total         & nbsp;       43,840

subtract        &nbs p;    53,240

Shortfall call it     10,000

EO yr 3

830,000 @ 4%     = 33,200

150,[email protected] 8%     = 12,000

Total         & nbsp;          45,200

Subtract        &nbs p;       58,564

Shortfall call it         13,000

EO Yr 4

767,[email protected] 4%     =  30,680

200,000 @ 8%    =  16,000

Total         & nbsp;           46,680

Subtract        &nbs p;       64,640

Shortcall it         &nbs p;    18,000

EO Yr 5

699,000 @ 4%     =   27,960

250,000 @  8%     =  20,000

Total         & nbsp;             47,960

She has a bond portfolio with 949,000 and she's able to maintain her lifestyle.

Meanwhile your REIT holders are dead! High interest rates totally tanked the value of realestate because of the cap rates on competitive investments and because higher mortgage payments and higher municipal taxes (due to the inflation and the higher debt service costs) both robbed real estate holders of equity.

Sorry. You lose this one. Based on the math.

I have no idea what the &nbsp: is all about it's in the system some how.

May 17, 2007 8:59 pm

[quote=Whomitmayconcer]

Sorry, All Reit, You’re all wet!

Let's say that the inflation rate is 10% for 5 years straight.

Let's say the 70 YO Little Old Lady has $1,000,000 yielding 4% tax free.

Let's say that she is spending 40,000 per year.

10% Inflation means that it takes 44,000 to buy the same things that 40,000 bought in our base line year.

[/quote]

Your not deflating things properly, you have to deflate everything to the base year.

40000*0.90:36000.000
#*0.90:32400.000
#*0.90:29160.000
#*0.90:26244.000
#*0.90:23619.600

So in year five,  her $40,000 in 2007 dollars has a purchasing power of only 23,619. So I really hope Mrs Daisy likes Whiskas.

And the same thing happens when you reinvest. A new 10y $1000 bond will only have 1000*(0.9)^10 = 348.678 in equivalent purchasing power. You are constantly reinvesting the same amount in nominal terms, but in real terms your purchasing power is getting ruined.

Anyone who owns nominal bonds is defenseless in the face of inflation. Now if we had advised Mrs Daisy to buy TIPS everything would be hunky dory, since the principal and interest payments are scaled to inflation. Same thing with a CPI linked SPIA from Vanguard/AIG.

As for REITs, landlords will raise rents in pace with inflation, while the poor mortgage holder (like a bond holder) gets paid a fixed amount of every more worthless currency. And of course many NNN rental contracts include rent escalation or CPI link clauses.

A general increase in the price level would increase the nominal value of real estate equity and all other physical assets. A general increase in the price level would decrease the real value of financial assets with fixed payments.

Real assets such as Real estate, Infrastructure/Pipelines, Natural resources, and Operating Companies are your best and only defense against inflation.

May 18, 2007 9:39 am

40000*0.90:36000.000
#*0.90:32400.000
#*0.90:29160.000
#*0.90:26244.000
#*0.90:23619.600

Erroneous. We're talking about INFLATION. We're talking about the amount of dollars it will cost to buy a given product(s) that had had an inflation of their pricing.

If gasoline costs $1.00 in year one and the price rises by10% per year for 5 straight years, it will cost $1.64ish at the end of year 5. To buy that gallon of gas, you will need to have 64.4 cents more money. If you have the extra 64.4 cents, you can buy the gas, if not, you buy less or you buy something else.

As to your deflator, that would be interesting if Ms LOL were going to spend her whole $1,00,000 dollars all at once. But since she's not going to, it's irrelevant. We all understand that if she were going to buy a million gallons of gasoline in our base year she would be able to, but that she would only be able to buy 610,000 gallons if the price went up but her principal did not. (That is the decrease in her purchasing power).

So in year five, her $40,000 in 2007 dollars has a purchasing power of only 23,619. So I really hope Mrs Daisy likes Whiskas.

IFF her portfolio had stayed static. But we've established that this is not the likely scenario if she was dealing with a competent bondguy. We can pretend that the discussion's parameters are that we pit someone with the 40/60 magic bullet against a complete idiot who locked Ms LOL into 30 yr munis exclusively (and even then I'm fairly sure she could be rescued by reinvestment of her bond portfolio) with a coupon rate of 4%; but that's not a fair match up from which to draw absolutist determinations now is it?

You are constantly reinvesting the same amount in nominal terms, but in real terms your purchasing power is getting ruined.

Thank God you've arrived Allreit, because the bond markets never thought of this before! Apparently, bonds don't really work, and nobody with any intelligence should ever invest in them! And yet... Some how, some why, they do... Could it be that the reason that interest rates rise in inflationary times is to compensate the bond buyer for the principal erosion? Could it be that there is a force greater than emotion at work in the bond markets, i.e. Mathematics?

It seems that you are working from a perspective that the bondbuyer is a weak participant in the markets. This misperception is reflected in statements like this :"while the poor mortgage holder (like a bond holder) gets paid a fixed amount of every[sic] more worthless currency." As if there is no market for the poor dumb mortgage holder to take a loss so that he can reinvest at higher rates elsewhere. Yes, in his case he's investing less assets (due to the loss he took and due to the erosion of principal) but bond traders have a few tricks up their sleeve's too. For one thing, they know that inflation doesn't last forever and when rates drop, the market value of long term instruments rise so swapping out the yield curve is one way to get their principal back.

If we're going to assume that we're heading into a hyper-inflationary period that just never stops... well then ALL bets are off because you just don't know what legislation comes out of such a period. Profits on hard assets could be taxed at 99% for all we know. (It might happen soon if a "windfall profits tax" is enacted, how will gains on USO or IAU or earnings at WY, MMM, PD and others be effected? You just don't know!)

The bond holder holds all of the important cards. Not least of which is the ability to throw the borrower into bankruptcy if he has the slightest slipup, and given that many professional real estate managers are constantly in the markets borrowing money, a steeply rising rate market along with an unfavorable lending market can cause slip ups of a catastrophic nature.

As far as the REIT manager is concerned. The problem that you have there is that you seem to be working off the OLD Inflation paradigm. That's the one that says that wages drive inflation. Therefore, if prices go up, it's because wages drove them up, and therefore, people could afford a rent increase. These days we have exported wage inflation to China. We are experiencing Commodity inflation as the rest of the world's standard of living increases. 10%+ inflation without wage inflation means LESS income with which to pay for things such as rent increases. Vacancy rates go up as the standard of living goes down. all of a sudden the "Inflation Proof" investment becomes inflation's victim! Taxes are higher at the Federal, State and local levels), heating/cooling rates are higher, competition is stiffer as beter capitalized companies take steps to eat costs just so they can survive, borrowing costs are higher and tenants are folding left and right as they watch their margins getting compressed (otherwise known as, they're losing money) due to the same factors in their industry.

And yet, my simple bond ladder allows my client to roll out of her 4% munis into munis that at LEAST match the rate of inflation and probably, do even better.

Yes you can use the fear trump card to win the greed trick. But that's only when you're playing bridge with little old ladies who don't know the full game.

May 18, 2007 1:44 pm

[quote=Whomitmayconcer]

40000*0.90:36000.000
#*0.90:32400.000
#*0.90:29160.000
#*0.90:26244.000
#*0.90:23619.600

Erroneous. We're talking about INFLATION. We're talking about the amount of dollars it will cost to buy a given product(s) that had had an inflation of their pricing. [/quote]

Inflation refers to a loss a purchasing power. Which results in less pruchasing power relative to given starting year. This you apply a deflation factor to reducing nominal currency amounts to their equivalent in purchasing power in a reference year.

I'm not going to run over how inflation is quantified nor how bad it is for people in fixed incomes. No bond ladder can save you.

The only solution is TIPS, because the real principal is indexed to inflation, wereas the nominal principal on a nominal bond is constant. Thus over time the total purchasing power of the entire portfolio and incomes streams is reduced.

Nominal Bond == Real Rate + Expected Inflation
Real Bond == Real Rate

Any time you own nominal bonds, you are making a big bet that the inflation expection priced into the bond at purchase is correct. You get only one shot at this.

Now If the market is wrong about the future level of inflation....

If you reinvest interest payments, you are in good shape. But we are not talking about reinvestment of payments, but about someone living off the income stream.

[quote] To buy that gallon of gas, you will need to have 64.4 cents more money. If you have the extra 64.4 cents, you can buy the gas, if not, you buy less or you buy something else.[quote]

So eventually you do end up going from steak to cat food, exactly my point.

Do you prefer Whiskas or Alpo?

[quote]IFF her portfolio had stayed static. But we've established that this is not the likely scenario if she was dealing with a competent bondguy. [/quote]

Her portfolio is static, no new money is going in to it. She is living entirely off the coupon payments.

[quote] We can pretend that the discussion's parameters are that we pit someone with the 40/60 magic bullet against a complete idiot who locked Ms LOL into 30 yr munis exclusively (and even then I'm fairly sure she could be rescued by reinvestment of her bond portfolio)[/quote]

Except that she is not reinvesting in the bond portfolio, but instead living off the income stream. What I say three times is true.

[quote]with a coupon rate of 4%; but that's not a fair match up from which to draw absolutist determinations now is it?[/quote]

4% is a good historical average rate for muni bonds

[quote]Thank God you've arrived Allreit, because the bond markets never thought of this before! Apparently, bonds don't really work, and nobody with any intelligence should ever invest in them! And yet... Some how, some why, they do... Could it be that the reason that interest rates rise in inflationary times is to compensate the bond buyer for the principal erosion? Could it be that there is a force greater than emotion at work in the bond markets, i.e. Mathematics?[/quote]

When it comes to investing, stupidity beats math any day.

Nominal Bonds do work just fine as long as realised inflation is < or = to the expected inflation priced into the bond.

People who have inflation linked liabilities (e.g the cost of living) should invest in inflation linked assets. People with fixed nominal liabilities (e.g insurance companies) should invest in fixed assets.

And the bond markets have thought of this, which is why in 1981 the UK government introduced TIPS.

[quote]It seems that you are working from a perspective that the bondbuyer is a weak participant in the markets. This misperception is reflected in statements like this :"while the poor mortgage holder (like a bond holder) gets paid a fixed amount of every[sic] more worthless currency." As if there is no market for the poor dumb mortgage holder to take a loss so that he can reinvest at higher rates elsewhere.[/quote]

That's why they call it fixed income. As a bond holder you get a fixed and limited stream of payments.

So he takes a loss on his $100,000 note, and reinvests the $60,000 elsewhere. What happened to the mortgage holders total purchasing power? Did it go up or down ?

But beyond the loss caused by interest rate shifts is the fact that the note, both its income stream and principal value, have greatly declined in real terms.

[quote]Yes, in his case he's investing less assets (due to the loss he took and due to the erosion of principal) but bond traders have a few tricks up their sleeve's too. For one thing, they know that inflation doesn't last forever and when rates drop, the market value of long term instruments rise so swapping out the yield curve is one way to get their principal back.[quote]

While the market value of the bond may be restored, the purchasing power is not.

If you bought a $1000 30 year bond in 1977,  and lived off the coupon payments. That nominal $1000 buys alot less in 2007, and the 2007-2037 income stream will buy alot less than the 1977-2007 income stream would.

I don't see $0.89 gasoline comming back anytime soon. Nor a good 5ct cigar.

[quote]If we're going to assume that we're heading into a hyper-inflationary period that just never stops... well then ALL bets are off because you just don't know what legislation comes out of such a period. Profits on hard assets could be taxed at 99% for all we know.[/quote]

You are grasping at straws. Fact is that holders of nominal bonds are defenseless against the erosion of purchasing power. There isn't a single thing they can do to keep a constant level of real income.

[quote]The bond holder holds all of the important cards. Not least of which is the ability to throw the borrower into bankruptcy if he has the slightest slipup, and given that many professional real estate managers are constantly in the markets borrowing money, a steeply rising rate market along with an unfavorable lending market can cause slip ups of a catastrophic nature.[quote]

Which is just fascinating because of the ability to raise rents in pace with inflation while the mortgage amortises away.

Inflation is good for real estate holders, because the rent stays constant in real terms, while the mortgage does not.


[quote]As far as the REIT manager is concerned. The problem that you have there is that you seem to be working off the OLD Inflation paradigm.[/quote]

And the most dangerious words in investing. It's different this time.


[quote]And yet, my simple bond ladder allows my client to roll out of her 4% munis into munis that at LEAST match the rate of inflation and probably, do even better.[/quote]

But the total value of the bond portfolio stays at a nominal $1Million. And the purchasing power of that million is forever getting weaker.

Fixed income + Rising Prices == Decline in standard of living.

[quote]Yes you can use the fear trump card to win the greed trick. But that's only when you're playing bridge with little old ladies who don't know the full game.[/quote]

Or with people who are willing to pledge their lives, fortunes and sacred honor to the idea the market has correctly anticipated future inflation.

May 18, 2007 1:49 pm

[quote]

Or with people who are not willing to pledge their lives, fortunes and sacred honor to the idea the market has correctly anticipated future inflation.

[/quote]

Fixed.
May 18, 2007 3:09 pm

"If you reinvest interest payments, you are in good shape. But we are not talking about reinvestment of payments, but about someone living off the income stream."

And I showed you what would happen with that income stream. You want to argue those facts?

No you want to put her in tha absolute worst case scenario and pretend that your method is then better than a more reasonable scenario.

You are right, no bond ladder is going to save her from using some of her principal to augment her income. Over the 5 year period she used up 50,000 dollars. Eventually, if there are no other changes, that will have a bad effect on her overall fiscal health. But she still has a goodly head start on not having any health to worry about (don't forget, she's 75 at the end of the 5 years if her burn rate doubles every 5 years she still has her same lifestyle till around 93).

I didn't make up the scenario, you did, a couple of years of 10%+ inflation, for a little old lady with a bond portfolio of 1,000,000 yielding 4% and she'd be eating cat food. It's just not in any way shape or form true. She's got 25 years of $40,000 on the principal alone.

"Except that she is not reinvesting in the bond portfolio, but instead living off the income stream. What I say three times is true."

I'm sorry, is this the Beetleguice rule? Say it till you're blue in the face for all I care. I could have whacked the snot out of your "reasoning" bny saying that all the little old lady needed to do was to do a bond swap out the yield curve (since you asserted that she had a 4% income stream) but I didn't go down that path, certainly, with a normal yield curve, the LOL could sell her short maturities at yields ranging up to 5 maybe 6% and roll the proceeds out to the long end where she was getting 8% or higher. But I didn't, because there is uncertainty in the pricing she'd get and so why confuse the issue? But if she sold 500 bonds at an average price of 90 and bought 450 bonds at 8% her income stream would jump from 40,000 to 56,000 in year one which would give her money to reinvest or to have on the side to fill in the shortfalls.

As I have made abundantly clear (and as you have acknowledged when you said " No bond ladder can save you. " Maybe you don't know what a bond ladder is?) she will have money coming due every year in the amount of $50,000.

"When it comes to investing, stupidity beats math any day. "

"So he takes a loss on his $100,000 note, and reinvests the $60,000 elsewhere. What happened to the mortgage holders total purchasing power? Did it go up or down ?"

Depends on what rate he got when he reinvested, doesn't it? If was a 7% mortgage and he sold it for 60 that means that he gave a yield of around 14% if it had 7 years to maturity (putting aside the issue of mortgage v. simple interest, principal at maturity pricing) So if he could have gotten 14% for 7 years the 30 year would be somewhere north of 21%. That means that his 60,000 is generating 12,600 and the 100,000 was generating 7,000. Now the purchasing power may be equivalent in this case but that is a different speculation.

You can stick with stupidity, I'll stick with the math.

"But beyond the loss caused by interest rate shifts is the fact that the note, both its income stream and principal value, have greatly declined in real terms. "

This is a given in the LOL scenario. Why? Because she is SPENDING THE MONEY. And as such the same thing is true in all scenarios. If she has a Reit that is spitting out 9% income stream and she is spending the 9%, she is losing purchasing power on the principal and the income. Oh except for one thing. The Reit is managed, but we don't want to compare it with an actively managed Bond portfolio, because then we wouldn't be able to scare the blue hairs at the bridge game out of their bonds and into our magical 60/40 with TIPS for only 2% management fees per year paradigm now would we?

"If you bought a $1000 30 year bond in 1977,  and lived off the coupon payments. That nominal $1000 buys alot less in 2007, and the 2007-2037 income stream will buy alot less than the 1977-2007 income stream would."

And yet, if you bought a 10 year note in 1967 at 3% and then in 1997 when it matured, you could buy 1,000 worth of a 10 year note at 18%! You could have bought 30 yr NYC Mac Bonds @ 16% tax free! And then, today that 1,000 would buy you an income stream of $50 per year. That's why this is a good idea if you are rich.

"And the most dangerious words in investing. It's different this time."

Yes, we're all aware of that "Gotcha". Let me ask you this. When was the last time people went from Filet to Fancy Feast due to the bond market? I'll tell you it was in the late 80's when interest rates went  from 10% on 1Yr cds to 4% and passbook savings accounts eliminated the 5% minimum interest rate. in one year. It was different that time. The result was the same but the reasons were different. People with a million dollars in cds went from making 100,000 per year to making 40,000 per year, overnight!

 So when you pull out that old chestnut I counter with. It's not different this time, but your looking behind you as you drive into a brick wall!

Inflation IS wage based, but they aren't OUR wages that are causing it. It is the wages of the Chinese and the Indians who are becoming consumers of OUR raw materials.

So you whistle in the dark all you want. You pretend that you know what you're doing till the cows come home. You hang on to the past and believe that it is indicitive of future results. Don't worry stupidity will beat math this time too. Whatever lets you sleep at night.

May 18, 2007 9:30 pm

You’re getting too wound up. relax. 



Let’s start from the beginning. There are three types of investments.


Fixed Cashflows
Growing Cashflows
No Cashflows



I don’t care very much for type 3, and am very concerned about the effects of inflation on type 1.



You said something, to my mind shows you don’t understand the point I’m making.


[quote]If she has a Reit that is spitting out 9% income stream and she is
spending the 9%, she is losing purchasing power on the principal and
the income.[/quote]



Now I’d like to know how you can spend down a building? Because my understanding is that the building’s resale price and rents both keep up with inflation unlike a nominal bond with no adjustment to principal and income.



This is very similar to an inflation protected security whose principal is adjusted upwards for the effect of inflation,. Real estate and hard assets are just risky TIPS.



A nominal bond ladder is like rearranging the deck chairs on a slowly sinking ship.



So you have many choices of type 2 investments.


TIPS
REITs/BDCs
Pipelines/Shipping
Natural Resource companies
Dividend Paying stocks.



The main question is how much of type #1 and type #2 you want to have.
Now I use muni-bonds for cash flow stability, but too much stability
gets you killed.



Having a portfolio of only fixed cashflow investments is very naive, in
fact dangeriously naive since you are gambling that the market has
correctly priced in future inflation.



So if a can of whiskas start costing
$75 and Alpo $63, don’t complain to me that million bucks and 4%
doesn’t go as far as it used to.


May 18, 2007 11:36 pm

I agree with both of you, and both of your ideas would work.



Allreit - yours would work because the purchasing power of the principal is always going to grow in TIPS & real estate(unless there’s a big tax law change that rips off the reason you’re purchasing them!) The problem you have in real estate is how soon do rents reset. There is no doubt, though, that in the past century real estate has been the only true inflation hedge until TIPS came along.



Whomit - Yours works because you’re extending your ladder to current rates as principal comes due. The issue in your portfolio is the speed of the change & the duration of the bond portfolio. If the jump is too great & we are not able to move enough of the bonds to the higher current rate we’re stuck. The other problem w/ TIPS is that they are a marketable security with a limited supply. If demand for these securities get too great, yields can be pushed down for new securities.



Ultimately, though, isn’t our jobs to put together multiple workable strategies for people so that they are not taking too much risk by having only one strategy. Wouldn’t we want to use both of your strategies, and a couple of others for people in this position. Wouldn’t we want to give them the best chance at getting to their goal by not supposing that any one way is absolutely right.

May 19, 2007 2:42 am

[quote=Ashland]I agree with both of you, and both of your ideas would work.



Allreit - yours would work because the purchasing power of the
principal is always going to grow in TIPS & real estate(unless
there’s a big tax law change that rips off the reason you’re purchasing
them!) The problem you have in real estate is how soon do rents reset.
There is no doubt, though, that in the past century real estate has
been the only true inflation hedge until TIPS came along. [/quote]



It’s not the only thing, but it was the simplest thing. All things
being equal, inflation will increase a companies net income. So a
company with a constant payout ratio will have a dividend that scales
with inflation. And if the company can grow faster than inflation, then the dividend will grow faster too.



Thus I love ETF’s like VIG and SDY, based on companies with long histories of raising dividends.



As for real estate, the issue of rent roll-over depends on the business
model of the REIT. In the NNN space, long term leases have automatic
CPI linked rent escalator clauses. B/c the NNN lease passes through the
costs of tax/utilities/maintenance to the renters, the NNN lease is pure stream of cashflows that is scaled to inflation.



Now when you have an NNN lease over a fixed mortgage, you get to arbitrage inflation. The real yeild of the lease is constant over time, but the real cost of the mortgage goes down over time.



In office/retail you either have rent escalation clauses or rely on lease rolldovers to maintain portfolio yield.


[quote=Ashland]Whomit - Yours works because you’re extending your
ladder to current rates as principal comes due. The issue in your
portfolio is the speed of the change & the duration of the bond
portfolio. If the jump is too great & we are not able to move
enough of the bonds to the higher current rate we’re stuck. The other
problem w/ TIPS is that they are a marketable security with a limited
supply. If demand for these securities get too great, yields can be
pushed down for new securities. [/quote]


Here’s the issue with the nominal bond ladder: The real purchasing power of the initial slug of cash is forever being reduced by inflation. Pushing that slug up and down the yield curve and/or rolling it into new bonds cannot restore that lost purchasing power.


The only way to maintain purchasing power would be to reinvest the
interest (equal to inflation) into new bonds thus keeping the slug’s real value constant. This would result in the
same effect as the principal accretion in TIPS.



But we are talking about people who live off the entire income stream without reinvestment, and thus no reinvestment.


[quote]Ultimately, though, isn’t our jobs to put together multiple
workable strategies for people so that they are not taking too much
risk by having only one strategy. Wouldn’t we want to use both of your
strategies, and a couple of others for people in this position.
Wouldn’t we want to give them the best chance at getting to their goal
by not supposing that any one way is absolutely right.[/quote]



This isn’t self-esteem camp. Everyone can’t win.



Any retirement income strategy that doesn’t take inflation into account is very naive at best and dangerious at worst. Telling people to buy truckloads of muni-bonds and nothing else is unsound.

 






May 19, 2007 9:06 pm

What All reit said was that the LOL with a $1,000,000 bond portfolio yielding 4% was destined to be eating cat food.

All I did was show why his alarmist position was flawed.

If the lady was a BYL (Big Young Lady) with only $100,000  and no subsequent investments he would have been righter.

As a little bonus I gave Allreit a glimpse into why realestate reits are not the "set em and forget em" investment he seems to want to expect them to be. It's funny that he should say about Carter "Does anyboby remember this man?" and yet he shows zero understanding of stagflation.

Rising comodity prices are NOT inflationary (of the economy), they are recessionary. Higher gas prices reduce discretionary income. Higher fuel prices mean higher costs for bussing and heating/cooling schools (for example) and the money for those price increases has to come from somewhere...Oh yeah! The taxpayers have to pay for that. And when the municipality is competing with a Chinese province for roadway materials, who is going to pay the higher prices? The taxpayer.These two tax increases will again reduce discretionary income. It's a snowball effect that will drive companies out of business. Freeing up realestate and then what kicks in? Supply and demand. Less demand into increasing supply means... LOWER RENTS, Not higher.A professionally managed real estate portfilio with have about 10% of the leases roll over per year (most commercial leases are 10 year contracts) Which means that they are in competiton for 10% of their portfolio, the bond ladder had 5% exposed (and had an extra 10 years of maturity to extend for yield if necessary).

Businesses closing makes labor available. When you are in business, you have to have a REALLY REALLY good reason to pay people  (especially people without a collective bargaining unit representing them) more money when your company is making less. When you have seventeen pretty girls asking for a job as your receptionist, and they'll work for less than your current receptionist, your current receptionist is not likely to be demanding a raise. This puts a real lid on local wages which are being squeezed by higher costs. It gives new teeth to the "Vicious Cycle" scenario.

May 19, 2007 9:51 pm

[quote=Whomitmayconcer]

What All reit said was that the LOL with a $1,000,000 bond portfolio yielding 4% was destined to be eating cat food.

All I did was show why his alarmist position was flawed. [/quote]

Under your assumptions of beign inflation it is flawed. Under my distressed scenario it works out like I said it would.

Your house doesn't burn burn down in any given year but you still plan for a distressed scenario via homeowners insurance.

[quote]As a little bonus I gave Allreit a glimpse into why realestate reits are not the "set em and forget em" investment he seems to want to expect them to be. It's funny that he should say about Carter "Does anyboby remember this man?" and yet he shows zero understanding of stagflation.[/quote]

Which would result in what? Lots of inflation, higher interest rates and slowed economic activity. Credit NNN should be should do ok in this case, and TIPS rally strongly.

[quote]Rising comodity prices are NOT inflationary (of the economy), they are recessionary. [/quote]

http://en.wikipedia.org/wiki/Cost_push_inflation

Higher input prices are calling, don't hang up!

[quote]And when the municipality is competing with a Chinese province for roadway materials, who is going to pay the higher prices? The taxpayer.These two tax increases will again reduce discretionary income.[/quote]

Everybody's cost is someone elses income.

Tax increases result in more government spending which results in more economic activity (since you don't have leakage to savings in government spending). When dollars are spent on imports, those dollars have to be spent by the exporters on US denominated assets (eg US goods/services or US financial assets e.g T-bonds)

[quote]It's a snowball effect that will drive companies out of business. Freeing up realestate and then what kicks in? Supply and demand. Less demand into increasing supply means... LOWER RENTS, Not higher.[/quote]

Which again depends on how you structure your RE portfolio by property type and market etc.

If you own on-campus medical office buildings, your in fine shape. If you own class B shopping mall in Detroit, not so fine.

This is why NNN real estate is so darn good to own. If you have a 20y NNN lease on Target or CVS, you are good shape.

[quote]A professionally managed real estate portfilio with have about 10% of the leases roll over per year (most commercial leases are 10 year contracts) Which means that they are in competiton for 10% of their portfolio, the bond ladder had 5% exposed (and had an extra 10 years of maturity to extend for yield if necessary).[/quote]

The market dynamics of lease rollovers are too complex to generalise. However a portfolio of long term NNN leases to credit tenants should outperform a typical nominal bond portfolio of equal credit quality and duration.

This will happen b/c the underlying real estate may appreciate, the rents will escalate, and they property will be released.

It's that combination of your assets geting marked-up for inflation *and* escalating cash flows that causes real estate to function like risky TIPS.

When you buy nominal bonds, you are matching an inflation linked liability (e.g living costs) to a non inflation linked asset (nominal bonds). This is a recipe for disaster.


May 20, 2007 1:20 pm

"Under your assumptions of beign inflation it is flawed. Under my distressed scenario it works out like I said it would. "

You said ' a couple of years of 10%+ inflation like during the Carter years.' (not an actual quotation because I don't feel like going back to find it right now, but this was the approximate statement.) a couple of years, 10%+ inflation and like during the Carter years. 

I went by your description..

Now you want to say this:So if a can of whiskas start costing $75 and Alpo $63, don't complain to me that million bucks and 4% doesn't go as far as it used to.

75 cents to $75 dollars in "a couple of years (I'll give you 5) means that you are looking at 100%+ inflation per year, so you're off by a factor of ten (yeah, that's close!) (I'm going to leave alone the idea that LOL still has only a 4% income stream because you refuse to deal with that reality.)

History shows that when there is inflation at that rate, people eat the cats. Cat food companies go out of business. Triple net lease or not!

"...slowed economic activity. Credit NNN should be should do ok in this case,"

Only in your fanatasy world, where everything works out the way you want them to 'cause you have the magical 60/40 bullet at the low low cost of only 2% management fee.

Interesting how you managed to avoid considering the paranthetical explication "of the economy" above.  I know higher prices are here. My point is that wages are not keeping up with them. Now, generally this imbalance would cause a reversal of the inflationary pressures and so inflation would be checked by the lack of demand, prices would even drop to find the level of balance between supply and demand. But when the dynamo of capitalism has been started up in areas of the world not effected by US supply demand (in other words, when China is a self sustaining economy , producing goods and services for its onw population, and not dependent on ours) then you have a situation where you just toss out all of your Old "it's the same as last time" ideas and deal with a new reality. That reality is that individuals will have inflation but the economy will not inflate to accomodate those pressures thus the economy will deflate at a rate faster than the costs inflate.

"TIPS rally strongly" Why would TIPS rally strongly? TIPS would be the semi equivalent of a zero coupon bond. An implied growth factor that only known after the fact and has any usefullness at the maturity of the bond. The current income on these instruments is pitiful, putrid, impoverishing! Your faith in them is like the faith people had in closed end bond funds.

You want to believe that there will be a rally in TIPS at a time when their competition will be 8% Exxon bonds trading at 50. "Let's see, should I go for the 3.375 TIPS bond that is priced at 135 to give me 2.5% current income and eventual growth at the rate of inflation (God ,I hope there's gonna be inflation to take care of the radical premium I'm paying to buy these bonds) or should I buy the Exxons with a 16% current yield and a worst case scenario doubling of my entry price at maturity (and if inflation breaks and rates come down I might be able to trade out at par much sooner)? I'll let the suckers take the TIPS bet, I'll go with the Exxons, at least I know they'll be here in twenty years!" (BTW, the capital appreciation on the Exxon bond would more than make up for the lost purchasing power.)

"If you have a 20y NNN lease on Target or CVS, you are good shape."

Tell that to the guy who had a 20yr NNN lease on Caldor's, or May's or Waldbaum's, or Circuit City, or Jack In The Box, or Thom Mc Can, or Service Merchandise and/or any of the other thousands of companies that no longer exist. And just whom do you think it was that went to the doctors in those medical campusus? No job and no money equals no insurance equals no money for the doctors. No money for the doctor means consolidation of the industry which means vacancy at the medical office campus. (Sure hope those doctors socked a ton of money away in a 10 year ladder of Muni bonds!)

What if you hold the 20yr NNN on a Home Depot and we run into serious stagflation? Do you think it's impossible for HD to go goldfish?

I sure hope your pipeline terms in an area that can still use it's product.

I also hope (actually I hope the opposite) that they don't prefect nuclear fusion while you're holding those units. We're all about 2 Nobel prizes away from clean energy in an abundance that dwarves all other sources combined.

I know of this place where there is a railroad bridge that goes WAY over the river. They won't sent trains over it anymore, but they sure don't know what else to do with it either... That was a no lose proposition back in the day! We would always need rail service ans we could raise the toll on that bridge as inflation ate away at the bondholders equity.

Now the equity stake holders in that bridge have gone out of business, lost more than everything (if they had to pay to have the bridge dismantled, which they didn't, because they gave that debt over to the taxpayers) and the poor bond holders (the ones whoes bonds matured with less purchasing power) were able to stay in their mansions. I sure hope that doesn't happen to your pipeline owners!

Well thanks for the conversation, you can have all the last words you want.

May 20, 2007 3:02 pm

Whomit, you’re starting to get frothy.



So I’m going to make my points simply.


Nominal bond portfolios w/o reinvestment are defensesless against inflation.


If you have inflation-linked liabilities (e.g living expenses) you
want to match them with inflation linked assets (e.g TIPS, Hard
Assets). Otherwise you have a basis mismatch.


The most directly linked inflation linked assets are TIPS and Real
property with long term escalating NNN leases to investment grade
(credit) tennants.


Any retirement income strategy must consider the risks of unexpected high inflation.
May 20, 2007 5:20 pm

If only we could get this thread widely disseminated to the investing public, especially the do it yourself-ers - they would all see the true value of advice.

Great thread, great debate.