Higher Interest Rates…So What’s the Problem?Part 2

Last post I spent some time discussing the impact of higher interest rates on portfolio strategy for investors.  I thought that it might make sense to discuss possible global effects as opposed to individual portfolios.  There are many implications for how a given economy may respond to moves in key interest rates that has various portfolio implications

  •         Higher interest rates = higher borrowing rates = declining trend in purchasing habits.  If you consider there are only two ways to purchase goods–credit or cash.  Cash purchases are largely unaffected by interest rates.  I mean if you have cash in your pocket to pay for a good you just do it.  However, credit purchases (which also tend to be larger purchases) are affected by interest rates.  The takeaway is that as interest rates increase, the cost of borrowing also increases which (in theory) should negatively impact credit purchases.  This is intuitive since the FED will lower interest rates in economic expansion and raise interest rates in order to slow economy.

Implication in portfolio strategy–> Sectors that involve lending would be favorable.  One example of this could be financial services, in that banks can increase the “spread” they pocket by charging higher rates on loans over time.

  •         Higher interest rates = more foreign investment .  If you lived in any country you essentially have two choices for investment–domestic or foreign.  In this simplified world, you would prefer to place your invested capital in the investment with the highest possible return (ignoring risk for now).  All else being equal, invested capital seeks its highest return.  So let’s now include the discussion of risk.  Any country’s risk-free rate is basically the rate you would earn on a cash deposit.  Given this, we can now establish that you would rather earn a higher return on your cash deposit than a lower one even if you had to deposit your cash into another country’s bank.  This is the intuition behind why higher US interest rates will pull capital out of lower interest rate countries into higher interest rate countries for the extra return. Adjusting for the risk of default, according to current central bank rates, the US seems to be one of the best choices for cash investment currently.  (Assuming you don’t want to make a cash deposit into Brazil or Russia!)

Implication in portfolio strategy–>Debt obligations of sovereigns with favorable economic outlooks would be favorable.  One example could be US bonds (e.g. government, corporate, municipal).  Specifically, longer maturities assuming portfolio construction includes bond laddering.

  •         Higher interest rates = stronger domestic currency.  This next notion probably will not be as intuitive given the current state of the global economy, since ultra low interest rates in the US have seen the US dollar as strong as it’s ever been.  Theoretically speaking, lower interest rates should weaken a currency given our previous argument because of capital “outflows” to find higher paying currencies (see the following discussion for more detail).  Suffice to say, this phenomenon is rare and is due to a myriad of other factors that are not within the scope of this discussion.  (Hint: One possible factor is that the US dollar as the reserve currency of the world attracts capital when the fear of global recession exists regardless of the level of interest rates.)  So, consider that foreign capital seeking higher returns will  buy dollars.  This demand for dollars will only increase its value relative to the currency being sold (in order to buy it).  Next, consider what happens on the other side of the equation, as capital leaves the foreign country (to buy USD), the foreign currency being sold will weaken.  Ultimately the price of goods in that foreign country will fall (relative to the US dollar).  This is what you are seeing in copper and other soft metals markets.  It is a multi-fold effect in that the country that exports the good receives less of their domestic currency (when they sell) and thus have less to pay back loans, thus deepening the debt cycle.

Implication in portfolio strategy–> Most commodities (e.g. metals, energy) investments, and the weaker emerging markets economies would be unfavorable.  For example, metals like copper have experienced multi-year lows as of this writing as demand has weakened and the copper producing nations have accumulated deficits.

Invest wisely!

Higher Interest Rates…So What’s the Problem?

As an investment consultant that manages fixed income portfolios, I have often discussed the implications of interest rates on portfolios. Those conversations usually begin and end pretty interestingly. However, I would have to say that by and large the impact of interest rate moves on existing portfolios (and portfolio construction for that matter) is over-stated. As with every accusation you have to find someone or something to blame, so I blame…THE MEDIA! It seems through “media distortion” only half-truths are told (or heard–if I were being trying objective) by the attending public. This is to say, that if you own bonds in your investment portfolio and have listened to any major news outlet in the last several years, you probably have heard that interest rates will inevitably rise. In particular, once this happens the value of any bonds in your portfolio will dramatically drop. Here’s the truth…

False Notion #1: “When the Fed raises interest rates, it will cause a decrease in my portfolio value”.
Incorrect. The first thing to understand as a bond holder is that your main risk to manage is credit and interest rate (these two are widely viewed as the most important). Credit risk is the risk that your cash flow or principal repayment doesn’t happen in future periods. This is directly a function of how financially solvent the bond issuer is going to be in the future. Interest rate risk (or also duration risk) is the risk that higher interest rates decrease the current market value of your bond. (Note the emphasis on current market value as opposed to maturity or future value). The media doesn’t usually tell you that interest rate increases do nothing to affect the maturity value of your bond holdings. Why? Because as a bondholder you have a covenant (or contract) that states the final value is a fixed number. This is why credit risk is a more appropriate focus of energy when it comes to discerning good investments.

False Notion #2: “When the Fed raises interest rates, it will affect the entire yield curve the same way.”
Incorrect. Parallel shifts in the yield curve are rare and it is unlikely that this next one will be parallel. So let me first explain the difference between a parallel shift versus a non-parallel shift. A parallel shift would mean that the 1, 5, 10, etc. year rates all move equally by the same amount either upward or downward. A non-parallel shift would mean that the 1, 5, 10, etc. year rates move unequally by some amount either upward or downward. Now, which do you think is more likely to happen? I would bet on the latter, because historically that is what normally happens. The non-parallel shifts are called “twists” and frankly the impact to the portfolio is hard to measure. However, there are techniques to immunize the effect on the portfolio. The scope of this discussion is not designed to cover that, but suffice to say your investment advisor should be able to construct a portfolio that protects against that.

False Notion #3: “Regardless, any move in interest rates upwards will be bad for my portfolio.”
Incorrect. Just because bond prices move opposite of interest rates doesn’t spell doom for your fixed income holdings. I think the main message here is know your total return. Total return is defined as the change in value plus income. An interest rate increase will only affect the “change in value” portion of the equation. The income portion of that equation is actually improved when you consider that the income can be reinvested in the increased rate environment and generates even more income to the portfolio. Reinvested income, or compounding, is the way to take advantage of a higher rate environment. No matter the maturity of your bond holdings, longer term investors have the distinct advantages of reinvesting their coupon income for even greater returns that will likely offset the change in value. The change in value can be estimated with duration. Let’s say that the duration of your bond portfolio is 6.0, that means for a 1% increase in interest rates, your bond portfolio will decrease by approximately 6%.

So the next time you are tuned into your favorite news channel and they mention that the likely effect of the impending rate hike will mean catastrophe for your portfolio, hopefully you don’t do something incredibly harmful like sell your bonds.

“It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so.”- Mark Twain

Maybe this profound aphorism should be expanded to include “…and what you’re told that just ain’t so”!

Invest wisely!

My Letter to the “Future” All-Stars

Are you headed to the big leagues? Here are some things you need to know!

Ray Dalio (one of the most respected and influential investors of our time) says that if you’ve been at the poker table a while and you still don’t know who the sucker is—it’s you.  There’s a lot of truth in Ray’s words.  Due to my passion to spread financial literacy across each demographic I thought I would write an open letter to a class of individuals that can make a real difference with your gift—professional athletes.  As a professional athlete with access to what seems to be a “lottery ticket” to most, I implore you to take advantage of this opportunity and don’t squander it as so many have before.  However, I would like to suggest a slightly different perspective than what you probably have been accustomed to taking.  First, think of each professional sports league as a funnel for billions of dollars that is orchestrated by several powerful owners groups.  Then I want you to understand that they have used planning to get to this point and will be billionaires for a long time after your career is over.  Next, consider that their wealth may have started in generations before them and will possibly continue for generations after (e.g. their children’s children).  It is a game of sorts that is being played by some very smart individuals.  But think of your potential if you were to employ some of the principles they have used to get you to where you want to go.  Could you learn the game?  Sure you could.  No doubt about it.  However, you are going to need some help.  After working for years in the financial industry and with hundreds of client families I have decided to share some of the knowledge and expertise that will get you there.   Why?  Because I don’t want you to be, as Ray calls it… THE SUCKER!

Why Am I Doing This & What is the Game

One of my most heart-felt missions in life is to be a maven of information. In Malcolm Gladwell’s book, The Tipping Point, he suggests mavens can best be described as “people we rely upon to connect us with new information” or “information specialists”.  That said, I find it really interesting that most professional athletes don’t realize the financial “game” being played in their respective sports. What is the financial game? It is the lucrative machine that each sports league greases when advertising budgets are increased every year to promote and endorse a brand that benefits a select minority. Now don’t get me wrong, I’m not a hater. I just think it quite ironic that long after you hang up your cleats or sneakers there will be a rich owner anxiously awaiting the next “you” to emerge from college and dawn the team uniform. But in exchange you get a very nice paycheck (in most instances) and what else? Do you get any other things of value? I mean are your best interests actually looked out for? Look. I applaud every franchise that is taking care of their players (as they should), but there are a lot that are not. I’m advocating that a strong focus be placed on the athlete’s best interests by who else but YOU! Owners are looking for a return on their investment because they assume a businessman’s risk when investing in a franchise, now it is your turn. Enough with the stories and documentaries chronicling the woes of players, deals gone bad, bankruptcies…it’s time to change this trend!

How can you change the trend? Develop Your Own “HPT”

Look, you have earned the right to play on the field or the court through hours and hours of hard work. You have overcome various odds and obstacles. There are only a handful of elites that can even make it to the big time like you have. On top of all the hard work it took to get there, you then have to maintain that level of performance and improve upon it. What do you think the chances are that you can continue that level of performance to stay competitive in your sport AND learn the ends and outs of this financial “game”? If you think they are low you are right. To put it bluntly, you need professional help. Have you considered that the owner of your franchise likely has a team of attorneys, consultants, strategists, CPAs, etc. to advise him about the direction of his financial enterprises—including the team that you play on. He has a “high-powered team” (“HPT”) to handle these affairs. What about your HPT?

Here are the players that should be on your team:

The Agent – This individual has probably been in your life for quite some time at this point. He may have been introduced to you by one of your trusted childhood coaches. Maybe this individual sought you out and the relationship began there. It really does not matter; he or she is a trusted advisor whose main responsibility is to make sure you are receiving market value for your services to the franchise.

The Financial Advisor – This individual may be brought in after the agent is hired. Ideally, the agent has a network of financial advisors he has worked with previously that he can introduce you to. HINT: You don’t need someone to write checks for you, you should be doing that yourself. You need someone who is knowledgeable, trustworthy, and experienced that possesses the heart of a teacher and the willingness to educate you on the financial choices that will be best for you and your family. This individual’s main responsibility is to help you prepare for the years when you won’t be able to play anymore.

The Tax Professional – This individual plays a very important role in dealing with your tax liabilities. As a high profile athlete with a high salary and future high earnings potential, you need to fully aware of the impact of taxes. This individual’s main responsibility is to make sure your taxes are paid correctly and on time. They may also provide advice on developing charitable giving vehicles to reduce tax liability while positively impacting your community or other things you care about. Also, in the unfortunate event of a tax audit, they go to bat for you so that you can continue to concentrate on what you do best.

Some Perspective about Taxes

For those of you that have not seen the “30 for 30: Broke”, I highly recommend investing the seventy-five minutes and your internet connection here. In the first 5 minutes you notice these outrageous amounts of money that these individuals earned and no reference to taxes paid. It is highly likely that each of those amounts created tax liabilities of at least 35% at the time they received those contracts with penalties and interest for amounts not paid in the year that the compensation was received. Were they aware of this? Maybe. My point is that the IRS doesn’t care whether or not you are receiving this type of advice on when and how to pay them. Their mission is tax collection—not tax advice. I advise all my high net worth clients to visit their tax professional once per year in the late summer or fall. Why? Your tax professional will be under the most stress and pressure in the Spring right before the deadline to file taxes. The best path for you is to file an extension and sort through your tax situation towards the end of the summer where you can have plenty of time to discuss strategies for the upcoming year.

Some Perspective about Investments

Most people will advise that you diversify your investments. I totally agree. Should you diversify your financial management though? Let me give you some advice from the trenches. When a client comes to me asking me what to do about an investment I did not recommend to them, (after a lot of listening) I typically recognize the mistake that was made. Was it a mistake to invest “away from me”? Not necessarily. I am an advocate for strategies that make sense and will enhance the well being of my clients, especially if there is a more knowledgeable and cheaper way to do it than I can provide. However, it should not disrupt the overall investment plan. What do I mean? Say that we create an investment plan that includes a 10% exposure to real estate in your portfolio, but then you decide to go in with a buddy and buy a 50% stake in a strip mall without consulting me to see how this works into your plan. We then have the following: 1) a possible over-exposure to real estate in your portfolio 2) additional tax considerations when it is sold, 3) how we liquidate the investment if you need cash and the costs associated with that, 4) what rights you have as a 50% owner versus a majority owner, etc. Not that this can’t be a good investment, but I think you see the purpose of getting advice for every investment decision made. One of the best things about having a financial guy or gal, is that you get to tell everyone that wants you to invest the following: “hey, that sounds great but I need to run that by my financial advisor first”. This takes the pressure off you and protects your interest by letting a trusted, experienced professional review the idea for its merits without any bias. Here’s the takeaway, always consult your financial advisor. That’s what he’s there for!

Some Perspective about Decisions Already Made

So let’s say that you already have individuals filling all or some of these roles, but you are wondering if they are the right individuals. It happens. Let me give you some criteria to monitor performance of these individuals. In most cases, I realize it is not just business, it may also be personal so you will have to use judgment. One thing to consider though is that you have one shot to make your career provide for not only your present self, but also your future self. Your future self won’t be able to jump as high and throw as far and he is relying on your present self to make the most of what you have now. This means that you will have to undoubtedly make some difficult decisions when it comes to forming your HPT. Your loved ones and those that depend on this decision will thank you and most of all, you will be able to live with yourself.

The Agent: The objective is to be getting market value for your services to the franchise. Ideally, your agent could quantify your value to the franchise in dollar terms to produce a number that should be closely reflected in your current contract. In addition, you may require this individual to negotiate endorsements for you off the court or field. This means you should be aware of what the top 10 or 15 players at your position are earning on and off the field and why. You should also be familiar with the current collective bargaining agreement for your league and how that impacts how your contracts are negotiated. I believe this analysis provides a baseline for measuring whether you are being adequately compensated for your skills and talents. Now don’t just think this should happen overnight either. There are probably improvements you can make physically, emotionally, and mentally that would help you reach your “true” value. All this should be taken into consideration when making any decision.

The Financial Advisor: The objective is to create a financial strategy that balances properly between current and future consumption. Your investment portfolio is part of this formula and how much you save for the days when you won’t be enjoying multi-million dollar contracts. However, it also is coordinating strategies that introduce tax reduction, charitable giving and estate planning to continue your legacy for years after you play your last game.

The Tax Professional: The objective is to minimize the taxes you have to pay on the income you generate. In my experience, the focus with many investors is on how much they make. However, I would highlight that focusing on how much you keep is the more important objective and that is what your tax professional is there to do. If there is a strategy that you should be taking advantage, he or she should be telling you about it.

So for now, congratulations on your progress and your future success—you deserve it!

Maybe we will work together in the future.

Very truly yours,

Dominique J. Henderson, Sr.