David Scranton: Welcome back to the Income Generation. The show where we provide information for that critical period in people’s lives when they’re either in or approaching retirement. Each week, I help you discover useful actions that serve to make this journey much easier, I’m David Scranton your host. I look forward to this opportunity each Sunday to share with you. Insight and expertise that I use in my own investment management practice. These are insights that you can either use as food for thought or decide to act upon while building or managing your finances as well as the money that you’ll need for retirement. Today on the Income Generation the focus will be completely on income generating investments as I answer one of my viewer e-mails. I’ve gotten a number of these calls and e-mails and requests to do more on the subject of bonds and fixed income. This particular e-mail is from Mickey in the Villages in Florida, she writes Dave, I watch The Income Generation every Sunday. I’ve learned a lot about why the media pushes stocks and mutual funds as well as the risk of history repeating itself with a long stock market selloff. However, you haven’t given a lot of detail about income based investments my husband and I have a portfolio of bonds that has treated us well and I thank my financial advisor for that. As you should Mickey, be thankful for that but she continues to write but there’s a lot that I don’t understand and I hate to keep asking him. Will you be talking about things like coupons, ratings, municipal bonds and how they’re priced in one of your shows? This could really be helpful to us and I’m sure other viewers. And that came from Mickey and Skip in the Villages in Florida. Well first, Mickey and Skip I hope you’re having a great day in the villages, I always have a fun time visiting friends and clients when I’m there. My office is actually about three hours south of you so I get up there whenever I can. I’ve been warning the Income Generation about some of the more common investments people have been taught to go to when investing for retirement. I’ve been suggesting that investments for those close to or in retirement are those that best serve the retiree’s purpose. Most often those investments are the ones that can be relied upon for a predictable and steady income stream. Investing for the purpose of income is crucial because there isn’t anyone who has invested in a stock mutual fund or precious metal for that matter. Who could possibly know what it’s going to pay back to them in five years or ten years or even next week for that matter so today, this show is completely dedicated to investments that are much more reliable and predictable. Those where the company has a contractual obligation to you and a promise to pay you a specific amount. These are the income investments for example, that my firm Sound Income Strategies specializes in utilizing to help clients. They keep those born before nineteen sixty-six sailing into and through retirement focused on the things that really matter. In today’s market breakdown you’ll discover extremely useful facts that most financial advisors don’t even know, I’ll reveal how for example, my clients at Sound Income Strategies benefit from interest rate differences between the various security types. We’ll talk about the reasons bond funds may be one of the worst investments for you as well as how to make the most of the guarantees on individual bonds as well as bond like instruments. I’ll also discuss how to decide if investing at today’s historical low interest rates is a good idea. My guest a little bit later today is one of the most brilliant minds in fixed income investing and global economics, Mohammed El-Erian joins me for a one on one. Where we’ll all learn together exactly what this chief economist of Allianz and former C.E.O. of PIMCO expects from interest rate moves as well as why America is the preferred nation of international investors. Then in our news and views segment Morgan Thompson and I will sit down to discuss nuances of different income generating investments, it’s not as complicated or overwhelming as most people think. In fact, once you know the difference between the many variables and choices of income securities it can almost be like into ordering an ice cream sundae. It’s this simple, if you and a few of your friends went in to Baskin Robbins for a Sunday you’d probably not be overwhelmed by the choices put in front of you because you’ve ordered Sundays before. And you know how ice cream shops work, so you’d appreciate the benefit and having many choices rather than being intimidated by them. It’s the same with fixed income, but if you had never been in an ice cream parlor and weren’t familiar with Sundays you might find the decisions to be complicated and overwhelming. Your head would spin with the thirty-one flavors you know little about first you have to pick what size you want, then you have to decide whether you want one two or three flavors. For those getting three flavors they have almost thirty thousand possible combinations and permutations to choose from. Then of course, there are toppings do you want chocolate, hot fudge maybe caramel then sprinkles or no sprinkles. Maybe nut or strawberries, with or without whip cream and the last decision is of course, the cherry on top. This is mind boggling if you think about it in any given week it’s unlikely that any two people get the exact same Sunday. But they’re all custom ordered and satisfy different customer wishes. My point is that for those familiar thankfully you’re not confused by all the varieties, it allows customization to no one’s taste but yours. So after the benefit of promise to pay income in return on principle I’d say variety is the second most positive thing about investments in bonds and fixed income based investments. Once you have an understanding of a few of the basics we’re covering in today’s show investing your retirement money with the purpose of income can be just a bit more complicated than deciding on dessert. And that’s how most of my clients view retirement, it’s life’s dessert I won’t promise that by the end of the show building your portfolio will be as easy as ordering a Sunday at your local ice cream parlor. But you’ll no longer be intimidated and might even be more knowledgeable than your current financial advisor. If you have money in stocks, bonds or even bank C.D.’s you’re in for a treat with today’s show about fixed income investments. Now, it may not be quite as exciting as picking from thirty-one flavors of ice cream but when done right it can provide you with enough financial comfort that you do even more of the things that you enjoy doing. Stay with us because you’ll be right back with our market break, down during the commercial you may want to text your advisor and make sure that he or she is also tuned in to NewsMax television, The Income Generation.
David Scranton: Fixed income securities, what are they? How safe are they? Can you get paid enough in this market? And when is the best time to invest? First, rather than use my own definition I went to investing answers dot com and I’m giving you their exact definition. I could not have made it any more concise, they say that a fixed income security is an investment that pays regular income in the form of a coupon payment, interest payment or preferred dividend. And they give this example, fixed income securities provide periodic income payments at an interest or dividend rate known in advance by the holder. The most common fixed income securities include Treasury bonds, corporate bonds, certificates of deposit and preferred stock. I would also include a couple of others in that but will get to them later in the show, people who invest in bonds and other fixed income are typically people who want income. For these investors knowing what they are expecting to receive is a cue benefit. You see unlike stocks or mutual funds, bonds have two important guarantees individual bonds I’m referring to, the first and most obvious is the fixed rate of interest for the term or the bond which is between now and the time it matures. It means you can depend upon a level predictable income stream, in previous shows you’ve heard me call this a bird in the hand. The second guarantee by the issuer is probably even more important to many Income Generation members. When a bond reaches a scheduled maturity you’re going to get paid according to the issuers contractual obligation to you, this is why my firm for example, puts so much emphasis on credit worthiness and risk assessment in addition to watching credit ratings and financial ratios. At my company Sound Income Strategies we not only look at ratings by the top three rating agencies but we also dig down even deeper and do our own analysis before entering into a transaction. The safest Bonds of course, are U.S. Treasuries they’re backed by the full faith and credit of the U.S. government in fact, they have the exact same financial banking as the cash that’s sitting in your pocket right now. That is backed by the U.S. Treasury, The Federal Reserve they’re considered riskless partly because if there are no good it also means your U.S. dollars are also no good. The next in the safety spectrum is generally considered with reasonably high safety are municipal bonds. Many of these are backed by the full taxing power of the state city or county, these are issuers that don’t often go out of business or get repossessed. Although it’s rare that a municipal issuer has problems we still pay close attention to what rating agencies say and we do our own analysis on any of these that we may want to add in our current client portfolios. In fact, I believe that all advisors using bonds should have charter financial analysts or CFA’s on staff doing further research, digging down and looking under the hood of anything that their clients own especially in the fixed income world. Corporate bonds are considered next in the risk spectrum, here is where you really have your thirty-one flavors or so to deal with. There’s a whole scale of credit ratings from three different rating agencies everything from excellent to what’s often referred to as junk. These nationally recognized statistical rating organizations evaluate companies based upon the company’s ability to pay. The strength of their management and the ability to raise money in the capital markets as well as many other factors. The most important guarantee that I mentioned earlier is that at maturity you are repaid your exact principal amount that you knew and agreed upon when you initially invested. It’s important to note that bond funds don’t do this, bond funds don’t mature and therefore technically they’re not a fixed income instrument. Essentially they’re a legal corporation that contains bonds but the corporation itself trades as an equity. Because this corporation itself doesn’t ever mature you don’t know what to expect to receive and you give up control over your money. I cannot stress enough that in my opinion you should avoid bond mutual funds if you’re at or near retirement, you should know that if you own bonds in your portfolio and have an unexpected need to raise cash you can do so. You can sell a bond before maturity in fact, investment grade bonds are very liquid and they’re actively traded on the open market at negotiated prices. The bond market itself is much bigger than the stock market. As we’ve said on the Income Generation before as rates go up the general rules that the value of your bond goes down. But does this mean you shouldn’t invest in bonds at all right now when rates are at a record low? Well, we’ll discuss that in a minute but keep in mind that for every day that you wait to invest and you have cash sitting on the sidelines you’re earning no or very little interest. And each day that you wait is a day that you’re holding on gambling, hoping and praying that interest rates in the future go up why? Because the longer you wait then you’ll need even a higher rate in the future to cover the cost of waiting. Plus if you are a person who plans to hold these bonds to maturity as many of our Income Generation members are then the price risk, the change in prices when interest rates go up really shouldn’t affect you. This is no different from an asset like a bank CD. You don’t get statements from your bank telling you that your CD is worth a bit less right now because if you sold it early you’d have to sell it at a loss. They just assume you’re going to hold it to maturity. If today’s income based investments accomplish your income needs then waiting and hoping for higher rates may prove detrimental. There are folks in Japan who are now living with low interest rates for the past twenty-five years and a few weeks ago the Bank of Japan lowered some rates to below zero. So waiting can be risky, this may actually be the best time to invest in fixed income that we’ll ever see over the next decade and here’s why. Most financial advisors don’t really understand fixed income investing, beyond the basics of the fact that when interest rates go up fixed income investments tend to drop in value. One nuance for example that many don’t understand is called risk premium. I don’t hear anyone talking about it but as other advisors catch on rates on higher paying securities may come down with increased demand. Let me give an example, back in two thousand and seven there are particular class of fixed income securities that we at our company Sound Income strategies were using to help a lot of our clients. And that class of fixed income securities are paying six and a half percent per year. At that time in two thousand and seven the ten year U.S. government bond, the ten year treasury which is generally considered to be a risk free investment if held to maturity was paying four and three quarter percent. So the difference between the risk free and this other class of investment that I’m referring to was one and three quarter percent per year. That means that investors required only an extra one and three quarter percent interest to go from something that’s completely backed by the government and has no default risk to something that had a little bit of default risk. That one point seven five percent that differential is what we call a risk premium. Now, the reason for that was because at that time in two thousand and seven people were really confidence they thought okay, to go from something that’s risk free that has risk I’m not going to worry too much, I only need a little bit more interest. Now fast forward to today, today the same ten year risk free, theoretically risk free U.S. government bond is paying about one and three quarter percent. That rate has dropped by three percentage points. But the interest that’s paid on this particular class of fixed income security I’m referring to today has only dropped by half percent. And went from six and a half down to six. So wait a minute, the risk free rate went from four and three quarters to one and three quarter and dropped by three percent but this particular class of security only dropped by a half percent. Why? Because when interest rates were dropping it’s because people are concerned about the markets and they have fear and as a result investors decided that they needed to get more interest to justify the extra risk of going up and above US Treasuries into any other class of investment. So the risk premium expanded from what was one and three quarter percent to what now is four and a quarter percent. So when you talk about the concept that interest rates go up and fixed income securities dropped in value most advisors who don’t specialize in fixed income securities always look at the ten year U.S. Treasury and they use that as a proxy. But what they don’t realize is that risk premium that we’re discussing today is something that has an offsetting factor, why? Because just like when the ten year Treasury rate dropped a lot and the rate on this particular class of security just dropped a little. It’s completely possible that the ten year Treasury rate goes back up by three percentage points and the rate on this particular class of security only goes back up by a half of a percent. So in some ways you could think of this ever expanding risk premium and shrinking risk premium as something that softens the blow when bonds decrease in value. For example, imagine the difference between jumping out of an airplane with no parachute versus jumping out of the airplane with a parachute. Now I don’t want to say for example for a minute that these class the bonds have no risk but the reality is that the risk premium acts kind of sort of as a parachute that helps soften the drop. And unfortunately, most advisors really don’t understand this instead they’re out there simply robotically quoting that if interest rates go up bonds go down. But they’re looking at oftentimes the wrong interest rate, the wrong interest rate that does not particularly apply to that particular investor. Although business news has focused recently on stocks and mutual funds which are what I call the chocolate and vanilla of the investment business. I’m going to show you that the income markets have many more flavors from which to choose and they look more appealing than ever before for retirement based accounts. Why? Because the easier to understand chocolate and vanilla, stocks and mutual funds appear to be on the verge of melting that’s why my firm specializes in the much broader yet more conservative variety of income based investment. Next we go one on one with Mohamed El-Erian and we’ll talk about interest rates, bonds, and the markets right here on the Income Generation.
Mohamed El-Erian is the chief economic advisor at Allianz. His new book is titled The Only Game in Town, Central banks, Instability and avoiding the next collapse. He’s chairman of President Obama’s Global Development Council, a contributing editor to Financial Times and the former C.E.O. of PIMCO. He holds a master’s degree and a Doctorate in economics from Oxford University and also author of the bestseller, When markets collide. Which one the Financial Times and Goldman Sachs business book of the year, you can manage as a fixed income advisor this is someone for whom I have a lot of respect and have followed over the years. So it’s a great pleasure to have you on our show today Muhammad.
Mohamed El-Erian: Thank you David. Wonderful to be with you.
David Scranton: Listen, first I want to talk about Janet Yellen in her testimony just a little while ago on February tenth before the House of Financial Services Committee. She talked a lot about a slowdown in China which of course we’re all aware of which is helping to create downside economic risk in our economy as well as other global economies. Current inflation measures suggest very little pricing strength and very little room for long term interest rates to increase. So my question is, if the yield curve remains as flat as it has been or even becomes inverted will banks and insurance companies resume their previous problems in your opinion?
Mohamed El-Erian: So it depends where they’re starting from, there’s no doubt that banks in particular are facing three elements that are developing a perfect storm particularly in Europe. First, the interest rate environment like you say we not only have interest rates coming down but the curve is flattening and could even invert which means they earn less. Second, those who have lent to the commodity sector and the commodity sector have a quality issue on their portfolio. So there’s concerns about the quality of the loans have made and third and this is also important, the regular environment has changed. So investors have less confidence that if something really goes wrong there will be support for them, put these three things together and this means pressure on banks in particular. And in Europe it means huge pressures on banks.
David Scranton: Yeah, I agree completely it makes a ton of sense. And in general central banks have come under a lot of criticism for their drastic manipulation of markets over the last few years. The question is will the Fed in or other central banks lose their resolve to squelch this volatility in their particular local markets in the future? Or do you think this practice is here to stay?
Mohamed El-Erian: So we have two developments. Yeah, we have two developments and you’re right the central banks realize that they’re under criticism but it’s important to remember they didn’t do this by choice, but they did this by necessity. Why? Nobody else was stepping in, they have political autonomy so they felt morally obliged to step in even though they didn’t have the right tools, and with time when you don’t use the right tools the collateral damage becomes significant. And that’s where we are today so we’re seeing two trends in the case of the Fed it is less willing to do… to continue doing this. In the case of the other Central Banks, the European Central Bank, The Bank of Japan, and The People’s Bank of China they’re still willing but less able. They’re less effective so the Central Community, Central Bank community as a whole is having a lot more trouble continuing its policy of repressing volatility and intervening with markets.
David Scranton: It’s interesting after the Fed hike in December, I was on a panel on Closing Bell that same day and I remember that when the Fed statement said that they’d be cautiously raising rates throughout two thousand and sixteen. It seemed completely unlikely to me and you know the FOMC, let’s face it certainly has access to more information than I do and almost any other entity. You personally think that they believed what they were saying at the time or perhaps were just trying to create a lot of optimism and self-fulfilling prophecy of sorts?
Mohamed El-Erian: So one issue with the Fed historically is that they tend to concentrate on domestic developments and if you were to look at the U.S. economy in isolation. You would argue that yes, it can support for interest rate hikes which is what they signaled at the time but if you look at the U.S. economy in the border context then you start getting worried. Why? Because you cannot be a good house in a poor neighborhood and what’s happening, the global environment is getting more risky. There’s less economic growth internationally and there’s more financial volatility so if you look at the U.S. in the context of what’s happening outside the US it’s very hard to see how they’re going to hike interest rates four times.
David Scranton: Well that’s a conversation that you and I could probably spend hours having if we were limited by the television show. Tell me, should small investors who are looking for income today should they be sitting at home waiting for rates to come back up? Or do you think with the global economic weakness we’re seeing today that rates are going to stay low for a long time so they might be better off just putting money to work in fixed income now versus waiting?
Mohamed El-Erian: So a lot depends on your starting position, so a few things that investors should keep in mind one, is this volatility will continue it is not going away. We’re coming out of a period of unusually repressed volatility and now we’re going to have payback so the first thing they should be ready for is wild volatility. Intraday, intra-week they’re going to see a lot of very strange things happening as a system tries to normalize again. The second element they have to remember is when they buy fixed income they’re buying at least two very distinct risks as you know one is interest rate risk and the other one is credit risk.
David Scranton: Of course.
Mohamed El-Erian: And they have to be careful on the credit risk side. Third patience is really important, as markets get dislocated good names and bad names go down together. So a patient investor would have opportunities to pick up good names at low prices, I would be cautious, I would be very measured at this point, I would value the optionality that cash gives me and I would make sure that I’m not over-exposed to volatility.
David Scranton: You and I seem to agree on so many fronts but maybe that’s because I was smart enough over the years to follow you and to learn from you so… Stay with us, we have to take a commercial break and when we come back we’re going to talk about Mohamed’s new book and some predictions and things that are going help you manage your money better. We’ll be right back. Welcome back, as a fixed income nerd you can imagine that I have a credible man crush in a way on our guest today. Our guest we’re talking to is Mohamed El-Erian the chief economic advisor at Allianz. And now we’re going to talk a little bit about his new book, The Only Game in Town. Central Banks, instability and avoiding the next collapse tell us Mohamed, what can our viewers learn from your new book? Things that they may not be hearing from a traditional financial advisor?
Mohamed El-Erian: The main point of the book is that all that we are seeing in terms of market volatility, in terms of negative interest rates in Japan and Europe, in terms of this very strange blame game between oil and stocks. All these things are part of a much bigger story and the story is actually quite a simple one, the world that we are on is ending. We will no longer be able to repress financial volatility, we will no longer be able to maintain low but stable growth. We are going to tip within the next three years the system is going to tip now what’s hard is that there are two possibilities. Nothing predestined about where we go, we could either tip in a much better place if our politicians response while alternatively it’s about recession, it’s about huge financial stability. So investors have to realize that we are entering this T-Junction, what the British call the T-junction the road ends and they have to think about the asset allocation accordingly. Which means doing things differently David.
David Scranton: How about oil? What’s your take on what’s been happening lately with oil? This is… this kind of sort of unprecedented.
Mohamed El-Erian: Yeah and it’s amazing to think that low oil prices have gone from being viewed as a blessing to be viewed as a curse. It’s not just a supply and demand issue, if it were just a supply and demand issue oil wouldn’t be where it is today it would be higher. It is also that the oil market has lost its seat belt, it has lost the swing producer, the notion that OPEC and Saudi Arabia would cut production in order to support prices. So the market right now is completely unhinged over the long term if you ask me where is it going to be in twelve to eighteen months’ time I’m pretty sure it’s going to be higher. But over the short term we’re going to see enormous volatility continue.
David Scranton: Do you think it’s another deflationary signal, the fact that oil has been dropping not as far because a lot of this is because the unhingedness that you just described. But in general, do you think it’s a deflationary signal as I do?
Mohamed El-Erian: Yeah, it is a deflationary signal with one qualifier it has a positive income effect. Why? It’s an immediate tax cut you go to the pump and you have more dollars in your pocket after you fill your tank. So this is an immediate tax cut, it has a deflationary price effect but it has a positive income effect the question as you rightly noted a couple of minutes ago is our households confident enough to spend this windfall?
David Scranton: Correct. In the last minute we have together today I’d like to you know time flies when you’re having fun. I’d like your take on what’s happened recently, a lot of advisors, traditional advisors are saying don’t invest in fixed income today because interest rates can only go up. But they miss the whole concept the offsetting element which is this the risk premium spread and we just talked in the last segment about risk premium spread. So do me a favor, tell our viewers what your take is on that.
Mohamed El-Erian: My take is to be very careful about the risk premium for now. We are going to see pressure, there is no patient capital to step in and stabilize risk premiums in general. But this will create opportunities why? Because you get this awful thing called contagion where good names and bad names are lumped together so be patient, there will be opportunity to pick up fixed income where the risk premium has moved excessively. So be patient but this is not an immediate opportunity, this is one that’s going to develop over time.
David Scranton: Yeah and at least investors saw that only seven or eight years ago so it shouldn’t be a total surprise but you’re right the contagion does occur and is an issue for investors. So it’s been a pleasure today, I want to let you know that I don’t think any less of you for the fact that you gave me the fifty-fifty answer I… Sometimes it is truly fifty-fifty so thanks a lot for being our show today.
Mohamed El-Erian: Thank you.
David Scranton: Stay right with us we’re going to take a commercial break we’ll be right back talking more about how you can earn more income conservatively in your portfolio. We’ll be right back.
Morgan Thompson: So, Dave if I understand your metaphor, the stock market and mutual funds which are like the Income Generations old standbys let’s call them vanilla and chocolate. They don’t seem to offer much more and the supposedly complicated fixed income market if you gain a little bit of knowledge it won’t overwhelm you and it’s much more satisfying. You compared it to thirty-one flavors and up to three scripts to build a Sunday with.
David Scranton: It’s much easier than people think it really is once they get the basic knowledge. The biggest problem though with fixed income investing is that it’s… there are fewer places you can go to actually access the information that you need to make decisions. Whereas the information for doing research just low level research on stocks and mutual funds is everywhere.
Morgan Thompson: Now I know there are different rating agencies. Can you explain a little bit more about the different ratings or I should say the different flavors available?
David Scranton: Different flavors absolutely, the rating agencies. The three major ones are Moody’s, Standard and Poor’s and Fitch and just to use one for example they’ll have a,b,c,d ratings but then they break it down even more. So they’ll have triple A, double A, single A, triple B, double B, single B. Then they break it down even more just like when you’re in school they’ll put plus and they’ll put minuses before each break.
Morgan Thompson: Just like a report card.
David Scranton: Just like a report card. So you have many different grades and the idea of this is to help the average investor determine the financial stability of the underlying issuer of the bond. Again, specializing in this type of thing we go beyond that and dig a lot deeper but for the do it yourselfer at home they should at least be able to understand those basic financial stability ratings and be able to interpret them.
Morgan Thompson: Okay. Well you’ve mentioned municipal bonds, I know that some of them save me from paying taxes on the interest payment.
David Scranton: Well, to use our ice cream analogy I like to say that it’s kind of like for those who are lactose intolerant or in this case those who are income tax intolerant perhaps like yourself. And the reason for this is because many types not all, but many types of municipal bonds are…they generate tax free interest to the bond holder.
Morgan Thompson: Okay.
David Scranton: And if you live in a state where they actually have income taxes, one thing we don’t have to worry about here in Florida but if you live in a state where they have income taxes and you buy a bond that’s issue word. It’s issued from the state in which you live then it’s actually tax free on the federal level as well as tax free on your state level.
Morgan Thompson: Okay, so sticking with our Sunday analogy because I’m liking this, it’s a lot of fun. If we were going to create a Sunday just for me I know I need hot fudge, I need cherries, whipped cream, little walnuts I like a lot of diversity. So if you were going to create a portfolio for me after bonds, what are some of the other ingredients you’d include?
David Scranton: Well there are several. For example, when you’re talking about bonds you’re talking about some that are callable, some that are convertible. If you get out of pure bonds into the world of what I call Bond like instruments you have things like preferred. BDC’s or even REIT’s.
Morgan Thompson: Okay, well this sounds like a lot to cover. Can we talk about them one at a time?
David Scranton: Sure.
Morgan Thompson: Okay. Well you know I like convertible cars so let’s start with convertibles.
David Scranton: Convertibles, okay. Convertible bond for example is kind of a hybrid between a stock and a bond so it’s something that the investor if they want to give up a little bit of interest with a non-convertible bond. They can actually have the ability to convert that bond to a stock if they think the stock’s going to do better. So in some ways you have the downside protection of a bond although again, with a little bit less interest payment. But you have the ability to have some of the upside potential of the stock market so it gives people a little bit of flexibility which I know you like.
Morgan Thompson: I do, good thing to be included. So I’m going to assume that call options have nothing to do with a phone?
David Scranton: Call options have nothing to do with a phone absolutely not. Callable bonds are bonds that are actually callable by the issuer, by the corporation just like you know when you have a mortgage in your home. If interest rates go down you can always refinance at a lower interest rate, you could pay off the bank in full and the same token with a corporate bond for example. When it’s callable it gives the corporation the ability to refinance at a lower interest rate so of course, all else being equal. If you have a callable bond versus a non-callable bond the corporation could have to pay just a little bit more interest for that privilege.
Morgan Thompson: Which could be good for you. Now you’ve said coupon a couple of times is that the interest rate the bond holder gets paid? Is that correct?
David Scranton: Yes, in fact, I want to talk about a couple of interest rates. The coupon rate is the stated interest rate that’s right on the bond certificate or any of those certificates for that matter. So that the person knows exactly what they’re going to get each and every year providing that the issuer doesn’t go through any default of sorts.
Morgan Thompson: Okay.
David Scranton: But there’s actually another number that’s more important it’s something called yield to maturity.
Morgan Thompson: Okay.
David Scranton: Which takes into account the fact that you might be buying a bond at its repayment value or face value or you might be paying less for it or more for it when you buy it. If you pay less for it then your yield to maturity is actually higher than the coupon rate because when it matures it’s going to be worth more and if you buy it out of what’s called a premium where you’re paying more for it. Then your yield to maturity is actually going to be a bit less than the coupon rate so when you’re looking at bonds the yield to maturity is actually the most important interest rate. Because it gives you the true economic rate of return between the times you buy it and if you (unclear 36:59) hold it to maturity combining the coupon rate as well as the change in price. The fact that you may have bought it at a premium or you may have bought it on sale.
Morgan Thompson: That’s a very important distinction and preferreds I know equities that have a set dividend they are kind of like a hybrid between stocks and bonds. What is a BDC?
David Scranton: Okay, a BDC is actually called a Business Development Corporation. It’s really a fund which lends money to smaller companies so as a result they’re getting higher interest rates because of smaller companies but it doesn’t mean that it has to be enormously high risk. Because what a BDC will do oftentimes is they’ll narrow it down to companies that take secure positions on the debt or companies that for example, don’t take a second home equity line in essence. So you know you have a first mortgage on your house it’s considered more secure.
Morgan Thompson: Right.
David Scranton: So you can get into BDC’s that have a first lien on assets and that makes them more secure.
Morgan Thompson: Okay and what’s a REIT?
David Scranton: A reit is called a Real Estate Investment Trust. It’s basically the stock of a company that owns rental property and the dividend that investors receive that flows through from the reit is really a flow through of the net rental income after expenses.
Morgan Thompson: Who said fixed incomes painful or boring? This Sunday’s delicious.
David Scranton: What were you expecting an ice cream headache after all?
Morgan Thompson: No this has been a lot of fun.
David Scranton: Well good, I’m glad I was able to clarify it a bit for you and I was glad that I made it fun along the way. And I also hope most importantly that I made it fun for you or Income Generation viewer so stay with us we have to take a commercial break and we’ll be right back with more important information about fixed income investing. Earlier when Mohamed El-Erian and I spoke he said you cannot be the good house in a bad neighborhood. In other words, even while the United States economy is showing some growth it can only improve up to a point when the rest of the world is faltering. Today, America is still viewed as the safest place to invest and that’s in large part what’s keeping many of our interest rates low. I believe this might just be the new normal for interest rates for years to come. That is similar to Japan’s interest rates where will experience decades where yields remain well below average. But many investors who want the safety and promise of a no return in fixed income have been waiting, there the proverbial deer in the headlights and they wait up to seven years now because they’re sure that higher rates are inevitable and just around the corner. They believe that higher rates are as certain as depth and taxes and they will eventually prove themselves to be correct but in the meantime, they should consider exactly how much they’ll continue to lose and never be able to recover under the more likely scenario. I mentioned Japan earlier, take a look at this chart of Japanese interest rates for the last twenty-five years you can see that in nineteen ninety-one and nineteen ninety-two there are around six percent or so. But they rapidly decline throughout the mid nineteen nineties. The decline in fact was similar to the drop off that we had back in two thousand and eight here in the United States. Anyone in Japan that’s been waiting for rates to go back up is much worse off now than if they had invested sooner in fact, in the news just a couple of weeks ago the Bank of Japan dropped one of their key interest rates even lower. The new interest rate paid is now a negative one tenth of one percent. The reason their economy remains weak is that much of Japan’s population is older and in the period of their life where people simply don’t spend as much. Later in life we naturally tend to make fewer big ticket purchases which in turn has an impact on all other economic activity. This is why their rates have been low for decades and Japanese stocks haven’t recovered either. Now consider this, the age of the average person in the United States is about ten years behind that of the Japanese population. If Japan’s experience can be used as an indicator it suggests that we might also be in for another ten years or more of extremely low interest rates accompanied by weak economy. Now, I personally have a lot of letters after my name I call it the alphabet soup. Each designation represents a certain knowledge base or expertise that I have acquired, these proficiency’s help when I meet with people that come to me for investment advice. But since two thousand and eight one of the things I have helped people with the most every day is not covered by any of these designations for which I had worked so hard. It’s called atychiphobia where the fear of being wrong. Some worry that if they invest say five years at five percent today and next year they could have gotten six percent instead that oh my goodness, they will have made a huge mistake. And they simply don’t want to be wrong when they look back. None of my designations suggest that I’m an expert in helping people overcome fear but in a way they all suggest that I am an expert in math. And in this case overcoming their atychiphobia takes a moderately simple mathematics problem and as I’ll show you in a minute. You can invest immediately and if rates do rise they may still have made the best decision by investing now instead of waiting. Conversely they can do nothing now and wait for a while on the sidelines in cash and be correct about interest rates rising. But find that they earn less money by being right in other words, win the battle and lose the war. So if they’re worried about being wrong they could be right and at the same time still be wrong. This will clear up any confusion or at least I hope so, a year ago a woman came to my office named Agnes, she had a one hundred thousand dollars five year CD. Which had just matured and had been paying her five percent, her bank’s new rate for five years was only two percent. This amounted to three thousand dollars of reduced income each and every year, now this was a big negative for her budget. So I explained to her other types of fixed income options to help her where she could get something close to five percent. She knew she had to do something but in our conversation I learned that she was afraid that if she invest today at five percent. She was concerned that next year the rate might even be six then she’d be upset. The fear was going to keep her frozen and prevent her from doing anything so I took out a piece of paper and I wrote this, five percent for five years on one hundred thousand dollars pays you five thousand dollars a year of interest. For a total over the five years of twenty-five thousand dollars. I then explained to Agnes that if she’s right and the rates are six percent next year she should still invest today. I then went on to explain that if you keep your money in the savings account for the next year earning zero percent and interest rates rise. In order to earn the same twenty-five thousand dollars of interest over that twenty-five year period rates on a four year investment would then have to rise to six and a quarter percent. Now, when I showed you those numbers neither of us felt that rates would rise by quite that much, she decided that waiting was probably the wrong thing to do. So far it’s proven to have been a great decision for her. Earlier although he was talking about banking authorities Mohamed El-Erian said with time if you don’t use the right tools the collateral damage becomes significant. It’s important to have the right tools or find a financial advisor with the right tools to manage fixed income. Neither Agnes nor her bank had these tools so over time she would have been worse off. The damage that some of their retirement accounts have suffered because not all advisors have the best tool set is one of the reasons I’m here each and every week. I want to help you the Income Generation understand that there are options. Options that you may not be hearing about anywhere else. I want to take this opportunity to thank Mohamed El-Erian and for his thoughts today. His brand new book is called The Only Game in Town. I’m now reading it for a second time if that’s any indication of the depth of insight you’ll find between its covers. I also want to thank Morgan Thompson for all her help today, we’ll see it back here again next week. And I want to make sure you at home know how much I appreciate the calls and e-mails coming into my office from you. For more information on today’s subject I just finished writing a report for my viewers called Renewable Retirement Resources, The Case for Fixed Income. Go to The Income Generation dot com and download your copy after the show. You can also download my special report called The Income Generation. Well that’s the scoop for today I’ll see you all again next week.