As an investor, you own debt. Someone else’s debt, their liability, is your asset. Your liabilities are carried by someone as an asset. Understanding that reality is key to balancing risk and reward, underscoring your economic wellbeing and security.
The balance reflected in your checking or money market account as an asset is debt, someone else’s liability, that you expect to be monetized and returned to you as instant liquidity on demand. The federal government can guarantee your savings as in FDIC-insured type accounts. Insurance companies can insure savings consistent with their ability to pay.
That’s why advisors pay attention to insurance company ratings. Outside of government entities and insurance companies, be careful of promises wrapped in “guarantees.” Charles Dickens famously declared, “Credit is a system whereby a person who can not pay gets another person who can not pay to guarantee that he can pay.”
Our modern economy floats on a sea of debt. The American dollar is strong because global creditors have faith that the U.S. will always pay its considerable, and mounting, debts. When faith in a country wanes, debt instruments denominated in its currency are marked down as “treasure becomes trash.” How many investors remember the 1982 Mexican and Latin America debt crisis and the number it did on stock market values? Ditto the 1998 Russian ruble debacle and more recent Greek and euro-debt worries?
The tenth anniversary of the Lehman Brothers implosion and the 2008 housing debt collapse is spotlighting the siren song of the explosion of “cheap to ‘no cost’” debt following the global meltdown.
A Sept. 15 WSJ piece (“Get Ready for the Next Financial Crisis,” Daniel J. Arbess) quoted a McKinsey report citing a 75 percent increase in sovereign, corporate and household debt in the last decade. The report indicated that the debt of 40 percent of U.S. companies is rated just above “junk,” and in some cases lower.
Retirees and pre-retirees hold debt as a refuge from stock market risk. Yet, debt instruments can be more volatile than equities at times, especially in a rising interest rate environment such as we face as the U.S. Federal Reserve and foreign national banks retreat from “quantitative easing” and some of the lowest interest rates in history.
In July 2016, the benchmark 10-year U.S. Treasury note closed at an all-time low yield of 1.367 percent. Lately the 10-year note has been flirting with 3 percent. Pundits wonder what happens when the 10-year rate surpasses its long-term average of 4.5 percent? When interest rates rise, bond values decline.
How high could interest rates go? You may be an “old timer” if you remember the all-time high of 15.82 percent on the 10-year T-note in September 1981, at the end of the inflationary 1970s. At the time with the prime lending rate peaking around 21.5 percent and 30-year mortgage rates reaching 18.63 percent, with my 7 percent fixed-rate mortgage I felt like a genius. Could that happen again? Not likely anytime soon, but never say never.
In the declining interest rate trend stretching from 1981 to recently, income investing was easier, recognizing that as interest rates fall, bond values rise. The long-term trend is in the opposite direction with rising interest rates and debt servicing strains. As advisors we are cognizant of planning strategies to deal with a range of risks, including inflation and interest rate trends that tend to correlate over time to some degree. Any form of income investing should be related to your personal risk tolerance profile, asset class diversification policy, time frames, cash flow needs, and liquidity concerns. As the yield curve steepens, as it may, bond laddering strategies may become more important.
For ultimate safety, in your “What if?” liquid reserve emergency fund have at least one year’s worth of living expenses in FDIC-insured money market funds.
For those screaming, “Are you kidding?,” no, I’m not. For those working and dealing with the realities of raising children and other expenses, a six to 12 months reserve is the ultimate in peace of mind and debt minimization. For retirees, a safe reserve of up to three to five years of cash flow needs allows you to ride out market cycles, sleep at night, and wake up with energy and purpose.
Safety is a relative concept and your overall investment strategy should be tailored to your net worth, relatively secure income sources, spending needs, debt obligations, and tax posture. You don’t need Bob Dylan to tell you “the times they are a-changin.’” Periodic portfolio reviews, like seasonal checkups for your heating and air conditioning systems, are always prudent.
Lewis Walker, CFP®, is a financial life planning strategist at Capital Insight Group; 770-441-2603. Securities and advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative and investment adviser representative of SFA which otherwise is unaffiliated with Capital Insight Group. He is a Gallup Certified Strengths Coach and a Certified Exit Planning Advisor (CEPA®).