Common Credit Mistakes And How To Avoid Them

Common Credit Mistakes And How To Avoid Them

“No man’s credit is as good as his money.”

E.W. Howe, novelist

What is credit? Credit is defined as the ability to borrow money or something of value now with the understanding you will repay the lender later with interest. Managing credit well is one of the essential disciplines in your financial life. Developing good credit habits can enhance your financial health.

Unfortunately, there are many ways to make common mistakes that can be costly by lowering your credit score. A reduced credit score can make it difficult for you to borrow at a more affordable interest rate, fall behind in paying debt, or turn off landlords from renting to you.

You are not born with good credit, but you can earn it by handling your debt reasonably well. Understanding your FICO credit score may help you to raise it a few points to a better level. By doing so, you may get lower interest rates when you take out loans, shaving your interest costs meaningfully.

Determining What’s Important To Your Credit Score

Calculating the FICO Scores formula involves five different criteria:

Payment History: 35%

Payment history carries the most significant weight in your score. Payment history picks up on patterns of making consistent payments on time for the length of your credit. Having a more extended credit history is a better gauge than someone who has just received their first loan. Having a good track record of not missing payments and being on time works in your favor.

For example, making a late credit card payment, that is, a payment past the due date will hurt your score.

Those who are new to getting credit have to build up a practice of paying what they owe on time. Any occurrences of past-due accounts or delinquencies, especially for current amounts, are red flags. This component looks at different account types such as credit cards, retail or store accounts, installment loans, mortgages, and finance company accounts.

Credit Utilization: 30%

As a significant influence on your credit score, credit utilization is the ratio of your total outstanding revolving credit balances divided by full available credit. Revolving credit refers to your credit cards and credit lines you may have but does not include your car loan (unless on your credit card) or your mortgage.

The utilization ratio is also known as the balance of debt to available credit or debt-to-credit ratio. It measures how much credit you have used for the total amount available to you. You don’t want to “max out” your cards. You should not be above a 30% ratio as it will impact your score. Stay in the mid-20s range to be assured of not hitting the 30% level. Think twice before closing a credit card as it will have a negative impact on this factor.

Credit History: 15%

Lenders look at your credit history and your experience with credit matters. The length of time of your oldest credit account and the average age of all of your accounts determine your credit history. The longer you have an account, the better your credit score. If you are new to obtaining credit, it will take time to benefit from showing up in your score. Don’t close your old credit cards because they count positively in your credit history. 

Credit Mix: 10%

Lenders favor some variety of borrowing in your mix of credit. A borrower handling different kinds of debt products may reflect less risk to lenders. A person without a credit card tends to be seen as a higher risk. That said, don’t go out and get different kinds of loans for the sake of improving your mix.

New Credit: 10%

Your inquiry will be reflected on your credit report for up to two years when you apply for credit. That is called a hard inquiry. As such, it can negatively impact your credit score, particularly if you are making multiple inquiries. However, don’t let it stop you from doing comparison shopping for the same type of loan.

A soft inquiry occurs when you are checking your credit score or report. Someone other than yourself may make a soft inquiry by accessing your credit background for something different than a loan such as an employer. Soft inquiries do not generate negative hits.

11 Common Credit Mistakes To Avoid

Avoid making common credit mistakes. Becoming informed and determined to avoid these mistakes may yield great returns for you and your family. I will refer to the score criteria when relevant to a specific mistake you may be making.

 

1. Not Paying Your Credit Card On Time

You are required to pay the minimum amount by the due date on your bill as a credit cardholder. If your household is like ours, you probably lead busy lives. You probably are responsible for many monthly bills, not just your credit card bills. If you are late paying a card bill, you will likely incur $25 the first time you are late, but the amount will rise the next time.

Depending on the terms of your credit card agreement, you may face a hike in your APR on any balance you carry along with future charges. Lateness is pretty consequential to your credit score as payment history at 35% of the FICO score calculation is the largest component.

To avoid being late in paying the required minimum, you should automate payments of all your bills, including your credit cards, through your bank account. When it comes to paying your card bills, automate and don’t procrastinate. The penalty charges are punitive for a reason.

2. Carrying A Large Balance On Your Credit Card

Paying the minimum on your credit card bill on time is an easy fix and makes the card issuers happy. They stand to make a tidy sum on interest income at the high APR rate they charge their average customer. Roughly 58% of cardholders carry an average balance of $6,354 per person at the current average APR of 16.03%.

Of course, card issuers are happy because it is highly profitable. The problem for cardholders is those carrying balances result in paying extra costs on their purchases. Instead, pay your credit card balances in full. Otherwise, it takes years to pay off your current payments while piling on more debt as you continue to use your cards.

An Example

Let’s say you have a current balance of $4,000, and your APR is 16%. Typically, your minimum payment as a percentage of your balance, around 2.5%, or $96 that you owe. If you pay the minimum rate going forward, it will take you 18 years and four months, costing you $4,148.86 in extra interest charges to pay that balance. And, that assumes you never make additional purchases with that card in the future.

Carrying high balances is dangerous for your pocket, and it also has implications for your credit score. After payment history, amounts owed (accounting for 30% of your FICO score) is your credit utilization rate. If you are using too much of your available credit on your card, it may signal to the banks that you are overextended or a potential risk.

Stay Well Below The 30% Credit Utilization Rate

Using more than 30% of your credit utilization can negatively impact your credit score and future borrowing ability. Stay well below that 30% threshold. It is essential to tackle your high balances by making a plan to pay off your card debt, usually the most expensive debt you hold at the double-digit APR. Become disciplined about your spending wisely. Credit cards are convenient, too convenient if you tend to overspend. Cut your spending drastically if you want to have a chance to reduce a large balance.

How To Raise Your Score By Lowering Your Utilization Rate

Most of us don’t pay a lot of attention to our credit card bill, but we should. Your due date is when the payment is due on your statement and reflects the previous billing cycle charges. The last day of the billing cycle is your statement’s closing date. The due date is the grace period, typically 21-25 days, and falls between the closing date and payment. The credit card companies are required to give you this period, not because they are friendly folks.

You are required to pay by the due date to avoid penalties. However, you can benefit by paying your bill on or before the statement closing date, the last day of the billing cycle. By doing so, you can improve your credit utilization rate and, therefore, your credit score. For example, if you have a $3,000 credit limit, spend $2,500 but pay off $1,900 before the closing date, it will appear as if you spent only $600, or 20% of your credit available on that card.

Related Post: 6 Ways To Raise Your Credit Scores

3. Don’t Close Any Credit Cards

Even if you don’t use certain credit cards, don’t close these accounts. Often we have several credit cards that were once appealing because of certain features or through a favorite store. However, over time, you have lost interest and decide to close the account to worry about theft or temptation to use it.

Don’t do this—the length of your credit history matters for 15% of your credit score. The longer you hold open cards, the better, even if you aren’t actively using them.

My Mistake

I made this mistake with a Saks Fifth Avenue card I applied for and got 10% off a large purchase I happened to make for a special occasion. While I liked to browse their stores, I realized I didn’t want to have their card. So, I closed the card. Perusing my credit report months later, I got a ding on my report, which translated into a lower score. To avoid this mistake, simply throw unused cards in a drawer and say goodbye.

4. Not Reviewing Your Credit Report Periodically

According to an FTC study, one out of five people has found errors on their credit report. The sooner you find the mistakes, the easier it is to fix them.

Current and future creditors use your credit report and review its potential impact on your credit score. Others that may want or need access to your credit report are landlords, utility companies, insurance companies, prospective employers. Also, legitimate access to your credit report may be required by collection agencies and if you are a party of court orders.

Fixing Errors On A Credit Report

Fixing errors on a credit report is not difficult, but you don’t want to delay doing so. Delaying a review of your credit report may result in you having to pay a higher interest rate than you should when you apply for credit. Don’t wait for those needs to arise. The best way to fix errors, disputes, or possible fraud is to follow these instructions.

Besides looking for errors, you may be dismayed at some notations on your credit report. Your report may shine a light on poor judgment or reflection of your impulse spending habits. Additionally, it may help you to pinpoint potential fraud when someone has made unauthorized inquiries or purchases.

Fear of fraud may motivate you to make essential changes to get the information in good shape before shopping for a home or a car. We once found a tax lien for a small amount that was burdensome in applying for a car loan. Be timely when you encounter these issues. It is easy to forget when something is a small amount but remains a nuisance to do.

5. Not Reading The Fine Print On Your Credit Agreements

Fewer than 1 in 1,000 people take the time to read the fine print online, spelling out the terms and conditions in financial contracts like credit cards, insurance policies, car, or mortgage loans.  Not doing so may have long-term financial implications for you and your family.

Credit card agreements have incredibly complex terms and conditions. You should understand the particulars of the APR, penalty structure, the benefits from cashback, rewards, discounts, and other perks they are providing.

Terms of Your Mortgage

When you are buying a home, it is typically, for most people, your largest asset. True, your attorney plays a significant role in helping you through the home-buying process. However, you should understand the key elements of the mortgage loan and its interest rate, fixed or variable, prepayment penalties, and length of the term. How owed mortgage interest compounds (semi-annually or monthly) can make a difference in the total cost of your home.

To avoid problems later, become familiar with the typical terms and conditions for the respective agreements you are shopping for. Certain laws have been passed in recent years to protect consumers from providers. These laws, like the Credit CARD Act of 2009, recognize the imbalance that often exists between parties. However, you are responsible for understanding what you are signing. Yes, these documents can be boring and hard to understand, so ask questions.

6. Paying A Loan Off Early Can Hurt Your Credit

If you suddenly received an incredible amount like a bonus or an inheritance, you may want to pay off your loan. Be aware that there may be negative consequences. Some loans, if paid ahead of time, incur pre-payment penalties. These are usually relatively small and worth getting rid of the debt burden. While there may be a temporary hit to your credit score, it is probably beneficial in the long term.

You would want to weigh the value of saving interest over the time remaining on the loan. Usually, there is a relatively small ding to your credit score. Unless you seek a bigger loan and need the best rate possible, paying off a loan should not be a big deal.

How It May Hurt Your Score

When you do not have much payment history (35% of score) may not be a good idea to pay off a car loan. An installment loan is a type of contract involving a loan to be repaid through scheduled payments like for cars and homes. As long as they are paid on a responsible basis, these loans are reflected positively on credit score according to Experian. A good credit mix means there are different types of credit being used. Credit mix accounts for 10% of your credit score, so paying off a car loan may negatively impact your score.

7. Don’t Make Excessive Hard Inquiries For A Loan

Creditors get worried about people making too many “hard inquiries” that occur when applied to a lender of some sort. Lenders see this as a sign of risk that you may be overextending your debt. As we mentioned earlier, hard inquiries may hurt your credit score.

On the other hand, “soft inquiries” occur when someone is accessing your credit report for reasons having nothing to do with a loan. Instead, it is someone such as a landlord considering whether to rent their house to you. That inquiry is for reasons better to understand your creditworthiness as a reflection of your character.

Hard inquiries to your debt burden is often a big problem. These kinds of consequential inquiries come from those who apply for loans or have too many credit cards that they max out. If you have too much debt, applying for debt will worsen your situation. Instead, you should consider working with a financial debt counselor that can provide strategies to reduce what you owe.

8. Avoid Cards With Annual Fees Unless They Have Important Features You Will Use

Generally, there are so many credit cards to choose from without an annual fee that paying one seems like a waste of money. That, at least, is the conventional thinking. Some yearly payments of $550 or over are outrageous but appeal to those who enjoy the card less for the numerous benefits than the status symbol they provide.

If you have the time and desire, you likely can find credit cards with annual fees below $100. There is enough competition in the industry for you to find appealing rewards and money-saving perks that pay for the yearly fee. Just make sure that you will use these benefits. For most people, finding a competitive card with good perks and avoiding the annual fee is the better way to go.

9. Overspending For Rewards

Studies show that credit cardholders spend more when they use their card as compared to paying with cash. As such, this has been referred to as “the credit card premium.” Rewards offered by issuers are designed to encourage more spending in order to get more points or some other perk. Ever sit next to another table where the diners are actively comparing the points and rewards they have earned? I have, and often wish I could get a dollar for every time I did!

According to a recent survey from Coupon Chief, one in five consumers say the rewards are the best perk, ahead of 16% who responded that building credit was the most valuable benefit. More concerning, 52% of Americans don’t actively track their credit card points. Holders are attracted to getting something for free; however, they may be more costly to those shoppers who are tempted to impulse buys.

10. Fear Of Getting A Credit Card

You don’t have to get a credit card. A third of Americans don’t have one for a variety of reasons. They could be fearful of temptation to overspend, poor credit, or prefer an alternative to a credit card. I didn’t have a credit card for many years, and then I used it sparingly when I did. My parents never had a credit card and never accepted cards in their retail store.

Credit cards have many benefits, but ONLY if you use it responsibly as we discuss here. Don’t fear getting a credit card. Instead, learn how to pay balances in full and on time. Building credit is important as a means of borrowing money for buying a car or a house.

11. Don’t Get A Retail Store Card

The temptation of getting a store card often comes right at the point of purchase when the store clerk waves an application at you. “If you sign up today, you will get 10% off today’s purchase, Ma’am?” And, you say, “Sure, why not?”

Okay, let’s rewind that conversation so that you understand that retail store cards may be a mistake. A store card has limited use because you can only use it at that specific store or enterprise. That’s great for the specific merchant because they collect a lot of information to market daily offers to you.

Other merchants do not accept retail credit cards. On average, store cards charge higher APRs than credit cards, which are already high enough. The average APR for store-only credit cards was 24.06% in 2Q 2020 versus 16.03% for traditional credit cards, according to WalletHub.

They usually provide low credit limits, so you won’t get a big bang in credit availability to improve your utilization rate to hike your credit score. At the end of the day, retail credit cards have fewer benefits than traditional cards.

 

Final Thoughts

Creditworthiness is a valuable trait when you need to borrow money, or someone wants a good read of your character. Take steps to avoid common credit mistakes that will put you in good standing and help you raise your score. To be in good financial health, managing credit well is an important discipline. Develop and maintain good credit habits and keep your debt levels from overwhelming your life.

Thank you for reading! Please consider subscribing to The Cents of Money blog and receive our weekly free newsletter. Stay healthy!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Finding Income In A Low Yield Environment As The Pandemic Persists

Finding Income In A Low Yield Environment As The Pandemic Persists

“Cash is king” is an old expression that implies that this most straightforward form of money has the most significant merit for investments. Liquid assets are desirable for their ability to be easily be converted into cash in times of financial stress.

When the stock market tanked in March 2020 due to the pandemic impact on our economy, those with cash on the sidelines were able to grab stocks at battered prices and benefit substantially. Participating in the market has been a challenging year unless you were holding a growth portfolio. Finding income from low-risk investments has been somewhat limited since the Great Recession and has become more so this year.

The Role of The Fed

The Fed, through its monetary policy, took swift action to deal with the economic downturn. They brought down the fed funds rate to nearly zero and expanded our money supply through aggressive quantitative easing measures. These necessary actions caused market interest rates, already low since the Great Recession, to their lowest levels historically.  We have commented on the Fed’s role in our economy and its impact on the markets here.

If you are an income investor, the low yield environment has been frustrating to earn returns. Retirees, and those who are risk-averse, often favor income investing. However, income investing is for anyone who wants to balance the risk in their portfolio.

Income generation will likely be a key priority for many people. According to experts, income investors are confronted with low-interest rates today, limiting their returns. So what are their choices? They can be patient or consider adding some risk to the portfolio, which will add better returns. I have faced a similar dilemma, concerned about having too much risk while reaching for yield.

What Is Income Investing?

There are several investment strategies, such as growth, value, and income investing or a combination to give you a more balanced portfolio. We wrote about growth vs. stock investing here. Income investing centers on building a portfolio of investments that are structured to generate income in predictable streams.

The income comes from interest payments earned from having cash in a high yield savings account, interest from bond yields, and stocks’ dividends. Income investors seek low risk, low volatility, stability in their investments that generate income to replace earnings after retirement. An income investing-oriented portfolio may be too conservative to build a retirement fund for someone in their 20s or 30s who have longer time horizons and better tolerate risk.

A more balanced portfolio can combine investments that provide more growth combined with less risky investments. Such a portfolio could be a mix of money markets, Treasury securities, municipal, and high-grade corporate bonds. To add more risk, stocks with good track records for paying good dividend rates can be part of this balanced approach.

 

Macro Background On Interest Rates And Inflation

Interest rates, the amount charged by a lender to a borrower, are keyed off the Fed’s fed funds target set as one of its primary policy tools. When the economy is weak, the Fed reduces the fed funds rate to stimulate the economy, influencing other borrowing rates. Consumers, if incented with a lower mortgage or car loan rate, spend and borrow money. Related post:

 11 Reasons Why Investors Need To Understand The Fed

As the economy recovers and strengths, it may cause inflation to rise. If inflation is too high, the Fed will raise the fed funds rate to cool off the economy. Inflation is when there is a general and steady increase in the prices of a basket of goods and services. Inflation reduces your future purchasing power compared to the money you have today. We have been experiencing low inflation, below the Fed’s target of 2%.

How Interest Rates And Inflation Impact The Markets

Interest rates and inflation rates can have a significant impact on stocks, bonds, and other investments.  When interest rates fall, the interest payments received from bank deposits decline. The low-interest rates will cause lower yields from income-generating investments like CDs, other money market securities, and bonds. Income investors rely on these investments for predictable income streams and to preserve their capital, but higher yields are hard to find unless you add risk. There are different strategies for an investor to add more income by balancing risk and diversification.

 The low-interest-rate environment should remain for the foreseeable future. What about inflation? Low-interest rates, if they do their job in stimulating the economy, can lead to higher inflation. If there has been a concern, it has been about zero inflation or deflation. Deflation is problematic because it means reduced pricing in goods and services.  Lower prices could lead to reduced wages, lower production hurting our economy.

Trade-Off Between Risks And Returns

All investors need to consider the risks and returns for their investment choices. Typically, risks and returns are positively correlated. Moving in the same direction means that making low-risk investments is usually commensurate with low returns while taking high risks should be compensated with high returns.

Wouldn’t we all seek low-risk investments to be rewarded by high returns? Madoff’s high return strategy turned out to be a spectacular Ponzi scheme.

Low-Risk High-Return Strategies

I can point to a few legal low-risk high return strategies if you look for income generation from money in savings. Here are a few possibilities  that may be beneficial for your pocket:

Refinancing your mortgage may produce savings, net of fees if you are currently paying a higher mortgage.

Paying off high-cost credit card debt will provide positive returns if you are being charged double-digit rates and carrying balances.

Reduce or eliminate other consumer loans if you can refinance loans at lower rates.

Improving your credit scores ahead of planned borrowing may produce some savings.

Lifelong learners can seek out learning new skills or training that can bump their salary.

Various Risks To Consider When Investing

Before anyone becomes an investor, you should understand that all investments carry risks. There are no free rides, but you can protect yourself from the downside of losing hard-earned money. While you may not be able to control all the risks, there are ways that you can protect yourself from them. The ability to take on risk varies by individuals based on age, income, net worth, lifestyle, time horizon, family responsibilities, and tolerance.

Here Are Some Of The Potential Risks:

Interest Rate Risk

Interest rate risk is a risk that occurs when interest rates rise, causing bond prices to fall. Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.

All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer bonds have higher yields.

Inflation Risk

Inflation risk, also called purchasing power risk, is the danger that your money will not keep pace with inflation. As such, your money will be worthless in the future than today.   When investing for the long term, be aware that inflation may diminish your returns. Deflation risk has the opposite effect. The value of an investment will decline in the face of lower overall prices.

Opportunity Risk

Putting financial resources into a bank savings account does not generate much income when interest rates are low. Putting money in a low yielding bank account is saving, not investing. As such, you incur opportunity risk from not pursuing higher growth options. 

Credit Risk

Credit or default risk is the uncertainty associated with not receiving promised periodic interest payments and the principal amount at the time of maturity from the bond issuer.

Liquidity Risk

You cannot easily convert some assets into cash without losing value, which is liquidity risk. An asset quickly convertible into cash with minimal loss is liquid. Treasury securities are notable for having strong liquidity characteristics. However, other investments such as real estate or collectibles have greater liquidity risk.

Time Risk

Time or duration risk refers to assets like debt securities that mature at different times. Typically, the longer the term to maturity, all other things being equal, the greater the risk. For example, a two year Treasury note should provide a lower return than a 30 year Treasury bond.

Volatility Risk

Market volatility risk varies between securities and even within an asset class. Typically, high growth tech stocks are likely to be more volatile than a utility stock.

Reinvestment Risk

Reinvestment risk is the risk that the return on a future investment may not be the same as the return currently found on the same asset. If you rolled over a CD this year that you owned in 2019, chances are you would be doing it at lower returns.

Where To Find Yield In A Low-Environment

Seeking income in the current environment is a matter of considering your risk-reward profile when putting together an investment portfolio. Sitting down with a financial advisor can be hugely beneficial. They likely have years of experience and talk to many investors facing the same predicament as you.

To help your understanding of the possible investments available and the relative risk, from the low to high risk, here are choices:

High Yield Saving Account

Keeping your money in a traditional savings account will not provide you much interest based on an annual percentage yield (APY). However,  it is a better alternative to keeping your money in your checking account. That is just a recipe for spending more.

High yield savings accounts are preferred over traditional savings accounts as they are known for rewarding with higher yields. Bank accounts are FDIC-insured up to $250,000 per account, so there is no risk. Restrictions like monthly fees, minimum balance requirements, and withdrawals offset offers of higher yields. During the pandemic, banks may have relaxed limits. Shop around as there is plenty of competition where you can get 0.80-1.00% APY.

Certificate of Deposits or CDs

A CD is an interest-bearing saving instrument purchased for a fixed period from three months to eight years. Minimum deposits may range from small amounts up to $100,000. CDs are FDIC insured, like bank accounts. CDs have slightly higher yields than high yielding bank accounts. For the best rates, check Bankrate for their best and latest rates.

The longer the period, the higher the rate on the CD. You probably don’t want to subject yourself to a more extended period if you expect higher inflation in the future.

Banks often have minimums of $1,000 with fixed rates are fixed through expiration. If you withdraw your money, you will likely pay a penalty charge. There are variable CDs where rates fluctuate.

Money Market Securities

Money market securities are a mix of short-term debt securities and are also known as cash-equivalents. Like high yield bank accounts, they are liquid as they can be quickly convertible into cash with little or no loss of value. These instruments are issued at a discount to par value by various issuers, borrowing for their short term needs. These money markets generally mature in one year or less and trade in the secondary market.

Money market securities differ by the issuer. The US Treasury issues Treasury bills; corporations raise short term capital through commercial paper (CP), banks issue negotiable certificates of deposits or CDs). A banker’s acceptance security is created by a company’s transaction with another and guaranteed by a commercial bank should the firm fail to pay the amount.

MMDAs And Money Market Funds

Money market deposit accounts (MMDAs) are government-insured from a depository institution. They vary on the size of account balance, the number of transactions each month, minimum deposits to open and maintain. Alternatively, investment advisers offer money market mutual funds. Money market funds are uninsured like the MMDA, but they may be more flexible in their terms.

Keep in mind, the income from money market securities is historically low. For example, a six month T-bill currently yields just  0.12% today, tracking our very low-interest-rate environment. Indeed, it is virtually risk-free that short-term T-bills have been traditionally more attractive to hold in a higher interest environment. While it is better than keeping your money in zero-interest savings accounts, it is not much in our pandemic-world of 2020. Historically, T-bills return 3.5% per year. The other cash-equivalent securities tend to trade at slightly higher yields than T-bills in a relatively narrow range.

Besides low risk, money market securities are for those that prefer liquidity and easy accessibility to money, particularly great for your emergency fund.

In the early 1980s, these cash-equivalent securities were very attractive, providing double-digit high yields in the face of a tough economy with high inflation. Keeping at least a small amount of your savings in money market securities makes sense for low-risk low return investors, especially when interest rates rise.

Government Savings Bonds

Series EE and Series I government savings bonds are promissory notes issued and backed by the US Treasury. Income generated is exempt from state and local income taxes. These are low-risk investments with low rates. The Series is available online through Treasury Direct. They can be bought at denominations as little as $25 and often are as gifts. Series EE provides a market-based fixed interest rate, and Series I adjusts for inflation.

Savings bonds have a 30-year maturity and can be redeemed any time after 12 months (if issued after February 2003). However, holders will lose the last three months of interest. Investors can report the accumulated interest or defer until maturity.

Bonds of Varying Risk And Return

Like money market instruments, bonds are debt securities issued by the borrower at below par for a fixed face amount with a specific interest rate (called the coupon). The issuer pays the principal on maturity.

To calculate your annual income streams from the coupon, you would receive an annual interest income of $40 on a $1,000 corporate bond with a 4% interest rate, paid semiannually. 

Bonds provide predictable fixed income streams. Bonds vary in credit risk from the Treasury securities rated AAA to municipal and investment-grade corporate bonds rated BBB or better. There are also corporate bonds that provide higher yields than investment-grade corporate bonds. The high yield bonds are often called “junk bonds” because of their more risky nature.

When you invest in a bond, you are effectively lending money to the issuer instead of owning part of a company’s equity when you invest in a stock. In the event of a default, a bondholder has a priority claim as one of the company’s creditors.

Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.

All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer issue bonds are at higher yields.

Treasury Bonds Are Safe and High Quality

In addition to the short term T-bills, the US Treasury issues Treasury notes (intermediate-term) and treasury bonds (up to 30 years). With these bonds, the Treasury is borrowing for long term needs as well as retiring debt. Longer-term maturities carry more yield based on more risk than short term securities. Like money markets, Treasury yields are historically low given the Fed actions that brought down interest rates when the pandemic impacted our economy.

Treasuries are considered virtually risk-free versus the other debt securities because of their triple AAA rating. Treasury investors have confidence in the full faith and credit of the US Government,

Historically, T-bonds returned 5.5% per year, but today it yields about 1.67%. Treasuries represent quality, safety, excellent liquidity and are modestly tax-exempt (holders do not pay state or local taxes). The primary risk in Treasuries is that they are subject to interest rate and inflation risk. To counter inflation risk, TIPs or Treasury Inflation-Protected securities adjust rates with the inflation-indexed CPI. Variable bonds that adjust inflation rates are also available in most fixed securities, particularly munis and corporate bonds.

Treasuries are desirable for many investors, especially those seeking quality, safety, and capital preservation. Without inflation protection, a bondholder with a 4% interest rate is fine if inflation is 2% or below. However, at that same 4% rate, the investor will be losing ground on your returns if inflation increases to 5% or more.

Municipal Bonds Have A Unique Tax Benefit

 State and local governments or municipalities issue general obligation bonds or revenue bonds for general long term needs, debt paydown, or infrastructure projects based on shifting population growth and regional employment. Minimum denominations are $5,000, so they are attractive for individuals and households. Muni yields at 1.52% on a 30 year AAA bond is close to the 30 year T- Bonds. Municipal bonds have better tax benefits than Treasuries.

Tax Exemption A Big Plus

Owning a municipal bond has outstanding tax benefits. Muni holders have federal income tax-exemption, and sometimes even state and local taxes are exempt. As a result, your aftertax returns on these muni securities will be higher than treasuries and may exceed the returns of riskier corporate bonds.

These securities are attractive, especially if your marginal tax rate is above 25%.

While rare, there have been some notable defaults, such as in housing. The default risk is historically low, below 1%. Muni bonds are generally safe, second to Treasuries in safety. An excellent way to minimize risk is to buy a municipal bond mutual fund bundled with diverse muni securities.

Corporate Bonds: High Grade Or High Yield

Corporations issue debt instruments vary by their credit risk, growth prospects, and potential restructuring. The higher-quality corporate bonds are investment-grade bonds, rated triple BBB, or better. They generate low-to-moderate returns historically. Yield is impaired in these securities as well in 2020. Moody’s current yield for the highest quality (Aaa) corporate bond is 2.36% versus 3.02% a year ago.

Disappearing AAA Corporate Bonds

There are only two corporate bonds with the coveted AAA ratings left: Johnson & Johnson and Microsoft. In 1992, there were 98 companies with the highest credit rating. Companies started increasing debt levels associated with merger & acquisition deals, leveraged buyouts, restructuring, damaging lawsuits, and the Great Recession.

High Yield Corporate Bonds

For risk-oriented investors seeking higher returns, high yielding corporate bonds could provide attractive returns. These are corporate bonds below investment grade and vary significantly. However, you need to do your homework as you would when buying individual stocks. I would recommend buying a high yield bond mutual fund readily available through Vanguard or Fidelity. Being diversified is your best path to exposure to these risky instruments.

The riskier, higher-yield “junk” bonds have higher yields than high-grade corporate bonds. Historically, junk bond yields are 3%-7% higher yields than investment-grade corporate bonds. Default rates are higher for junk bonds, rising to the mid-teens rate during the Great Recession. Typically, debt-heavy companies that are restructuring issue junk bonds. Today, investors seeking higher yields may want to consider high yield bonds currently in the 3%-4% range, but; remember these bonds carry higher risk.

Holders of corporate bonds do not have any tax benefits like treasury and municipal bonds. These bonds tend to have pretax yields higher than their brethren. Historical corporate bond returns average about 6% per year, below the 9%-10% return of the common stock. As creditors, these bondholders have priority claims in the event of a default, which stockholders do not have.

Preferred Stock

Preferred stock is considered equity but shares characteristics with bonds and common stock. This security is a type of fixed income ownership security in a corporation. Like a bond, preferred stock may have call provisions and rarely provide voting privileges held by stockholders. Preferred stockholders receive fixed dividends per share and have priority claims after bondholders but before common stockholders receive dividends. The market price of preferred stock is sensitive to interest rates, like bonds.

The attraction to income investors is the regular dividend payments. Investors can rely on dividends. Sometimes companies skip payments, due to poor results, for example, but are eventually paid to the holders of cumulative preferred stock provisions. Preferred stockholders have priority claim over the common stockholders. The preferred stock carries a higher risk than traditional high-grade corporate bonds but less so high yield bonds or growth stocks. For income investors, preferred stock may be a good alternative.

Not every corporation issue preferred stock. Specific industries are known to issue preferred stock, such as financial institutions, telecom, energy, and utility companies. You can buy them individually though, for diversification purposes, buying ETFs like iShares US Preferred Stock ( 4.93% yield) or Invesco Preferred (5.49% yield) may be more desirable.

 Common Stocks With Strong Dividend Track Records

With the highest historical  S& P 500 annual returns of 9-10% relative to money markets and bonds, stocks (“equities”) are attractive instruments to own in your portfolio. However, they are too risky for most income investors.

Income Stocks

This group of stocks is classified as income stocks (instead of growth stocks) because they tend to grow less quickly but are relied on for above-average dividends consistently paid. These stocks tend to be less volatile because of the higher dividend yield, which provides an anchor.

Companies or stock groups with above-average dividend yields are  ATT, Verizon, Kraft Heinz, energy stocks, utility stocks, and REITs. Dividends from REITs, or Real Estate Investment Trusts, are substantial because they are required to distribute at least 90% of their taxable income to their shareholders annually. The average dividend yield for equity yields is above 4%, making REITs an attractive investment.

They are presumed to be safer, defensive, and slower-growing companies. One concern is whether that high yield is vulnerable to a cut in its dividend. Look for high-quality companies that have a history of paying above-average dividends.

Blue-chip stocks that pay dividends may be an excellent place to go for companies that have been around a long time and have track records. Not all blue-chip stocks pay dividends.

Dividend Aristocrats

Income investors may want to look at Dividend Aristocrat stocks. These stocks are an elite group of companies in the S&P 500 that paid and raised its dividend every year for at least 25 consecutive years. There are more than 60 companies on this list in 2020.

This subsector of above-average dividend-paying stocks is attractive for income investors. Coca Cola, Johnson & Johnson, Dover, Chevron 3M are in this elite group for more than 50 years.

Final Thoughts

Income investing is known for its predictable income streams and preservation of capital. Finding income in a low yield environment may be difficult these days. Adding some risk to a basket of government and corporate securities and income-oriented may be a good strategy. Remember to remain diversified in your assets.

Thank you for reading! Please consider subscribing to The Cents of Money blog and receive our weekly free newsletter. Stay healthy!

 

10 Tips To Diversify Your Investment Portfolio

10 Tips To Diversify Your Investment Portfolio

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”  Robert G. Allen

When you have some savings, it is good to invest and allocate your money to work.

Keeping too much of your money in your checking account is too tempting to spend and counterproductive.

The best time to begin investing is now—the earlier in your life, the better your wealth accumulation.

As you grow your savings, you want to consider your investment goals, risk tolerance, time horizon, and where to invest.

Investment Goals

How to invest and allocate may differ on a range of factors. You may adopt different strategies based on age, income, family responsibilities, lifestyle, financial resources, risk tolerance, and desires. 

 You are diversifying your portfolio by considering various asset classes: stocks, bonds, money markets, and real estate. We have some guidance for new and experienced investors: Investing Rules For Success-It’s Not Rocket Science!

At different points in your life, your priorities may be to realize one or more of the following objectives:

  • Buy your own home, finance your children’s education, take vacations, buy a car, or start a business.
  • Gain wealth and financial freedom.
  • Increase your current income or add some financial flexibility.
  • Meet your retirement needs.
  • Preserve your capital.
  • Set risk tolerance

There are degrees of risks for all types of investments. The exception is when you keep all your money in savings accounts in the bank where they are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per person and per bank account. However, you will earn little to no money.

Risk and reward, sometimes referred to as your return, are positively correlated. The risk/return relationship means that higher returns come with greater risk, while low-return investments come with low risk.

Investment Horizon

If your time frame is short given your age or needs, you may want to opt for low-risk securities versus someone who can invest for a 20-30 year horizon. They can better absorb risk and volatility.

 10 Tips For Diversifying Your Investment Portfolio:

#1 Asset Allocation

You should distribute your money among different assets based on your age and lifestyle. You can afford more risk in your portfolio at a younger age and be aggressive with more growth, such as stocks, than someone closer to retirement age. A good rule of thumb for allocation is to subtract your age from 100, and that would be the percentage of stocks in your portfolio.

For example, a 30-year-old could keep 70% in stocks (100-30) in the portfolio with 30% in bonds. On the other hand, a 60-year-old should reduce risk exposure and have 40% in stocks and 60% in bonds.

#2 Diversification Is A Must

Don’t put all of your eggs in one basket. Instead, you should be distributing your money among various classes of securities using an appropriate allocation. You should diversify within each security class. Investing in 10 energy stocks is not diverse. Branch out into multiple industries with different characteristics (e.g., high growth and strong dividend history).

# 3 Growth Stocks

Stocks provide more growth, appreciating faster than other financial instruments over the longer term. However, the stock market can be volatile, as witnessed by the 57% decline during the Great Recession. It is a good idea to buy mutual funds or ETFs when you are first investing to achieve a diverse stock portfolio.

#4 Money Market Securities for Cash

Investors can easily convert money market securities into cash without loss of value. They are low risk/ low return instruments with liquidity, stability and provide access to money. The Treasury bills rated AAA are the closest to risk-free securities. They can be bought individually or as part of a MM mutual fund, including other short-term securities.

While these securities are known for safety, they do not provide much income. The Fed has battled the COVID-impacted recession in 2020.  They reduced the fed funds rate to virtually zero and used aggressive measures. As a result, its needed actions have extended the low yield environment, challenging investors to find income from low-risk securities.

#5 Bonds With Different Characteristics

Investing in bonds is desirable for more predictable income streams. It is desirable to invest in various bonds: treasury bonds, municipal bonds, and corporate bonds. These all differ in terms of credit risk, liquidity, and tax benefits.

#6 Buy-Hold Strategy and Don’t Be Greedy

It is a prudent idea when building an investment portfolio to use a buy-hold strategy rather than trading securities. That said, don’t be afraid to pare down a holding that has appreciated too fast or begins to occupy a more significant proportion than you prefer. An old Wall Street saying is: “Bulls make money, bears make money, pigs get slaughtered.” I mean, don’t be greedy.

# 7 Understand factors that impact the financial markets

You should know the role of interest rates, their connection to inflation, and how the Federal Reserve’s monetary policy can significantly impact the financial markets. To calm the markets, the Fed stepped in with substantial liquidity to combat the economic downturn caused by the pandemic in 2020. The Fed reduced already low-interest rates, making it hard to find income for savers and risk-averse investors.

#8 Have Some Exposure to Global Markets

Investors seek potentially higher returns and exposure to faster-growing global markets, especially when the US markets are experiencing weakness. The best way to do that is to find an ETF or mutual fund representing the exposure you want.

# 9 Start Early To Benefit From Compound Interest

The earlier you begin to save and invest for retirement and investment accounts, the longer the time to take advantage of the power of compound interest.  Start in your 20s. Find a compound interest calculator, plug in some numbers, using what you can set aside monthly for investing.

Use a reasonable return (don’t use 12%, which I have seen and find it challenging to achieve. Instead, try 7%) and provide the number of years you have until your retirement.

# 10 Rebalance Your Portfolio Periodically

It is essential to periodically review your investment portfolio and consider rebalancing the various assets. Review it annually and make changes based on significant life milestones. Meeting with your financial advisor or accountant is an excellent way to review where your investments stand relative to you and your lifestyle.

Different Asset Classes

Common Stocks

With the highest historical  S& P 500 annual returns of 10% relative to money markets and bonds, stocks (“equities”) are attractive instruments to own in your portfolio. Investing in stocks is among the best ways to build wealth.

Common stocks represent equity ownership in a publicly-traded company or business enterprise. Your holdings reflect the number of shares you have. As common stockholders, you have voting rights on major company issues determined by your fractional share amount.

These equity shares are different than money market and bond securities, commonly referred to as debt securities. Owners of these instruments have creditor rights and do not vote like equity owners.

The Wealthy Get Wealthier, But You Can Get Rich Too

A recent study by the Federal Reserve in 2016 found  51.9% of families owned stocks either directly or as part of a mutual fund for investment and retirement accounts. However, the distribution of stock ownership by wealth percentile shows that the top 10% hold 84%, the next 10% have 9.3%, and the bottom 80% save 6.7%, according to a 2017 paper published by NYU Professor Edward N. Wolff.

Asset Allocation And Diversification

Recognize the challenges of investing. I have been an investor, an equity analyst, and I teach finance courses in college. As part of their requirements, students develop diverse stock portfolios using the stock market game. To a great extent, I share my experiences and mistakes during the bull and bear markets. Nothing prepares you for the next great crash as we had in March 2020. The unexpected pandemic of 2020 caused substantial market volatility.

Many factors impact the stock market. Investors should have a basic understanding of the economy, differences between industries, and company fundamentals. You need to understand the basics when investing on your own instead of having a financial advisor or buying mutual funds.

Learn about the differences between stocks, bonds, money market securities, and other asset classes. Be aware of what you own, whether it is individual stocks, or through mutual funds in your portfolio, setting up a  529 Savings Plan, or as part of your retirement accounts. Stocks tend to generate high returns but naturally carry higher risks and volatility than money markets and most bonds.

How To Determine Your Allocation

You need to manage the risk with a balanced portfolio with assets distributed among stocks, cash-equivalent securities, bonds, and real estate.

Generally, a stock allotment guideline in your total portfolio considers your age deducted from 100. So if you are 30 years old, you should invest 70% of your portfolio in stocks with the rest in a mix of money markets and bonds. The 70% percentage is conservative and can go higher to 80% allocated to stocks.

However, a typical 60 years old’s portfolio should divide their ownership more conservatively: 40% in stocks with 60% in bonds and money markets.

Diversification is essential and your best means for reducing risk.

Holding a broad stock portfolio, along with a variety of bonds and money market securities, smooths out the bumps you encounter. Investing at an early age helps to weather the ups and downs in the financial markets and benefit from the compounding of returns long term.

Once the shares are publicly issued, they typically trade on the New York Stock Exchange or the NASDAQ. The stakes are accessible for all investors to buy and sell. If they are privately issued, they are closely-held, usually by a small group of individuals who may be founders or families owning a substantial part of the business.

Stocks tend to be the most common investment vehicle for households, either through tax-advantaged retirement accounts or taxable investment accounts.

Active Versus  Passive Investors

Individuals and households can be active investors by buying the shares outright through brokerage accounts or Robo-advisors, thus becoming direct owners. Alternatively, as passive investors, they can buy mutual funds and exchange-traded funds (ETFs) representing indirect ownership of publicly traded shares.

If you are just beginning to invest and have limited resources and research time, consider buying a mutual fund or ETF.  Exposure to only one or two individual stocks is too risky.  I have different types of funds you can search for just below. Funds or ETFs will provide you with a more diversified basket of securities from the get-go. Later on, if you want to become more active, you can do your stock picking.

Those with more assets often have access to private money managers and hedge funds. Their fees are often higher than low index mutual funds and ETFs without necessarily providing higher returns.

Dividend income, dividend growth, and stock price appreciation determine stock returns. Related Post: How To Start Investing: A Guide For Investors

Choose from the different types of funds (or ETFs) that might fit your needs:

#1 Company market capitalization.

From large-cap company stocks with a capitalization of $10 billion to midcap stocks from $2 billion up to $10 billion range; and small caps of less $ 2 billion.

#2 Industry Sector.

You may be seeking one or more industries with different characteristics to counterbalance your portfolio. Adding tech, consumer discretionary, industrial, and finance companies would diversify risk.

# 3 Value stocks

Value stocks are stocks trading below their intrinsic value compared to their fundamentals. Benjamin Graham is the founder of this type of investing. Warren Buffett and Charlie Munger favor these strategies for their Berkshire Hathaway portfolio. Examples of value stocks are General Motors, GE, and Philip Morris.

# 4 Growth-oriented

Above-average growth comes with higher risk. These stocks appreciate at higher rates above the average for the market but don’t always pay dividends. Growth companies tend to plow their cash flow back into their business rather than pay dividends. A few examples of growth stocks are Amazon, Tesla, cloud companies like Salesforce, biotech stocks.

#5 Blended funds

A combination of value and growth stocks can offset some of the risks in # 4. 

#6  Dividend Growth Stocks

This group contains companies that have above-average dividend yields like ATT, British Petroleum, REITs. They are presumed to be safer, defensive, and slower-growing companies. Look for high-quality companies that have a history of paying above-average dividends. These names provide less risk but provide exposure to stocks.

# 7 Dividend Aristocrats

An elite subsector of above-average dividend-paying stocks not only provides above yields but are known for 25+ years of dividend increases. Chevron and PPG Industries are in this select group.

#8 Balanced

An investment portfolio should have a mix of different asset classes with fixed income and equity to help you achieve asset allocation.

#9 Index To A Specific Market Benchmark

It is difficult for the best portfolio managers with the expertise to “beat the market.” These funds track market indexes’ performances like that of the S& P 500 or the Russell 2000 for smaller cap stocks. These are prevalent ways to participate in the stock market.

# 10 Target Date Funds

These mutual funds adjust the asset mix based on your age and retirement plans. Vanguard has many funds labeled by decade eg. “2040.” They are appropriate for 529 Savings Plans and 401K retirement plans and a taxable investment portfolio.

# 11 Domestic or Global Markets

Suppose you may want to add international exposure to a mostly domestic-only portfolio for higher growth, especially if the USS is experiencing weak or recessionary growth. Several funds provide equity or mixed (including bonds) basket of companies in many countries, regionally oriented like Asia, or specific markets like China or India.

#12 Specialty funds

Gaining in popularity are specialty funds that contain stocks that represent companies with strong social responsibility or sustainability. ESG funds are portfolios of equities or bonds which address environmental, social, and governance factors into the investment process.

Money Market Securities

Money market securities are debt securities and are also known as cash-equivalents because investors can quickly convert them into cash with little or no loss. These instruments are issued at a discount to par value by various issuers, borrowing for their short term needs. These generally mature in one year or less and trade in the secondary market.

The US Treasury issues Treasury bills; corporations raise short term capital through commercial paper (CP), banks issue negotiable certificates of deposits or CDs). A banker’s acceptance security is created by a company’s transaction with another and guaranteed by a commercial bank should the firm fail to pay the amount.

T Bills or Money Markets Account

Individuals and households would largely buy the more popular T-bills with minimum denominations of $1,000. Individuals can buy a pool of money markets as an FDIC-insured money market denominated account (MMDA) or money market mutual funds. The investor would be holding a bundle of different money market securities, including Euro CDs issued in US dollars by European banks at higher yields is often in the funds.

On their own, the other money markets have higher denominations ($100,000) and are out of reach for the average household. Institutional investors often own or trade these securities.

For example, a six month T-bill currently yields just  0.12% today, tracking our very low-interest-rate environment. Indeed, it is virtually risk-free security but has been more attractive to hold in a higher interest environment. While it is better than keeping your money in zero-interest savings accounts, it is not much in our pandemic-world of 2020. Historically, T-bills return 3.5% per year. The other cash-equivalent securities tend to trade at slightly higher yields than T-bills in a relatively narrow range and low yields.

Besides low risk, money market securities are for those that prefer liquidity and easy accessibility to money, particularly for your emergency fund. Today’s yields are significantly lower than historically based on the Fed’s actions to combat the pandemic’s effects on our economy. 

In the early 1980s, these cash-equivalent securities were very attractive, providing double-digit high yields in the face of a tough economy with high inflation. Keeping at least a small amount of your savings in money market securities makes sense for low-risk low return investors, significantly when interest rates rise.

Older investors should be reducing their exposure to risky stocks and placing more of their portfolio in these securities and bonds

A Variety of Bonds

Like money market instruments, bonds are debt securities issued by the borrower at below par for a fixed face amount with a specific interest rate (called the coupon) and a specific maturity date when the issuer pays the principal.

To calculate your annual income streams from the coupon, you would receive an annual interest income of $40 on a $1,000 corporate bond with a 4% interest rate. The payment is paid semiannually or $20 every six months.

Bonds provide these predictable fixed income streams. Bonds vary in credit risk from the Treasury Bonds rated AAA to munis and corporate bonds with varying debt levels. There are also corporate bonds with high yields, so-called “junk bonds” because of their risky nature.

When you invest in a bond, you are effectively lending money to the issuer instead of owning part of the equity of a company when you invest in a stock. In the event of a default, a bondholder has a priority claim as one of the company’s creditors over stock ownership.

Relationship between bond prices, interest rates, and inflation

Bond prices and their yields have an inverse relationship, moving in opposite directions. When there is a high demand for bonds, bond prices rise, yield declines, and vice versa.

All money market securities and bonds have interest rate risk. As interest rates rise, the market value of existing debt securities tends to drop because newer issued bonds hav higher yields.

Warning: A Mini Macroeconomic Lesson For You

These securities also have inflation risk. There is a close connection between interest rates and inflation. Inflation refers to the rate at which prices for goods and services increase, reducing our purchasing power.

As inflation increases, so do interest rates. Interest rates, of course, are the amount charged by a lender to a borrower. The federal funds (“fed funds”) rate set by the Federal Reserve influences interest rates.

The fed funds are the interest rate at which depository institutions borrow and lend each other from their reserve balances overnight. That rate influences different interest rates, such as the prime rate, mortgages, and auto loan rates.

When inflation rises above the targeted 2% rate, the Fed, through its monetary policy, will raise the fed funds rate to stem inflation from going higher.

Related post: 11 Reasons Why Investors Need To Understand The Fed

As a bond investor, you don’t want your bonds to erode in value because of other bonds’ availability sporting higher yields. Issuers of Treasuries, municipal and corporate bonds know this so that they will offer inflation-indexed or protected securities. The yields on these bonds will adjust according to a formula linked to an inflation indicator like the Consumer Price Index (CPI).

Without that protection, a bondholder with a 4% interest rate is doing fine if inflation is 2% or below. However, at that same 4% rate, the investor will be losing ground on your returns if inflation increases to 5% or more.

Minimum denominations range from $1,000 for Treasuries, $5,000 for municipal bonds, and $1,000 or $5,000 for corporate bonds.

There are several different types of bonds with notable risk differences.

Treasury Bonds Are Safe and High Quality

In addition to the short term T-bills, the US Treasury issues Treasury notes (intermediate-term) and treasury bonds (up to 30 years). With these bonds, the Treasury is borrowing for long term needs as well as retiring debt. Longer-term maturities carry more yield based on more risk than short term securities.  Like money markets,  Treasury yields are historically low given the Fed actions that brought down interest rates when the pandemic impacted our economy.

Treasuries are considered virtually risk-free versus the other debt securities because of their triple AAA rating. Treasury investors have confidence in the full faith and credit of the US Government,

Historically, T-bonds returned 5.5% per year though they too are lower these days. Treasuries represent quality, safety, excellent liquidity and are modestly tax-exempt (holders do not pay state or local taxes). The primary risk in Treasuries is subject to interest rate and inflation risk. TIPs or Treasury Inflation-Protected securities are in demand as they adjust rates with the inflation-indexed CPI.

Treasuries are desirable for many investors, especially those seeking quality, safety, and capital preservation.

A True Story

I recall a story early in my Wall Street career when a friend of mine, a trader, had received an eight-figure bonus at the end of the year.

Curious, I asked what he was going to invest in with his bonus? With little hesitation, he practically yelled out, “Treasuries, of course!”

I was a stock analyst, and being surprised at his choice, I asked him why and he said, “Treasuries are safe, I have young children, I have all that I need, and I spend modestly, save abundantly, I donate generously, and I am risk-averse.”  That made more than a modest impression on me.

Municipal Bonds Have A Unique Tax Benefit

State and local governments or municipalities issue general obligation bonds or revenue bonds for general long term needs, debt paydown, or infrastructure projects based on shifting population growth and regional employment. Minimum denominations are $5,000, so they are attractive for individuals and households.

Tax Exemption A Big Plus

One of the outstanding benefits of owning a municipal bond is favorable tax treatment. Muni bondholders have federal income tax-exemption, and sometimes even state and local taxes are exempt. As a result, your aftertax returns on these muni securities will be higher than treasuries and may exceed the riskier corporate bonds.

These securities are attractive, especially if your marginal tax rate is above 25%.

While rare, there have been some notable defaults, such as in housing. The default risk is historically low, below 1%. Muni bonds are generally safe, second to Treasuries in safety. An excellent way to minimize risk is to buy a municipal bond mutual fund bundled with various muni securities.

Corporate Bonds: High Grade Or High Yield

These debt instruments issued by corporations vary by their credit risk, growth prospects, and potential restructuring. The higher-quality corporate bonds are investment-grade bonds, rated triple BBB, or better. They generate low-to-moderate returns historically. Yield is impaired in these securities as well in 2020. Moody’s current yield for the highest quality (Aaa) corporate bond is 2.32% versus 3.02% a year ago.

Disappearing AAA Corporate Bonds

There are only two corporate bonds with the coveted AAA ratings left: Johnson & Johnson and Microsoft. In 1992, there were 98 companies with the highest credit rating. Companies started increasing debt levels associated with mergers & acquisition deals, leveraged buyouts, restructuring, damaging lawsuits, and the great recession.

High Yield AKA Junk Bonds

For risk-oriented investors seeking higher returns, high yielding corporate bonds could provide attractive returns. These are corporate bonds below investment grade and vary significantly. However, you need to do your homework as you would when buying individual stocks. I would recommend buying a high yield bond mutual fund readily available through Vanguard or Fidelity. Diversity is your best path to exposure to these risky instruments.

The riskier, higher-yield bonds may be called “junk” bonds. Historically, junk bond yields are 3%-7% higher yields than high-grade corporate bonds. Default rates are higher for junk bonds, rising to the mid-teens rate during the Great Recession. Debt-heavy companies or those restructuring often issue junk bonds. Today, investors seeking higher yields may want to consider high yield bonds in the 3%-4% range but carry higher risk.

Drexel Burnham And Michael Milken

The earliest part of my career began at Drexel Burnham, known for developing high yield bonds by Michael Milken and his role in that market. That high yield market ultimately forced the company into bankruptcy. Mixed thoughts aside, many companies I covered as analyst survived and prospered due to those high yield bonds.

Holders of corporate bonds do not have any tax benefits like treasury and municipal bonds. These bonds tend to have pretax yields higher than their brethren. Historical corporate bond returns average about 6% per year, below the 9%-10% return of the common stock.  Bondholders are creditors who have priority claims in the event of a default, which stockholders do not have.

Rebalance Your Portfolio Periodically

It is essential to review your portfolio periodically and make sure it is balanced for your life. When you are young, you should take some risk given your longer investment horizon. As you grow older, you want to reduce risk by shifting more into predictable income streams.

Thank you for reading!

Have you reviewed your portfolio? Is it diversified enough? It is a good idea to work with a financial advisor or professional when considering changes. What strategies have worked for you? Please share your comments as we love to hear from you!

 

A Silver Lining To The Pandemic

A Silver Lining To The Pandemic

It has been hard to be optimistic as the coronavirus outbreak has devastated many families. We have been forced to change our ways of living in a hurry. Job losses are high and haven’t finished climbing. Small businesses are struggling or having to close. Difficulties vary by socioeconomic class with those of modest means hit the hardest. The gaps in broadband connectivity have become more apparent during the pandemic.

Yet, there may be a silver lining for us whether as individuals or society. In any disaster, silver linings may emerge from the gloom and doom. Find the brightest part of your day even during this crisis. We found 8 positive aspects that may have lasting benefits:

1. Saving Money

Many Americans have reduced their discretionary spending habits as our lifestyle has adapted to the coronavirus outbreak. We stopped going to restaurants, reduced our impulse shopping, and deferred purchases. Many people have paused gym memberships, canceled vacations, used far less gas, and saved on tolls. By not traveling to work daily, I have realized about $1,500 in savings just by working from home.

Lower Discretionary Spending

Retail sales in the US have dropped 16.4% in April. With lower retail sales, US credit card spending fell 40% during March and early April according to JP Morgan. These numbers are not a surprise. On the other hand, spending on essentials is up 20%. This coincides with our experience. By staying home, we probably saved about $1,500 exclusivity on r meals. I have cooked virtually every day for our family of four. Normally, we tend to eat out with friends or family several times a week. Naturally, our grocery bills are higher than during normal times. Overall, we spent less.  I know we are not alone in saving money. According to a Fidelity Market Sentiment study, Americans have lowered discretionary spending by 48% during COVID-19.

The CARES Act Has Provided More Benefits

The CARES Act and other government programs have provided more money for those experiencing financial hardships. For those who lost jobs, there were higher unemployment benefits and stimulus checks. The Act is allowing pauses on student debt and mortgage loans for a few months. Landlords and credit card providers have been more amenable to deferring or modifying their charges. With reduced driving, try to negotiate lower rates on car insurance. You may be able to get to reasonable discounts on other services.

Now maybe a golden opportunity to reset your financial priorities. Try to use some of the savings from reduced spending, added benefits, and pauses in debt for emergency purposes. Put some of these savings to work to reduce your debt. This pandemic took us all by surprise. Build up your emergency fund if you can. A large number (44%) of Americans are boosting their emergency funds.

2. Distance Learning Became More Widespread

The Covid-19 pandemic has proven to be a boon for distance learning as schools of every level were forced to close.  Over one-third of post-secondary students took at least one online class pre-pandemic according to NCES during 2018-2019. Roughly 65% of higher education students, including graduate levels, had not enrolled in any distance education. However, as students were sent home from campuses, online learning platforms were available in a variety of formats. Faculty took the lead in instituting technology to mirror the traditional classroom.

These platforms require two-way communications, content delivery, and permit instructors to assess student work. Formats such as Blackboard Collaborate, Zoom, and Webex supported those needs. Distance learning was a hasty move for many but a great alternative to losing the opportunity for education. As a professor at our community college, I prefer the traditional classroom. However, I was encouraged and motivated by my students’ adaptability to the situation. As a result, I wanted to help them as much as possible given the circumstances.

A Good Experience Given The Circumstances

I found some notable benefits using the online learning environment. The platform was flexible, providing for sharing materials like power points, videos, and other learning materials. Student interactivity would vary but even the shy spoke up more than previously. Learning online requires students to be more self-disciplined. Most students rose to the occasion. More students came on time and chatted more in class discussions. The experience can only improve with better planning for remote learning. With more time, faculty can develop more content conducive to the online platform.

Related Post: The Virtues of Online Learning: A Personal View

Our class met online synchronously. We didn’t have a choice when the coronavirus disrupted our traditional classroom. Synchronous learning means that online classes meet in real-time at a set time. A popular alternative to this is asynchronous online classes which do not occur at the same time. For undergraduate students, I prefer the synchronous mode which provides some structure like the meeting time

Expand Broadband Connectivity

It was easy to empathize with all college students. The abrupt departure from campuses during the middle of the term was frustrating. Many lost their work-study programs,  potential internships, and job interviews. That’s not all. Many students headed to homes lacking broadband connectivity and computers. Lacking the ability to connect to others exists for parts of our student population–Native Americans, rural and poor communities. Previously they depended on schools for their Internet and computer needs. However, even libraries were also closed when they returned home.

To expand connectivity to more people, the FCC has created “Keep Americans Connected.” Hundreds of major broadband providers, companies, and organizations have signed a pledge until June 30th to offset the coronavirus impact on Americans. They will:

  • waive any late fees incurred by residential or small business customers;
  • not terminate service to these customers because of their inability to pay bills due to the pandemic; and
  • open its Wi-Fi hotspots to anyone who needs them.

This will only be a short term measure to fill the broadband gaps that exist for many American communities.

3. Remote Working Became Essential

Prior to the pandemic, there was a lot of employer resistance to allowing employees to work from home. Like distance learning, the need to keep organizations running resulted in more people working from home. The latest Gallup poll reported that 62% of employed Americans say they have worked from home. This is a doubling of the previous rate since mid-March. Of those surveyed, nearly three out of five employees want to continue to do work remotely as lockdowns are removed. However, 41% prefer to return to their workplace.

Both employers and employees have found benefits, such as flexibility, independence, and better engagement. Remote work boosts productivity with employees being 35-40% more productive than at the office. Cost and time savings for the employees and organizations have been realized. Employers will want to continue some of the huge savings from reduced travel, hotels, conferences, car rentals, and meals out with clients. Employees may feel the same way about the inordinate amounts of time spent traveling away from home. Video conferencing appears to have worked well. Fewer face-to-face meetings may be the new normal.

Related Post: Coronavirus: A Tipping Point For Rising Flexible Work Options

4. Telehealth Usage Rises

Telemedicine has been viewed as a technology tool to provide greater health care access to vulnerable populations. However, usage has grown at a slow pace with only 9.6% of consumers using telehealth. Remote consultation is in lieu of a doctor’s office, urgent care, or emergency room according to a JD Power report in 2019. Younger people ages 18-to-24  have used telehealth the most (13.1%). On the other hand, seniors (5.3%) are the least likely to use the service than any other age group. Slow adoption was likely due to a lack of awareness and urgency.

That was then. Things changed dramatically with COVID-19. The health crisis has created not just an awareness but an urgency for patients to turn to telemedicine. Remote consultation has been encouraged by medical professionals who themselves want to remain healthy. Hospitals and urgent care facilities have been overwhelmed and their health care workers have been spread thin by the crisis.

The American Medical Association has updated guidelines for telemedicine in practice to help physicians swiftly ramp up their capabilities to care for patients. During this crisis, states have allowed more flexibility and discretion related to HIPAA Privacy rules.

Those who provide telehealth services report that growth has skyrocketed. There is no doubt that the coronavirus produced a boon for the services given greater awareness and need. People who have non-coronavirus ailments have increasingly used video consultations with doctors rather than going to medical facilities. This growth trend is likely to continue beyond the crisis.

5. Virtual Living Provides Greater Inclusivity

With all of these remote offerings–distance learning, work-at-home, and telehealth–virtual living may provide more inclusivity. Vulnerable populations, such as the poor, ill, disabled, and senior communities, may be able to participate as never before. For many, physical attendance at colleges, work, churches, religious, and cultural institutions may be nearly impossible. On the other hand, increased virtual offerings will make cultural events and facilities more accessible and affordable to an expanded population. These offerings can be limited only by our imagination and include Shakespeare, theatre, dance, museums, opera, and concerts.

The disabled population often needs greater accommodation in the workplace. Increased remote working may provide more opportunities for those who can more easily work from home as technology platforms improve and expand. Virtual living will require better broadband connectivity for all.

6. Finding Environmental Benefits

As a result of the dramatic drop in train, plane, and automobile traveling (my favorite movie!), environmental benefits have been reported globally. An unprecedented decline in emissions has been reported due to reduced oil demand. For the first time in history, US crude prices per barrel dropped to below zero. Oil producers actually paid others to take their barrels away because they did not have enough storage available. Improvements in our environment with reduced pollution have been cited. National Resources Defense Council pointed to some people in India being able to actually see the Himalayas from afar due to less pollution.

As more people stayed home, noise pollution has been lessened. Appreciating nature and wildlife has been a benefit for humanity. The big question is how long will an improved environment remain? It should be for all time as some of us may be experiencing these beauties for the first time. Even China, among the most polluted countries, saw improvements. As a direct effect of coronavirus and the reduced driving and fewer factories in operation, China’s skies became clearer.  Levels of nitrogen dioxide, a pollutant caused by burning fossil fuels, were down as much as 30% over China according to NASA. It remains to be seen if these benefits last as economies open up globally and cars return to the road.

7. FDA’s Accelerated Time For Drug And Testing Approvals

The US Food and Drug Administration  (FDA) has been expediting its review process of diagnostic and antiviral drugs since the COVID-19 pandemic. It has been providing more flexibility to develop and offer tests to combat coronavirus. The FDA’s timeline has shortened as it works with test developers and laboratories. They are using a relaxed standard, Emergency Use Authority (EUA). The EUA allows tests to be made available based on less data.

The FDA has accelerated its drug approval process over the past four decades. Using the “Accelerated Approval” pathway established in 1992, drugs for serious or life-threatening conditions can get a green light from the FDA with less evidence. To some, this may mean weaker evidence and more risk.

However, not all drugs are going on the fast track. The coronavirus event is a perfect example of why the FDA’s accelerated approval process is needed. A 2018 MIT study reported that nearly 14% of all drugs in clinical trial eventually win approval from the FDA. If you ever had a loved one with metastasized cancer, you would know the importance of the faster process providing access to a new treatment to slow tumor growth.

8. Express Gratitude To Your Communities

This coronavirus pandemic has been a difficult event. It is not over yet. Staying home with our families within our town has shined a light on the importance of being part of the community. We recently moved from Manhattan to a small community. During the outbreak, I felt like I had one foot in two different communities. From the 7 pm daily banging of pots and pans for health care workers in NYC to the outpouring of communal concern for shuttered shopkeepers and restaurants, we all are expressing our gratitude for others in our lives.

Expressing gratitude has a number of benefits, all healthy. It certainly beats anger and frustration. Hopefully, this pandemic is a one-time event worthy of sharing with your children and grandchildren.

Final Thoughts

The coronavirus outbreak has been a hardship. However, silver linings can sometimes emerge out of such crises.  As a society, we were forced to go online for learning, work, and health care. The digital divide among certain communities have become more apparent. We need more broadband connectivity to level playing fields across the country. By staying home, we may have realized some savings that can be used to reduce debt and/or be put aside for emergency purposes. Due to the coronavirus, our environment appears to have improved at least temporarily. Finally, let us share our gratitude with so many who paid a higher price to keep us safe.

Thank you for reading! We appreciate you taking the time to do so. If you found value in this post, subscribe to our weekly newsletter and become part of our community.

Coronavirus: Protect Your Finances And Your Future

Coronavirus: Protect Your Finances And Your Future

“When we are no longer able to change a situation, we are challenged to change ourselves.”

Viktor E. Frankl, Man’s Search For Meaning

Our values are tested during a crisis. We have learned that we need to make certain changes to our lives. As such, we have adapted our social relationships, our working lives, distance learningl to preserve our health and that of our communities. Crisis breeds uncertainty which none of us like. We don’t know how long this crisis will last before we can go back to normal. What is certain is that there will be more crises in our future.

To better deal with the anxiety, focus on what you can control and be true to your long term values. Use this time to reflect on what is important to you and your family. Take measure on what you have learned during this crisis about yourself. Some of the adjustments we are making will be transformative. Besides healthy handwashing, maybe you have experienced telemedicine, distance learning or remote working, options that are likely to grow.

Increased Financial Stresses

Many families are realizing greater financial stresses during this pandemic. The economy is in a downfall, financial markets may not yet have bottomed, and job losses are rising.Take some steps to review and strengthen your financial priorities and goals.

After all, April is Financial Literacy month. COVID19 has provided new meanings to our money values. While not all of our goals relate to money, it may be more about what you value. You may need better habits to accomplish your goals. Consider what changes you can make as a result of this crisis.To better achieve our short term and long term financial goals, we need better habits.

7 Steps To Improve Your Finances:

 

 

1. Emergency Fund Is A Necessity

Building an emergency fund for unforeseen events is essential. The coronavirus is a black swan event of major magnitude. A black swan event by its very nature is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. We have had major flu outbreaks but the impact of COVID19 brings more comparisons to the Spanish flu in 1918.

While no one could have predicted this pandemic, we should always have access to liquidity to pay for our basic living expenses. Establish an emergency fund of at least 12 months of your living expenses and learn where to invest it. Your fund should be a big enough cushion to pay your monthly bills and costs such as food, rent or mortgage, utility, health care, car, property taxes, and pet care. Previous guidance of 3-6 months seems woefully inadequate during these times.

This is not wasting assets as some think. Instead, it is preserving your future assets prudently. Without such a fund, you may have to borrow to pay your rent and other basic needs. File for unemployment insurance in your state which has been boosted in your state. Plow any incremental savings into your fund.

2. Make Savings A Habit

Yet we all have excuses as why we don’t need to set up an emergency fund account. You believe you have a stable job, your parents will help you out or you can always use your credit cards. You may not be able to fathom putting one month of savings, let alone the recommended one year of basic living expenses  in an emergency fund. It could simply be that you are procrastinating and intend to have one. Unfortunately, you can’t time your financing needs for the unexpected times you need cash.

Start saving a little at a time. Saving is always a good financial habit. You should budget for 10%-20%  of your income to go into savings. Part of those dollars should go towards unexpected needs. With social distancing (really physical distancing), you are likely to find that you have more savings because of less entertaining, not eating out and canceling vacations.

Life will eventually go back to normal, hopefully soon. Why not put some of those savings into your emergency funds? The rest of thost funds should be distributed to paying down debt, ongoing retirement contributions and careful investing in the market. Here are some ways to save without changing your lifestyle significantly, ” 25 Ways To Save Money And Feel Good About It.”

3. How To Pay Off Debt

As a result of the coronavirus, there may be some help regarding different kinds of consumer debt. Recently, government actions have added some flexibilities for temporary forbearance or payments of student loans, mortgage loans, personal loans, car loans, or possibly credit cards. Additionally, if you own a small business with less than 500 employees there may be benefits for the owners and employees if you abide by restrictions. However, you need to understand what the rules are. For example, there may be mortgage relief associated with the coronavirus. Now would be a good time to refinance your mortgage and othr debt at lower rates.

Check These Resources For Help

However, it is best to take a look at the Consumer Finance Protection Bureau for advice. Take a look at the Small Business Administration or SBA website for their guidance, especially for disaster loans if you are a small business owner. Those who are having trouble paying your bills or loans should review America Saves has a wealth of information here. If you have federal student loans, the government has placed your loan during this emergency into administrative forbearance from mid March 2020 until end of September 2020 with more information here.

Generally, you should adopt a plan to keep your debt levels at manageable levels. I advocate reducing loans with the highest loan rates first. On the other hand, if reducing small amounts of debt works better for  your motivation, then do that.   Automate payments to avoid late payments. Pay your credit card balances in full, not just the minimum. Spend within your means to lessen or eliminate your borrowing needs and avoid having to use your credit cards excessively.

4. Stay Vigilant And Check Your Credit Reports

With every crisis, financial scams increase. Phishing and investment scams rose during the 2008 financial crisis and coronavirus outbreak is no exception.  Scams like phishing involve the sending of emails and texts purporting to be from reputable companies. They are inducing you to provide personal information, like social security numbers, credit card numbers and passwords.

Both the FTC and FDIC have issued alarms to consumers to stay vigilant. Monitor your credit reports to find errors, and to find ways to improve your FICO score. This will help put you in a position to have financial flexibility when needed.

5. Continue Your Retirement Contributions Or 529 Savings Plan

If you lost your job or are on furlough, you may not be able to make the same contributions to your 401K,  Roth IRAs or 529 Savings Plan. If you are able, continue to do so without interpretation even if in smaller amounts during this time. Remember that these accounts benefit from tax-deferments and compound growth. Avoid withdrawing money from these accounts as there may be penalties beyond the loss of growth. Hopefully, we are in a short term crisis and you don’t want to damage your long term growth.

Generally, save for retirement through tax advantaged employer-sponsored benefits. Separately open up an IRA (preferably a Roth IRA) for more retirement savings.

Set up a 529 savings plan as early as possible for your newborn. This can help you and your child avoid borrowing later on for their college tuition.

6. Investing During A Down Market

Does an economic downturn mean you should sell stocks? Not necessarily if you have a long term strategy. Financial markets go through corrections, bull and bear markets. Selling during economic downturns will provide actual rather than unrealized losses. Many times that is the worse time to sell your securities. That said, when stocks do go up, it is a good idea to at least trim some of your holdings in these kind of markets if you are risk intolerant.

Take a look at our stock indices from peak to trough during the Great Recession:

Dates                                  S&P 500                      DJIA                  NASDAQ

10/09/07-Peak                   $1,565.15                 $14,164.53            $2,803. 91

03/09/09-Trough                $ 676.53                   $ 6,547.05             $1,268.64

Percentage %                        -56.8%                     -53.78%                 -54.75%

By mid May 2009, the S&P 500 was up 30%, rising over 60% by year-end 2009. Although you can’t pick the exact bottom of the markets, you can go bargain shopping for stocks that have undergone corrections or are in bear territory. For example, tech stocks have been strong leaders in the market but corrected during US-China on-off trade talks (remember that?).

What Can We Expect

Jobless claims are soaring and will continue for at least several months. The St. Louis Fed has pointed to a 32% unemployment rate by second quarter 2020 based on credible back of the envelope calculations.  Companies are reducing their upcoming earnings forecasts because of  reduced demand. Our economy has been shocked due to disruption but the Fed continues to proactively add liquidity to our markets as the federal government has added fiscal stimulus and likely to add more to our markets.

Could this mean we can bounce back quickly from that wicked unemployment rate and if so, could we miss a stock buying opportunity?  No one has picked the bottom unless they called it retroactively. (Wink, wink). That said, for those who have some available funds, it could be a good time to invest money in stocks so long as you have a long term horizon. Use small amounts and diversify your holdings if you are buying individual stocks. Better yet, research and find some low cost index  S&P 500 funds that mirror the market.

 7. Practice Gratitude More…It Helps Our Spirits And Our Finances

Be thankful for what you have; you’ll end up having more. If you concentrate on what you don’t have, you will never, ever have enough.” Oprah

We still can stay connected during this crisis, if not physically at the moment. Expressing gratitude to loved ones, colleagues and our heroes help us, let alone those who deserve it. Who hasn’t felt moved by strangers helping others, checkout at the grocery store, or stories we are reading on the Internet. We have new sets of heroes to thank such as bus drivers who we usually walk past, doctors and healthcare workers who risking their lives, construction workers and so many more.

  •  Simply smile at what you have in terms of family, friends, a job or career you enjoy.
  • Send old fashioned “thank you” notes to those whom you are grateful to or for having them in your life.
  • Keep up a gratitude journal to save those great moments.
  • Practice saying and thinking about gratefulness in a meaningful way.

I admit that there are times when I focus too much on life’s burdens that feel like they are overwhelming me. Exercising your ability to switch gears to counting your blessings over burdens often works for me. With two teenagers, it can be challenging to have some quiet moments for yourself. However, I find it can work for the good.

Sometimes losing a loved one makes you more grateful. It may run counter to the most difficult experiences. My mother lost her whole immediate family and extended family except for my Uncle before the age of 20. Yet, she was always grateful for her life and that of her brother’s. It gave her the chance to have her own family.

Having a traumatic experience often makes us grateful. We truly are going through a difficult time sharing a common enemy that has no political affiliation, no color, ethnicity, or religion.

Let’s be kind and grateful to each other. By the way, did you know that gratitude can lead to better finances? Really, read about that here.

Final Thoughts

Financial stresses have increased for many Americans as a result of the coronavirus. Clearly, we are entering a period of  an economic downturn and increased uncertainties. It is a good time to focus on what we can control rather than on the uncertainties. As April is Financial Literacy month, we reviewed 7 steps to improve your finances. Think for the long term. Practice gratitude to our loved ones  which helps our spirit and patience. Stay healthy!

We appreciate you taking the time to read our blog and welcome any of your comments and thoughts!

 

 

 

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How To Prepare For A Coronavirus-Related Recession

How To Prepare For A Coronavirus-Related Recession

How To Prepare For A Coronavirus-Related Recession

A recession is a more than likely economic outcome caused by coronavirus. The swiftness of the impact of COVID-19 on our communities is unprecedented in modern times. This virus is a serious natural disaster spreading on a global scale. The virus is a pause button on our society.

Its results are not yet showing up in economic indicators.  Latest figures on unemployment remain low at 3.5%. Initial claims for unemployment insurance were down.  That’s because the latest indicators were largely based on February numbers, prior to the virus in the US. Unless you’re in denial, you know a recession is coming. If you are old enough you may recall how bad the economy got in 2008-2009. Fear is a justified feeling though each recession may be different as it is event-driven.

Fed Emergency Action Mirrors Efforts Taken For The Great Recession

At this writing, the Fed cut its benchmark interest rates by a full percentage point to a range of zero to 0.25%. They will also be buying at least $700 billion in Treasury and mortgage bonds. The Fed will be be joining a global coordinated effort with major central banks including Canada, England, Japan, Switzerland and the European Central Bank.

To put this in perspective, the Fed is using a near mirror image of near zero rates and quantative easing that were used during the severe 2008-2009 recession. In a relative short time, this Fed is using its power to lessen impact of virtual shutdown on our economy. We as Americans, as consumers and as the number one economy in the world have not been here before. COVID-19 is the kind of beast that has rattled our financial world. I applaud their action. However, implementation and impact will takes time.

Let’s get back to some basics.

What Is A Recession?

In its simplest terms, a recession is a decline in economic activity involving at least two consecutive quarters. The National Bureau of Economic Research or NBER defines an economic recession as a “significant decline in economic activity spread across the economy lasting more than a few months, normally visible in GDP, real income, employment, industrial production and wholesale-retail sales.”

Recessions can be mild and short like in 2001 when it lasted eight months. On the other hand, they can be  more severe as the Great Recession which lasted 18 months. What typically happens during a recession is this: consumer spending drops impacting businesses. In turn, they are forced to slow or stop hiring and potentially implement layoffs. Unemployment rises and households have difficulties paying bills and their debt.

The Fed’s Monetary Policy

The Federal Reserve has moved fast to lower the fed funds rate and add liquidity into our financial system. By lowering their benchmark, they influence all interest rates. That will result in lowered rates including the business prime rate, loans for mortgages autos and colleges. They look at many economic and inflation indicators—leading, coincident, and lagging–that telegraph where we are relative to typical business cycles. Leading indicators are predictive and occur before changes in economic cycles. They include the S&P 500 index, housing permits, and initial claims of unemployment insurance.

Government And Private Actions On Paid Leave For Workers

It is not just the Fed that is moving to help consumers. On a parallel track, there have been the beginnings of coordinated actions by government with the private sector. Help is needed for their employees and those who own small businesses. Besides the desperate need for available testing, workers without access to paid leave when falling ill or hospitalized experience additional stresses. Access for workers to paid leave varies dramatically with high numbers of people not covered according this table. Large companies offer paid leave but who pays for those who do not have that benefit?

It is difficult for those living paycheck-to-paycheck to make ends meet. Without paid leave, low hourly wage workers, freelance workers and others who are not being paid for any time off when sick. Some emergency packages are being put in place for those in need. Otherwise, some who are ill may take their chances going to work so as not to lose their earnings or job. This poses a nightmare scenario of the virus spreading faster. Social distancing in communities will come at a serious cost but the virus will spread faster without it.

From Bull Market To Bear Market In A Record Time

The impact on our volatile financial markets have been felt deeper and harsher than the many of the other leading indicators. Terms like stock market crash, corrections and bear market emerged in quick succession.  A stock market crash occurs when the market falls 10% from its 52 week peak in a matter of days of trading. On the other hand, a correction in the market is more gradual, with stocks falling 10% from the 52 week high typically over months. Bear markets result after a 20% decline from a 52 week level. This also happens over a number of months. The reaction in the markets to the coronavirus, once it arrived in the US from China, was rapid.

The End Of The Long Bull Market

Here’s how the stock market did in recent weeks illustrating its swift moves.The S& P 500 index used as a market proxy peaked at $3,386.15 on February 19th, declining  to just $2,978.76 on February 19th in six trading days. This a 12.3% drop into solid correction territory. We officially entered a bear market on March 11th when the S&P 500 hit a low of $2,707.22 that day, closing at 2,741.38, ending a 11 year bull market.

Since World War 2, we have had 26 market corrections (not including the latest one) with recoveries taking about 4 months on average. However, if stocks go into bear territory as we are now, there is more pain and it takes more time to recover. During that same timeframe, there have been twelve bear markets averaging a decline of 30% over 14 months,  taking 24 months to recover. The most severe recession was from October 2007 to March 2009, or 18 months. Stocks dropped 57% and took 4 years to recover.

When Will The Markets Bottom?

It is anyone’s guess when the markets decline will bottom. We don’t yet know the severity of the coronvirus spread or its full economic  impact. Hopefully, aggressive Fed action and containment efforts by government, private sector, communities and people will work well. There has been talk of fiscal stimulus that may further soften the downturn.

Here are five possible clues as to when the stock market bottom may be close:

  1. The Fed will be constantly looking at economic indicators to decline, trough and stabilize to signal our recovery. They will take further action, expanding quantative easing similar to what what has been announced just today.
  2. Economists look to the Conference Board Leading Economic Index which is composed of 10 indicators (including the S&P 500 index) that move up or down several months before the economy.
  3. We can look for the number of coronavirus cases to slow outside China. China seems to be recovering. I cheered when I read that Apple Stores are reopening in China.
  4. We have not yet hit chaos in the US, and our virus experience follows Europe, notably in Italy which has been locked down. Coronvirus cases will climb in the US, peak and start to stabilize in the US soon. When it appears the virus is under control, it may be a good time to buy.
  5. Corporate buybacks return with verve. Many companies have a lot of cash but have not activated their repurchases.

You Don’t Have To Wait For A Bottom

When the markets are particularly turbulent, I have used Investor’s Business Daily. They provide charts, volumes, market  upturns, downturns, and follow-through days. A follow-through day indicates a rally attempt has succeeded and the market direction has changed from a correction into a “confirmed uptrend.” It tells you to start gradually buying stocks again. Stock rises need to be accompanied by above average volume for a number of days to confirm a market uptrend.

On down days in the market, I have bought some shares to average down my cost basis. I am a long term investor, not a trader. Like most people, I have found it hard to look at my stocks on a daily basis. I don’t think we are near the bottom but who knows where that is. However, if you are going to own stocks for the long term, you can begin to add to your existing stocks or buy names that were on your previous list but may be at bargain levels.

Steps To Take To Prepare For A Recession

 

1. Save More, Spend Less

You may find it easier to save more during the coronavirus period. By staying closer to home, you are likely not eating out, shopping, going to the theater, concerts, sporting events or movies. True, you can order in or shop online. Use this time to cut down on spending for things that are unnecessary. Put savings to work in your emergency fund.

Make sure you are increasing your liquidity in your savings accounts or money market deposit accounts (MMDA) which are insured by the FDIC. It is not clear how long you may experience less work hours or reduced face-to-face time with clients. We wrote about how it important it is to have an emergency funds in the previous post here. Consider using some of these savings to set up an emergency fund if you don’t have one. It is never too late to start.

 2. Retirement Saving Accounts

You probably noticed a sharp drop if you even dared to look. It may get worse before your accounts look better. If you have a long term horizon before you are going retiring, do little or even nothing. Keep your automatic paycheck contributions in place especially if your employer offers match contributions. That extra money is valuable and through compounding, grows faster. Remember that if you take money out of these accounts that you are counting for later on, you will lose future compounding benefits and maybe even have to pay penalties for early withdrawal and taxes.

Unless you are facing or are about to face financial hardship, avoid drastic changes like a shift to cash especially if retirement is not imminent. Stocks which have been battered should not be sold as they have the greatest upside when it is time for the markets to recover. Bonds, especially high quality bonds like treasuries may be better places to withdraw money from. Investors flocked to these bonds for their safety, selling more risky stocks.

On the other hand, if you are near retirement, your portfolio should already be shifting into more bonds relative to stocks. Check your retirement accounts to see if you have put your money into target date funds which adjust accordingly by age of holder or recipient. Resist withdrawing unless you have an emergency. It is hard to replace these dollars.

3. Refinancing Opportunities

With mortgage rates likely to be further reduced with today’s action by the Fed, don’t wait until the virus outbreak goes away to use them. Consider refinancing your loan if you can get a healthy drop in your rate and/or shorten your term.  If you have been paying your bills on time, your credit may have been improved, enhancing your refinancing abilities.

The higher your credit score the better your new loan terms will be. Consider your budget and what is most appealing to you: a lower interest rate or a shorter term. A lower interest rate will reduce your monthly payments while a shorter term (from 30 year to 15 year term) may raise your monthly amount but you get rid of the loan faster.

4. Buying or Selling Your Home

The National Association of Realtors are seeing reduced home buyer traffic and that is likely to get worse before it improves. That is understandable as “Open Houses” aren’t very appealing in this environment. However, if buying a home was on your list, it is a good time to start house hunting online. The low mortgage rates will be a stimulant for buying your home once the virus is stabilized For sellers, this is a tough time, especially if you are in need of the proceeds of the sale but take some heart that demand will come

5. Paying Off Your Debt

You need to continue to reduce your debt. If you have the opportunity to refinance your mortgage or car loan you should do that now. Remember to pay your credit card balances in full each month. Simply paying the minimum requirement is not enough. Reduce your spending so you can pay your bills in full.

You may have heard that President Trump took some action related to student loans as part of emergency executive actions. He called for a waiver of your student loan interest on federally held student loans “until further notice.” Until it is seen in writing it is a bit unclear. It is not a suspension of monthly loan payments or loan forgiveness. It appears that your monthly payments will remain the same but credited towards the principal amount of your loan rather than waiving all of the interest you owe. This will likely lower the principal amount while they pause some of the interest that will be accrued during virus period. It is good but not as much as had been hoped for.

Positive Takeaways Will Emerge From COVID-19’s Wreckage

The coronavirus has had negative consequences. There are high costs for businesses and their employees not just in the cruise or travel businesses. The financial impacts are spreading to other businesses as well.

While the coronvirus has had negative consequences, here are some positives we are experiencing:

  • Closing of schools and colleges have increased reliance on distance learning. Imagine no more snow days because classes will be held online.
  • Time to learning new skills if you are staying home.
  • Reflection time, goal setting or review your future plans.
  • Heightened awareness about your communities.
  • Appreciation for the businesses and institutions that you depended on that are closed now. Validate their value by shopping or visiting them when the dust clears.
  • Taking  more health precautions in the future when we have minor illnesses around family, friends, acquaintances, and co-workers.
  • Kindness has been increasing in this tough environment. Let’s be thankful for what we have.

This too shall pass.

Final Thoughts

We have been experiencing dramatic times at lightening speed. The stock market fell into bear territory quickly, reacting to the anticipated impact on our economy and communities. The uncertain environment has been taxing in recent weeks signalling an inevitable recession. The Fed has undertaken massive emergency measures to lessen to burden on our economy that has not yet faltered. This post was designed to explain what is going as we grapple with these circumstances in our lives.

As a professor, I am rapidly redesigning my courses for students as we rely on distance learning for rest of the semester. As a mom, I will driving my kids to school to retrieve their books so that they can begin their own virtual learning experience.

This will be our new normal for awhile as many millions will do likewise. I truly wish you good health and happiness. I will continue to post as always. I am anxious to hear how you are doing! Please consider subscribing to our newsletter and our community.

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