AAII Journal Editor
Tug of War in the Bond Market
The argument for using variable-rate bonds.
How Much Is Needed to Start Investing?
Not much, but consider fees and expenses.
AAII Discussion Boards
What’s your opinion of the floating rate Treasury note?
This week’s AAII Sentiment Survey results:
Bullish: 32.2%, down 5.9 points
Neutral: 35.1%, down 3.1 points
Bearish: 32.8%, up 9.0 points
January 23, 2014
January 9, 2014
December 19, 2013
December 12, 2013
December 05, 2013
November 28, 2013
November 21, 2013
November 14, 2013
November 7, 2013
October 31, 2013
October 24, 2013
October 17, 2013
October 10, 2013
October 3, 2013
September 26, 2013
September 19, 2013
September 12, 2013
September 5, 2013
August 29, 2013
August 22, 2013
August 15, 2013
August 8, 2013
August 1, 2013
July 18, 2013
July 11, 2013
July 4, 2013
June 27, 2013
June 20, 2013
June 13, 2013
June 6, 2013
Investors now have a new type of Treasury bond to add to their portfolio and could have a new retirement option by year-end. Yesterday, the Treasury Department auctioned $15 billion of two-year floating-rate notes, with demand far exceeding supply. On Wednesday, President Barack Obama introduced MyRA during his State of the Union speech.
I briefly mentioned the floating-rate Treasury notes in last week’s newsletter, but want to share more insight. The interest rate on these two-year notes resets each day. The interest rate is based on the highest accepted discount rate of the most recent 13-week Treasury bill auction. (Auctions for 13-week Treasuries are held weekly.) This feature will cause the quarterly interest payments to fluctuate depending on the short-term direction of yields. If 13-week Treasury bills are auctioned at higher yields, the floating-rate Treasuries will pay a higher level of interest. Conversely, if the 13-week Treasury bills are auctioned at lower yields, the floating-rate Treasuries will pay lower level of interest. (The calculation is a bit more complex, but this description provides a good rule of thumb.)
Traditional two-year Treasury notes pay a fixed interest rate of interest instead. They pay the same amount on a semiannual basis regardless of what the bond market is doing. This is how traditional U.S. bonds operate as well—you lock in a stream of income at the time of purchase. Traditional bonds will have higher coupon rates (interest rates) at issuance than floating-rate bonds (“floaters”) of the same maturity and credit quality as compensation for the uncertainty of future interest rates.
Floaters are desirable in a rising interest rate market environment. Under such scenarios, a floater should lose less value than a traditional bond. In a falling or stable rate environment, you would likely do better with a traditional bond. As is the case with any investment, purchase price matters; even bonds can trade at premium valuations.
Floaters are issued by other entities. In the U.S., financial institutions are the most common issuers of these types of bonds. In “The Bond Book” (McGraw Hill, 2011), Annette Thau says floaters have “tended not to work out quite as well as had been hoped.” Rates are not reset fast enough during periods of extreme interest rate volatility and the coupon rates of floaters are often less attractive than traditional bonds. Marilyn Cohen of Envision Capital Management does think floaters can have a place in a portfolio, but should only be bought when their prices pull back.
MyRA is a retirement savings option targeted toward Americans without a workplace savings plan (e.g., a 401(k) plan). It will be akin to a Roth IRA and should offer the same tax treatment as a Roth IRA. The sole investment option will be similar to the Government Securities Fund (“the G Fund”). The G Fund is part of the Thrift Savings Plan (TSP)—the retirement plan for federal employees—and invests exclusively in a non-market short-term Treasury security that is specifically issued to the TSP. The fund’s earnings consist entirely of interest income on the security. This is why President Obama was able to claim principal protection as being a feature of MyRA.
MyRA will be available to households with incomes of up to $191,000. The initial investment could be as low as $25, and additional contributions can be made in increments as low as $5. Participants will be allowed to save up to $15,000 or for a maximum of 30 years. After either limit is reached, the account will be required to be rolled over into a Roth IRA (likely at a third-party broker or mutual fund, though that detail has yet to be explained). An initial pilot plan is anticipated to be offered through participating employers by the end of this year. Anyone meeting the income requirements appears to be eligible to participate, however.
Sidestepping the issue of whether the federal government should be creating a new retirement savings plan (I’ll leave that discussion to the political pundits), I think MyRA is a good alternative versus not saving for retirement at all. Having an auto-enrollment option, which requires employees to actively opt out of participating versus having to make conscious decision to enroll, would increase the likelihood of participation by workers. The conservative nature of the sole investment offering will expose participants to significant inflation and longevity risk, however. Plus, some brokers and mutual fund companies have relatively low minimums for opening an IRA account. For example, Fidelity and TD Ameritrade have no minimum dollar requirements, while Vanguard and T. Rowe Price have a relatively low minimum of $1,000 to open an IRA account. Account minimums are generally waived for employer-sponsored retirement plans and some firms may waive the initial minimum requirements in exchange for agreeing to regular direct deposits.
Clarification on the Model Shadow Stock Portfolio Rules
In regard to last week’s commentary about our Model Shadow Stock portfolio, I want to share the following from Jim Cloonan regarding foreign stocks and the Model Shadow Stock Portfolio.
“There has been a little confusion about foreign stocks. The rule is that foreign stocks are fine if they are listed on a U.S. exchange (NYSE, NASDAQ) and meet our other requirements. The exception is Chinese stocks. We do not buy Chinese companies no matter where listed and we recently added that we won’t buy a company no matter where it is headquartered if the majority of its business is in China. The data from China cannot be relied on and verification is impossible.”
More on AAII.com
- Tug of War in the Bond Market – Marilyn Cohen explained her logic for using floating-rate bonds in this 2011 AAII Journal article.
- Bond Basics for Individuals – A 2001 AAII Journal article gives a primer on how to invest directly in individual bonds.
- How Much Is Needed to Start Investing? – The minimum amount is very low, but you need to consider commissions, fees and taxes.
- What’s Your Opinion of the Floating Rate Treasury Note? – Tell us on the AAII Discussion Boards.
- Don’t forget to take the Sentiment Survey.
The Week Ahead
Dow Jones industrial average components Merck (MRK) and The Walt Disney Company (DIS) will report earnings on Wednesday. Slightly less than 100 members of the S&P 500 will report throughout the course of next week, as earnings season shifts from large-cap companies to smaller companies.
The ISM’s January manufacturing survey, the PMI’s January manufacturing index and December construction spending will be the week’s first economic reports of note with a Monday release date. Tuesday will feature December factory orders. The ISM’s non-manufacturing survey and January ADP Employment Report will be released on Wednesday. Thursday will feature January international trade data and the first estimate of fourth-quarter productivity. January jobs data, including the change in nonfarm payrolls and the change in the unemployment rate, will be released on Friday. Keep this month’s arctic vortex in mind when reviewing the January economic data over the next two months.
Five Federal Reserve officials will make public appearances next week: Richmond President Jeffrey Lacker and Chicago President Charles Evans on Tuesday, Philadelphia President Charles Plosser and Atlanta President Dennis Lockhart on Wednesday and Boston President Eric Rosengren on Thursday.
AAII Sentiment Survey
Bearish sentiment rose back above its historical average, nearly hitting a four-month high in the latest AAII Sentiment Survey. This increase in pessimism, combined with a drop in optimism, has caused bears to outnumber bulls for the first time since August 22, 2013.
The increase in pessimism and the declines in both bullish and neutral sentiment are an indication of a more cautious outlook for the six-month direction for stock prices.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 5.9 percentage points to 32.2%. This is the lowest level of optimism registered by our survey since August 22, 2013. It is also the third consecutive week that bullish sentiment is below its historical average of 39.0%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged, fell 3.1 percentage points to 35.1%. This is the fourth consecutive week with a neutral sentiment reading above the historical average of 30.5%.
Bearish sentiment, expectations that stock prices will fall over the next six months, surged upwards by 9.0 percentage points to 32.8%. This is the highest level of pessimism registered by our survey since October 10, 2013. This week’s reading also ends a streak of 15 consecutive weeks with bearish sentiment below its historical average of 30.5%.
January’s volatility continues to cast clouds over individual investors’ short-term outlook for stock prices. Since registering 55.1% on December 26, 2013, bullish sentiment has fallen by a cumulative 22.9 percentage points. In addition to the modest decline in the S&P 500, concerns about the market having reached a short-term top, valuations, the pace of economic growth and Washington politics are dampening investors’ mood. Offsetting these worries is earnings growth, economic growth, the record highs established by the large-cap indexes earlier this month and the Federal Reserve’s tapering of its bond purchases.
This week’s special question asked AAII members if they are currently favoring large-cap, mid-cap, small-cap or micro-cap stocks. Popularity decreased with company size as 45% of respondents prefer large-cap stocks, 26% prefer mid-cap stocks, 19% prefer small-cap stocks and 7% prefer micro-cap stocks. Several respondents picked two of the four categories.
Many respondents said they liked large-cap stocks for their comparative stability, the possibility of the bull market ending sooner than later or because of the payment of dividends. Mid-cap, small-cap and micro-cap stocks were largely favored on the expectation of better price appreciation. Some respondents said they favored large- and mid-cap stocks because of the outperformance small-cap stocks have experienced.
Here is a sampling of the responses:
- “Large caps, because they have higher yield and better safety in my humble opinion.”
- “Large-cap stocks paying dividends. Given my bearish tilt, I am generally favoring these kinds of stocks as defensive posturing”
- “Large cap; they tend to do well near the end of a bull market.”
- “Mid cap—I believe they will move more than large caps and are safer than small caps.”
- “Small cap—they have better prospects of growth in earnings and stock appreciation than other market segments.”