Whether you’re only now peaking out from behind the sofa or you’ve been investing passively like a trooper and refusing to look at your portfolio until Boxing Day, if you’re reading this site you’ve probably seen headlines implicating US bond yields in the recent assault and battery on the stock market.

For example:

• Surging yields raise threat of tipping point for stocks – Wall Street Journal

• Here’s why stock-market investors suddenly freaked out over rising bond yields – MarketWatch

• Treasury yields are increasing again, reigniting concerns about higher rates in financial markets – CNBC

Are pundits in this game of financial Cluedo right to finger Mr Treasury Bond in the trading den with a cudgel as the villain?

As always – who knows. There are plenty of dodgy-looking drifters riding around stock market town at the moment and occasionally firing their guns into the air, from geopolitical tensions and rising oil prices to high valuations in the US and its trade spat with China.

Any of those other factors – and more, or perhaps nothing specific at all – could have been the trigger for what wasn’t a particularly large correction anyway, especially in America.

Investing nerds like me still debate what caused the huge 1987 crash. We can’t expect a definitive answer to what’s so far been a run of the mill wobble.

Higher rate hate

All that said, I suspect sharply rising Treasury yields are probably having an impact in various ways on the market.

In particular, the commentary from US central bankers that there may be several more rises to come seems to be vexing in some quarters.

Many of the same commentators and traders who chastised the US Federal Reserve for a decade for suppressing rates to record lows now seem happy to put the boot in again when rates are rising.

Given markets move on sentiment in the short-term, this sound and fury can make a difference.

The obvious question is why do rate rises matter, anyway?

After all, a US 10-year government bond is still only yielding a little over 3%. For almost all the post-World War 2 period, that would have been considered bargain basement.

Also, why should UK investors care? We’ve seen a couple of rate rises here, but our yields are still much lower than in the US.

Isn’t everything bigger in America? Why not the yield on the 10-year Treasury bond?

Alas, contrary to some wishful thinking in recent years, we do not live on a financial island in splendid isolation. Warren Buffett calls US government bond yields the gravity of financial markets, and we almost invariably feel the impact here of major developments there.

For example, the relative attractiveness of putting money in a US bank instead of a UK or European bank can move both our bond markets and our currency, by influencing the behaviour of massive and rootless capital flows. Money tends to go to where it’s treated best.

As for rising yields themselves, I’ve had a few queries about this both here and in the archetypal pub.

I’m certainly not a bond expert or a stock market historian – some of our readers are far more knowledgeable about the mechanics of the yield curve than me!

Nevertheless I did make a fair fist of explaining the potential issues arising from the prolonged low interest rate era back in late 2016.

It seemed to me then that Central Banks were ready to start closing the spigots on super-easy money. Politicians, too. I mused that they feared that the core business model of banking risked becoming unprofitable, with unpredictable knock-on affects.

I’m not sure that’s proven out, but the rate rises have certainly started, at least in the US and UK.1

On the down low

Bond yields rising off the floor may matter to traders and analysts long before they are seen in costlier mortgages or over-indebted ‘zombie’ companies going bust.

As I wrote in my long piece:

A discounted cash flow model puts a discount on the future cash due. This reflects the uncertainty about future profits, as well as inflation and interest rates.

Normally, distant payouts are deeply discounted. But with the risk-free rate so low that doesn’t happen so much.

Why does this matter?

Because uncertain future forecasts have grown in importance compared to near-term cash flows. A discount rate of 2% doesn’t have much impact until you get far out.

This makes the present value of an asset even harder than usual to determine with confidence. Because future cash flows assume greater importance, the valuation is based on more finger-in-the-air guesswork.

It’s a nerdy-sounding but important point that may mean market valuations are wildly off. Even a modest rise in rates could cause a crash in all sorts of assets beyond what we’d expect.

I’ve heard a couple of people ask why technology shares that pay no dividend fell the most in last week’s kerfuffle.

Nobody owns those for income. Surely it should be utilities or ‘dividend stalwarts’ like Unilever and Johnson and Johnson that should be most marked down, if nervous investors believe they can now get the regular cashflows they require from bonds again?

That makes sense, and I do think the relative attractiveness of dividend-paying companies compared to government bonds will shift over time if rates keep rising.

But it’s the change in the discount rate that explains the theoretical shift in the valuation you’d put on say an ASOS or an Amazon, or even a Fevertree. The companies may rapidly start looking more expensive in an analyst’s model, even if nothing has changed in the business itself.2

Anyway, rather than rehash that article again here I’d suggest rereading those two previous pieces for more on how low yields may have distorted things in the past decade. Unwinding such distortions, where they exist, seems bound to have some impact.

Here are the links:

• Understanding the low interest rate era

• The problem with low interest rates

Also, if you tend to read Monevator via email or you don’t check back on the comments much, you will have missed the long thread that followed the latest Weekend Reading.

If you are feeling blue after a kicking that – incredibly enough – at one point had the FTSE 100 back at 1999 levels, you might at least find some comradeship in the thoughts of fellow readers.

(Thanks again for sharing all!)

1. The Federal Reserve further announced in late 2017 that it was beginning to reverse QE – what it calls ‘Policy Normalization’. [↩]
2. The more prosaic reason they fell farthest is that people dump pricey growth shares in times of panic! [↩]

What caught my eye this week.

Sensible readers who passively invest and so haven’t been following the gyrations in the markets this past week, please jump to the links below.

Oi! That includes you, Accumulator!

Right. I presume I’m now addressing only those readers who have ignored our exhortations to invest purely into index funds like Saint Accumulator – those who instead get up to naughty active activities like yours truly.

In which case, I’m curious: How was it for you?

Ooft!

For my part I’ve had one of the toughest 10 days or so that I can remember, investing-wise.

At the worst point my portfolio was down by nearly 10% in barely a week.

That’s not the end of the world – I’ve seen far worse – but what was infuriating is that I’m running the lowest equity exposure in my tracked portfolio since, well, forever.1

True, I was still well over 70% in pure equities. Ben Graham – who advocated 75% at the most bullish times and 25% at the least – would have frowned, given that I have slowly been decreasing my exposure to shares partly on account of my nervousness about the rampant complacency others were showing concerning the risks of shares. (Especially in the US, but also here whenever we made a case for cash or bonds.)

Still, I’d hoped mine would prove to be a pretty eclectic 70% collection of shares, as it had in the past, and hence it wouldn’t simply shadow the market down. That proved optimistic.

Most times over the years when markets fall 5-10% quickly, I’ve owned some small caps or thinly-traded larger companies that don’t move much at first. Many a pleasant 30 minutes I’ve spent trying to grind out a few points of gains or risk reduction by rejigging between them in a sell-off.

This time, none of that. Almost everything was down – on Thursday in some cases by 7-10% on the day.

Had underlying markets become more (or less?!) efficient since the last lurch down? Was I unlucky? Or was there something different going on with this fall?

One aspect wasn’t a mystery. I knew I was running some chunky additional risk with my active stock selection.

If I were marketing my portfolio as a fund, I’d perhaps spin it as a ‘barbell’ approach of low volatility assets mixed with ‘strong conviction holdings in global disruptors’.

But what it boils down to is I own several outsized shareholdings in tech shares that have multi-bagged. They are taking forever to whittle down, because I own them outside of tax shelters for historical reasons. And that, as I’ve written before, is a massive pain.

There are paperwork hassles. There are capital gains taxes to consider. Also, I am trying harder not to sell my winners too soon, because sins of omission have cost me much more over the years than sins of commission. (That is, I’ve forgone big gains by selling too soon and putting the money raised into some turkey.)

I knew this risky exposure was there. It was another reason why I’d been de-risking the portfolio where I could inside my tax shelters. But clearly I miscalculated somewhere because when the markets fell, I still went down with it.

Remember – I felt I was running less risk versus the market because I held fewer equities.

What’s more, historically my portfolio has been less volatile than my underlying equity benchmarks – even with the concentration risk and sector risk I manage, and even when I’ve been near-100% in shares.

Hence I really felt it in the nads when it all came to naught in the falls.

It’s not a disaster. I was nicely up against three of my four benchmarks year-to-date (YTD) when the rout started, and I’m still ahead of each of those by several percentage points. I remain down against the world index YTD, but the gap didn’t really widen. I’m underweight the US/dollar, and I think the under-performance here in the last couple of years will probably reverse if and when pound recovers.

We’ll see, but anyway I know I shouldn’t feel too bad that a bit of mean reversion has caught up with me.

So why do I?

Partly I think it’s because my purposeful risk reduction hasn’t paid off.

This slightly gives me the willies.

Lord make me a passive investor, but not yet

I have an existentially bleak view about active investing. In fact I’d bet I see active investing as far harder than almost any active investor you’ve met, despite what I feel is my creditable record.

In the middle of last week’s sell-off I described what I believe is required to even try to beat the market nowadays to a friend asking for advice on Facebook. He persisted even after I told him my only advice was – as ever – to invest in some select index funds every month from his salary and come back in 30 years.

He said he’d seen the news, and wanted to know if it was a “buying opportunity” because in his opinion the market had been too calm before.

Didn’t I have anything clever insights, he wanted to know? As usual I got the impression he felt I was blowing him off by urging him into passive funds. Keeping the good stuff to myself!

Eventually I snapped. Me in blue:

Often I tell friends I won’t know if I was a successful active investor for another 40 years, whatever my track record is to-date. It’s that uncertain, and luck is so hard to disentangle from skill.

As that renowned day trader Sophocles wrote:

“One must wait until the evening to see how splendid the day has been.”

I know I’ve not been obsessed over the past nine months, if I’m honest. I’ve spent countless weekends shopping for home furnishings. It’s ages since I read an annual report in bed gone midnight – something I used to do more weekday nights than not.

I thought about putting everything into a Vanguard LifeStrategy 60/40 when I bought the flat near the start of the year, and taking a year out. Perhaps, on this evidence, I should have.

Home alone

I guess I also have to acknowledge that the mortgage I’m now running to sit in this flat that I’m typing from has probably turned some of my dials to new settings.

For as long as I’ve been investing, I’ve had a relatively monstrous buffer between me and the streets. Long-time readers might even recall that I really started actively investing when I decided to put my house deposit to work in equities, rather than in property, way back in 2003.

Don’t get me wrong, there’s still a big buffer in place. I feel secure… a healthy monthly cash flow from earnings in the front line, cash deposit ramparts, NS&I saving certificate moats, and a five-year fixed rate mortgage that means I’m safely inland from raids from along the coast. My assets well outweigh my debts.

Still, mine is not the fortress balance sheet it once was.

Effectively, like anyone with an investment portfolio and a mortgage, I can consider my portfolio to be levered up. (Because I could instead use the portfolio to pay down the debt.)

This was by design, but it would be foolish to deny there’s a price to pay.

Losing loadsamoney

Finally, while I’m sharing, there’s also the fact that while I’ve suffered bigger percentage losses in a week – far greater in the financial crisis – this was the biggest in cash terms.

I’m ten good years on from 2008, and hence I have more money exposed to the shredder. It’s harder to be as gleeful at the prospect of a bear market as I used to be.

Perhaps that’s why my back pain returned on Thursday. Like George Soros’ gnomic spine, mine tells me when I’m stressed, which is handy because I seldom feel stressed much.

I felt it this week.

A warning to recalibrate before the big one? Or have I just got to get my money-losing muscle memory back?

Something to ponder.

How was it for you?

[continue reading…]

1. Or less glibly since 2007. But in those days I treated my entire net worth as one big investment pot, so it’s not really like-for-like. [↩]

Here at Greybeard Towers, the economy has taken a turn for the worse. Like many other freelance writers and editors I know, I’ve seen a softening in the marketplace in which I sell my skills.

These things happen. Ten years ago – exactly ten years ago, as banks imploded, and stock markets plunged – the same thing happened.

Back then we had kids still living at home, and the last few thousand pounds of a mortgage to pay off. Today, my wife and I are far less encumbered with fixed outgoings. Nevertheless, the experience has been instructive.

Firstly, it’s been instructive in that I took a decision to cushion the hit to our lifestyle by withdrawing a monthly income of several hundred pounds from my ISA-sheltered share portfolio.

This was a weird sensation, and left me – no, leaves me – feeling oddly guilty. For the first time in decades, instead of reinvesting dividend income, I am withdrawing it, and spending it.

Somehow, it doesn’t – yet, anyway – feel right.

All change

The second instructive experience has been less angst-inducing, but is still challenging.

Namely, I have decided to accelerate my plans for retiring. Or, rather, semi-retiring. I hope to carry on working, but I’ll also be taking a pension income.

As readers with long memories may realise, this wasn’t the original game plan.

For years I have planned to retire at 70, gradually winding down as my seventieth birthday approached. And – to be blunt – probably carrying on doing a few simple commissions for long-standing clients, if such opportunities came along.

But having just turned 64, with the state pension two years away, it seemed sensible to consider taking income from my two SIPPs.

Former pension minister Steve Webb’s much-vaunted pension freedoms have not only made that easier, but also introduced new options such as UFPLS1 flexible drawdown.

Frankly, why not take advantage of these freedoms?

From strategy to tactics

Right from the outset, the broad strategy seemed clear:

• Disregard the annuity option. Some form of cautious drawdown on my assets should leave an inheritance for the kids, as well as hold out the prospect of a growing income.

• To this end, take the natural yield, rather than eat into capital. With tax-free ISA income from a share portfolio, some freelance earnings, other investment income, two state pensions, and my wife’s occupational pension, that would be ample.

• Although (as I’ve written before) I’m attracted to the more flexible end of the new pension freedoms – and in particular, to UFPLS – it would be necessary to figure out some way of mitigating the effects of the £4,000 Money Purchase Annual Allowance (MPAA) limit, which would severely restrict my ability to shelter freelance earnings in a SIPP, away from the beady eye of the taxman. This wouldn’t be a problem with an annuity, or with drawdown (as long as I didn’t drawdown any income, just tax-free cash), but would be a problem with UFPLS.

All good stuff, but I was uncomfortably aware that it was very high-level stuff, as well. The practicalities would need thinking through, and organising. And I would need to be very careful about avoiding any hidden bear traps.

Plus, of course, there was a significant element of irrevocability. Once I’d triggered drawdown, for instance, there would be no turning back.

A summer of careful reading and researching beckoned.

Here’s what I found, along the way.

A route to follow

One immediate realisation was that multiple pension providers offer an abundance of free literature, readily downloadable. I devoured stacks of it.

I could also send off for pension projections and illustrations – including my personal state pension forecast of £148.88 a week, or £7,768.35 a year, which was curiously empowering.

The government’s Pensions Advisory Service and Pension Wise websites also contain a wealth of useful information.

Not all the advice I obtained was through the written word. Determined to do things ‘properly’, I took up my option of a free pension consultation with the government’s Pension Wise service, booking a Pension Wise appointment, which duly happened in early August.

The adviser, named Colin, was incredibly knowledgeable, and we went the distance, going for the full hour. Well worth doing, and highly recommended.

Right from outset, it was clear that the inflexibility of traditional drawdown posed a challenge.

Essentially, I was turning on a tap, releasing a flood of income. Should the freelance market pick up, I’d face an awkward choice between turning down work or getting clobbered by higher-rate tax. Due to the MPAA rules – designed to clamp down on tax-rebate ‘recycling’ – once I’d sheltered £4,000 in a pension, any further earnings were taxable.

This in turn reinforced the attraction of UFPLS as an option.

While UFPLS is a form of drawdown, it’s a flexible form of drawdown. If the freelance market picks up and my earnings look to leave me exposed to a hefty higher-rate tax liability, I can simply turn the UFPLS income tap to the ‘off’ position. Like this I can maintain a level income, by using UFPLS as the balancing factor.

On the other hand, the initial plan of a monthly UFPLS income seems unrealistic. Providers do offer it, and apparently people do take it. But the paperwork seems disproportionate, with every UFPLS drawdown triggered by a completed UFPLS application form, and accompanied by an ensuing (and legally required) UFPLS illustration.

Being pragmatic, it probably makes sense to combine my two separate SIPPs into one, and going for three-monthly or six-monthly UFPLS payments, rather than monthly payments. The downside: to some extent, this will limit my ability to ‘flex’ income to avoid higher-rate tax.

Finally, the rules around the taxation of pensions after death seem unduly harsh. If I die after age 75, and my wife survives me, the remaining pension investments she will inherit are taxed as income. That’s not a good option for a sum that should amount to several hundred thousand pounds.

To avoid a massive tax hit – repeated again when the kids inherit it after my wife dies – it’s necessary to set up a dependents’ drawdown account, from which an income is taken.

More research is needed here, but at least I’ve got 11 years to undertake it.

Ready, steady… go?

So what have I done? Nothing, so far. But at least I know the broad outline of what I will do, when I push the button.

Our income, at the moment, is just about adequate without massive belt-tightening. (If you’re looking for a first-class writer and editor, get in touch…)

What have I learned? More than I thought I would.

Moving into retirement – and making the right choices – is a complicated business, unless one goes for the straightforward annuity option. I knew that already. Even so, I’m still surprised at the complexity of the choices I face.

The government, it seems to me, has brought into being a range of pension freedoms, but hasn’t invested the time and energy to provide a regulatory and tax framework to help retirees readily access those freedoms. That is regrettable.

Making the right retirement choice was difficult enough in the old ‘annuity versus drawdown’ environment. It’s tougher still, now.

Read all of The Greybeard’s previous posts on deaccumulation and retirement.

1. Uncrystallised Funds Pension Lump Sum [↩]