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Should We Fear Debt?

Summary Avoiding an indebted investment is short-sighted, because data shows that debt levels and returns aren’t always negatively correlated. By tilting to the segments that are more sensitive to movements in credit spreads, investors must be willing to accept the greater influence of the equity markets. Look at the data before you believe a strategist who encourages you to avoid indebted companies. By Chris Philips Late last year, Josh Barrickman, head of bond indexing at Vanguard, blogged about the smart beta movement in fixed income. Josh challenged the notion that a company or country could flood the market with debt, which would invariably harm market cap-focused investors. You’ve probably heard it before: “Why would anyone want to invest in the most indebted companies or countries? It’s just throwing good money after bad.” While this premise may seem logical and intuitive on the surface, as with many things we see or hear, a bit of logic and perspective can diffuse superficial arguments. First, some perspective from a unique source. I’ve been catching up on some reading, and one piece in particular stuck with me – an article referencing a story about astronomer Carl Sagan. When presented with “evidence” of alien abductions in the form of an individual who was convinced beyond doubt of having been abducted, the astronomer responded: ” To be taken seriously, you need physical evidence… But there’s no [evidence]. All there are, are stories .” So, should we believe the stories and fear debt? The answer is, it depends. But as a general practice, avoiding an investment simply because of its level of debt is short-sighted. For example, see Figure 1, which shows the relationship between a country’s debt-to-GDP level and the returns of that country’s bond market. Included is a mixture of developed and emerging market countries, with a requirement that each country report a debt-to-GDP ratio and 10 years of bond returns. I’ve highlighted two “groups” of countries – those that have seen low returns over the last 10 years and those with higher returns. Notably, there’s no apparent relationship within each group or across groups. Higher debt levels didn’t always lead to lower returns, and low debt levels didn’t always lead to higher returns. So, rather than take intuition at face value, as investors we must ask ourselves: “What causes one country with a low debt-to-GDP ratio to return 1.5% per year, another to return 4% per year, and yet another to return 7.5% per year?” Clearly, market participants are taking many more factors into consideration than just the perception that debt is scary and should therefore be avoided. Figure 1. Another consideration involves the actual portfolio ramifications of focusing on debt levels as a screening metric. The easiest strategy with which to evaluate the impact of debt involves weighting an index according to a country’s GDP instead of to its bond market. And if we compare the Barclays Global Aggregate Bond Index to the GDP-weighted Global Aggregate Bond Index, we see an immediate attraction: Duration is reduced marginally from 6.47 to 6.33, but the yield increases by close to 20% – from 1.72% to 2.06% – by moving to the GDP-weighted index.¹ Less risk and greater return? Free lunch alert! However, if we closely examine Figure 2, we can clearly see what’s going on. By moving away from market cap, you underweight the U.S. and Japan and overweight various emerging market segments. After all, the U.S. and Japan both fit the profile of the most indebted countries. One implication is that while both indexes are considered investment-grade, the GDP-weighted version has a noticeable tilt towards lower-quality bonds. Figure 2. Why is this important? Because as much as we’d like them, free lunches do not exist. Case in point: From January 1, 2008 through February 28, 2009 (the last notable equity bear market), the Aaa segment of the Global Aggregate Bond Index returned 0.2%. The Aa segment returned 5.8%, the A segment returned -17.1% and the Baa segment returned -14.0%.¹ In other words, by tilting to the segments that may be more sensitive to movements in the credit spreads, investors must be willing to accept the greater influence of the equity markets, particularly during really bad times. What’s more – and what’s important – is that a primary motivation for holding fixed income (at least in our opinion) as a consistent and meaningful diversifier for equity market risk may be marginalized (see: Reducing bonds? Proceed with caution ). My advice? Next time you hear a strategist, sales executive, or portfolio manager encouraging you to avoid indebted countries or companies, ask yourself whether you should buy into the hype. Indeed, as Sagan is famous for stating: “Precisely because of human fallibility, extraordinary claims require extraordinary evidence.” So, let’s all take a deep breath and repeat: “I’m not afraid of debt, I’m not afraid of debt.” Source: Barclays Global Aggregate Bond Index. Notes: All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Securities of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.

Why Indexing Works [New Research]

It’s no secret that I think most investors should index. To be more precise, I’d call most “investors” savers. And if you’re treating your portfolio as if it’s your savings, then your financial goals are pretty simple: 1) outpace inflation and 2) reduce the risk of permanent loss. You don’t need to “beat the market” or just maximize returns. The best way to achieve these two goals is to implement a diversified, low fee and tax efficient portfolio. Given all that, indexing is the obvious way to achieve this given its inherent diversification, low fees and tax efficiencies. Of course, there are lots of ways to index and I personally prefer a countercyclical indexing approach (as opposed to a more traditional procyclical indexing approach), but that’s not what this is about. This post is just highlighting a nice new paper that was released yesterday further discussing why indexing works: “We develop a simple stock selection model to explain why active equity managers tend to underperform a benchmark index. We motivate our model with the empirical observation that the best performing stocks in a broad market index perform much better than the other stocks in the index. While randomly selecting a subset of securities from the index increases the chance of outperforming the index, it also increases the chance of underperforming the index, with the frequency of underperformance being larger than the frequency of overperformance. The relative likelihood of underperformance by investors choosing active management likely is much more important than the loss to those same investors of the higher fees for active management relative to passive index investing. Thus, the stakes for finding the best active managers may be larger than previously assumed.” [ Why Indexing Works ] This is consistent with something I posted not too long ago . One of the problems with stock picking is that the gains tend to be highly skewed. Your top performers produce most of the returns. The distribution is very uneven. So, it’s not like you’re just trying to pick the stocks that outperform the average. In order to create consistent market beating returns you basically have to know which stocks will be in the 20% of the outliers. Add on taxes and fees and you’re climbing a huge uphill battle. Anyway, go have a read. It’s a pretty good one and it even makes a slight case for stock picking in case you’re looking for it… Share this article with a colleague

Is The Recovery Of GLD Underway?

Summary Shares of GLD have bounced back in the past couple of weeks. The recent depreciation of the U.S. dollar has helped pull up the price of GLD. Will the recent rally of GLD continue? Shares of the SPDR Gold Trust ETF (NYSEARCA: GLD ) have rallied in the past couple of weeks, following the disappointing non-farm payroll market and a weaker U.S. dollar. The gold market isn’t out of the woods just yet – even though some analysts already suggest the recovery of gold is underway – as the Fed is still on course to raise rates in the coming months, and the U.S. dollar may start to climb back up if future U.S. economic reports such as JOLTS and consumer sentiment show better-than-expected results. But for now, the gold market benefits from the current market conditions. The U.S. dollar isn’t picking up, for now The appreciation of the U.S. dollar during the first few months of 2015 came to halt. Although the gold market saw short-term gains during the first half of the year, it dropped between April and July. Since then, however, gold has remained relatively flat, as the U.S. dollar also remained relatively (compared to the beginning of the year) stable. (click to enlarge) (Source: FRED ) The hesitation of the FOMC in raising rates, and the lower-than-expected growth in non-farm payroll report helped pull up the price of GLD. The minutes of the last FOMC meeting also didn’t offer much input as to when the Fed plans to raise rates, or any new insight behind the Fed’s deliberations. But the main issue will remain the progress of the U.S. economy, including when it comes to inflation and labor. As for labor, the JOLTS report will be released this week, and may boost the U.S. dollar if it shows better-than-expected results. It may offset the adverse impact the NFP report had on the U.S. dollar. Nonetheless, the market isn’t convinced that the Fed is ready to raise rates. As of the end of the week, the implied probabilities of an October rate hike are below 10%, while in December, the odds are still nearly unchanged at 37%. And these odds suggest the market isn’t convinced that the Fed will raise rates. And in a recent interview, Federal Reserve Vice Chairman Stanley Fischer opened the door for a scenario in which the Fed may opt out from raising rates this year, as opposed to repeated claims that the Fed, including Chair Yellen , aims to raise rates this year. He stated that a rate hike is expected, but isn’t a commitment. As long as the Fed isn’t raising rates, the U.S. dollar may remain flat or even decline against other currencies, which will keep fueling the rally of GLD. But GLD isn’t the only way people invest in the yellow metal – some also consider buying coins. And the demand for coins seems to have gone up in previous months. Higher demand for coins? The U.S. mint experienced a rise in gold coin sales back in July-September. Since then, however, sales have gone down and are at among the lowest levels for this year, as presented in the following chart. (Data Source: U.S. Mint ) This is only a signal as to the changes in the physical demand for gold for investment purposes in the U.S. So far, the slow fall in gold prices in the past few months may have fueled a rise in demand for gold during the summer. I have pointed out in a previous article that total demand for gold declined in the second quarter. So even though this recent finding may signal (albeit it should be taken with a grain of salt, considering it’s not a complete account of the changes in the demand for gold coins on a global level – less than 10%) a modest gain in demand for coins during the third quarter, it’s still too early to determine if this means the gold market is tightening, and how this could affect the price of gold in general and GLD in particular. Final note The recent rally in GLD may not last long, especially if the U.S. reports including JOLTS and consumer sentiment show promising results. If not, the recent rally of GLD is likely to continue until other central banks boost their QE programs (ECB or BOJ), which will drive up the U.S. dollar, or until the Fed starts to drop stronger hints as to timing of the historic rate hike, which seems less likely to occur this year. As long as the Fed keeps pushing the rate hike to a later date, the price of GLD will keep seeing modest relief. For more please see: ” Gold and Inflation ”