Thoughts from Pawleys on Investment Strategy

Sometimes the noise of the markets can be a distraction from basic fundamentals. The best strategy to cushion both stocks and bonds (including mutual funds) is to focus on quality. For fixed income (and we do a fair amount of tax-free municipal bonds, especially within South Carolina), the highest rated bonds will be less volatile when interest rates rise. When the economy slows, corporations with consistent earnings and little debt tend to be less volatile. Look for consistency and quality, and avoid swinging for the fences with low-quality momentum stocks and poorly rated bonds, because you will likely get burned. Having a plan can help you stay on track, especially when news and political events start to cause anxiety in an otherwise healthy market. Random, unplanned changes rarely pay off. Remove low quality investments and trim over-weighted areas in your portfolio. Many investors lost 50, 60, even 70% during 2008 because they forgot to rebalance and held lower quality investments. A well balanced, 50/50 portfolio of high quality investments would have dropped approximately 15% that year. Adding structure sounds like an obvious guideline, but because most investments are sold on a commission-basis, many people end up with a random collection of investments that don’t necessarily fit together. Like any sports team, a solid portfolio is constructed of individual parts that work well together as a whole. Lastly, news sources can generate lots of hype and create worry…but investing should be fun. Having our local schools and parks operate effectively would not be possible without the debt issued by municipalities, which enables investors to enjoy a stream of tax-free income. The creation of capital through the equity markets is what allows innovative companies to grow and expand, while investors reap the benefit of growing capital and even dividend income along the way. Enjoy the process and have fun!

© 2014 Pawleys Investment Advisors, LLC. All rights reserved.

Beware Rising Interest Rates

As of March of 2012, the 10 year U.S. Treasury yielded 2.35%, and pundits said rates could not go lower – they did.  Afraid of the stock market plummet that coincided with the economic downturn, investors have fled to the safety of fixed income investments.  Following the recession of 2008-2009, investors poured over $1 trillion over a few short years into bond funds.  In the meantime, the S&P 500 has more than doubled in value, and those investors have missed out on historical investment gains.  There is a saying that while history may not exactly repeat itself, it definitely rhymes.  I caution against “reaching for yield.”  Longer term bond funds with below average quality will face downward pressure in a rising interest rate environment as new bond issues become more attractive than the older, seasoned bonds held by funds.  During 2013, long term U.S. bonds lost -9.92% as interest rates started to rise.

Launched in 1973,  the Vanguard Long Term Investment Grade Bond Fund is the oldest Vanguard bond fund.  When the Fed started raising short-term interest rates in 1993-1994, the fund plummeted over 17%.

VWESX November 1993 through December 1994 – Yahoo! Finance

The time period from October, 1993 to November, 1994 was one of the most difficult times for bond funds.  Spoiled by the high rates of the 1980’s, investors sought alternatives to low rate bank deposits, CD’s and money markets.  Money poured into bond mutual funds in the months preceding this time period.  When rates started to rise, short-term funds and those funds that invested in lower quality securities lost significant amounts of money.  Fast-forward to today – interest rates have already started to rise, so it is VERY important to review bond mutual fund holdings for duration and average credit quality.  When rates rise, in general, the most volatile bonds are those with the longest maturities, deepest discount prices (such as zero-coupon bonds) and low credit ratings, so these are areas that investors should consider avoiding.  As always, review your overall asset allocation percentages and be sure you have a written plan for your financial goals.

By focusing on short-intermediate term high-quality bond funds and ladders of highly rated individual tax-free municipal bonds, investors can mitigate the downward pricing pressure created by a rising interest rate environment.  Keep your “safe” money safe.

© 2014 Pawleys Investment Advisors, LLC. All rights reserved.

Alternative Minimum Tax and South Carolina Municipal Bonds

Before you read further, remember this: consult with your CPA regarding your personal situation as it may relate to AMT.  In the meantime, what is the Alternative Minimum Tax and what does it have to do with investing in South Carolina tax-free bonds?  The origin of AMT goes back a few decades when an alternative tax was implemented to offset high-income individuals taking excessive deductions and hence, paying little or no tax to the Internal Revenue System.  Tax code is, of course, very complex, and way beyond the scope of this article.  But I will touch on three important points for you to remember:

1.  AMT can be triggered by a combination of high deductions, passive income, the exercise of stock options, income from private activity municipal bonds, and a number of other factors.

2.  These days, even average income taxpayers with modest deductions may trigger AMT.

3.  The code around AMT is complex and subject to frequent revision by the IRS, so as I mentioned at the top, consult with your tax professional.

When investing in tax free municipal bonds in South Carolina (or other states), be sure to understand if an issue pays interest that may be subject to AMT.  The tax-exempt status of municipal bonds is based on how the proceeds of the debt issuance are used, and if there is any level of private activity, the interest may be deemed taxable or subject to AMT.  As always, please drop me a note if you have any questions.

© 2013 Pawleys Investment Advisors, LLC. All rights reserved.