CD’s and Money Market Funds As of June, 2018

For many years’ the USA (and much of the developed world) offered very low interest rates on accounts with low risk (guaranteed accounts).  The policy was known as “ZIRP” or “zero interest rate policy”.

As a result of ZIRP, this author started exploring CD’s purchased through a brokerage, which offered a couple of percentage points more in return (than zero) with the same, virtually zero risk.  These brokerage account CD’s typically offered higher returns than you can get from your local bank or savings accounts.

Over the last couple of years, however, the USA has begun to raise interest rates.  Today, the VMFXX money market from Vanguard offers a return of 1.74% (with an expense ratio of 0.11%).  There is also an expectation of continued increases in the future, although no one knows for certain what will occur.

Since the “base” rate is now effectively about 1.75% (more or less), the CD forward “curve” looks like this:

  • Base rate (no CD, leave in money market) – 1.75%
  • 1 year CD – 2.30%
  • 2 year CD – 2.80%
  • 3 year CD – 3.00%
  • 5 year CD – 3.30%
  • 10 year CD – 3.40%

When you buy a CD, you essentially “lock up” your money for that duration.  If you have a 2 year CD, for instance, you can always buy or sell off that CD, but if interest rates go up you won’t receive back 100% of your investment.  For example, if you have a 2 year CD at a rate of 2.80%, and short-term interest rates move from 1.75% to 2.00%, for example, and you needed to sell your 2 year CD, you might receive 99 or 98 cents on the dollar (it could seem higher because you’d also be getting back interest accrued prior to your next payout, for example if you had a semi-annual payout).  These are really minor “losses” in the grand scheme, especially if you are dealing in the thousands or even few hundreds of thousands.

The future of our interest rate policy is (as always), essentially unknown.  Interest rate policy is also closely tied with the value of our currency, although this takes the entire conversation off into a far more complex direction.

In a time of ZIRP for an extended period (we had it from 2008 to 2015), buying products like CD’s was essentially the only way to get any sort of risk free return on interest at all.  With short term interest rates at 1.75% and (likely?) heading upward, now there are more options on the table, including doing nothing and taking the short term rate or locking up funds for the near term or even medium term.

All of this income is taxable.  Thus the effective rate that you receive is lower, depending on your tax rate.  Tax rates did come down a bit with the 2017 tax changes, with most folks in the 12% / 22% / 24% range.  Thus if you get 2% your return is effectively around 1.5% – 1.6% after taxes.

This blog will also look into the current state of iBonds, another product that is essentially risk free that we reviewed in the past, in an upcoming post.

 

Hedging the US Dollar in the “Basic Plan”

Recently the US dollar has strengthened against most foreign currencies.  This means that you could buy foreign stocks and they could do well in their local markets (for example, the Japanese stocks were generally up for a time) and yet you would have losses when your ADR or ETF was valued in US dollar terms.

While you cannot generally hedge the currency risk in a single stock ADR (for example, Toyota), they now offer ETF’s that give exposure to foreign markets but also hedge those currencies against the US dollar, so you receive their “actual” return (good or bad) rather than their actual return PLUS the impact of the rising or falling US dollar.

For instance, let’s look at the VEU Vanguard ETF (one of my favorites, the Red line below) against a new ETF I started looking at, HEFA (the Blue line), over the last two years.  You can see that the total return was 1.1% positive in HEFA and 14.2% negative for VEU over that time span.  This difference is due almost totally to the rise in the US dollar against foreign currencies that make up the bulk of those stock indexes (the Euro, the Japanese Yen, the Australian Dollar, and the Canadian Dollar).  You can see that the peaks and valleys of the blue and red lines track together (they move in the same direction) but the red line sinks as the US dollar rises over the last two years.

 

VEU vs HEFA Last 2 years
VEU vs HEFA Last 2 years

One negative impact of this, all else being equal, is that hedging costs money and this should be expected to drive up fees on your ETF.  The ETF for Vanguard (VEU) is 0.14%, which should be considered somewhere near rock bottom.  The HEFA ETF expense ratio is 0.35%, which is also very low, but higher than the Vanguard product.  This isn’t a perfect comparison because generally the Vanguard ETF’s have the lowest expense ratios due to their member-owned structure.  HEFA is part of iShares which is now owned by Blackrock, a major competitor of Vanguard.

It should be noted that the VEU and HEFA indexes aren’t exactly the same in terms of countries that they cover and weighting of markets but as you can see above they generally move closely in tandem and the majority of the difference is due to the impact of the US dollar against foreign currencies.

This is of interest because the US Federal Reserve is considering raising interest rates soon, which theoretically would cause the dollar to rise which would make holding shares in other currencies less profitable.  Of course this is already priced into the dollars’ current level, which could mean in practice that if the Fed doesn’t move fast enough or make enough moves, the dollar would fall.  If anyone ever tells you that they can predict interest rates or currency moves you should not believe them; there is no reliable way to predict either one although there are mass industries of pundits attempting to do so.

Thus for my “basic plan“, the question is, should you also consider adding currency-hedged ETF’s and not just the two basic ETF’s (VEU and VTI).  The question is whether to replace part of your VEU allocation (how much you buy) with something like HEFA (there are other ETF’s, but this seems to be a pretty good one, with a large base of investors and from a company like Blackrock which isn’t going away any time soon).  Here’s what would happen – if the US dollar falls against major foreign currencies, you are going to make less money than you would otherwise if you hedge it.  If the US dollar rises, you will make more money than you would otherwise with the hedged product.  Also note that the hedging may not be perfect, but would likely shield you from the vast majority of the impact, especially on major currencies like the Euro.

I think that this is getting a lot of play in the financial press right now and I predict that at some point these products will be mainstream.   It took a long time to move from “active” to “passive” investing and it has taken many more years for ETF’s to begin to take a large share of new investments away from mutual funds.  This is another long term trend that started on the margin (there were very few currency hedged funds a couple years ago when I looked, and they were expensive) but is now going mainstream, and the additional expenses for hedging seem quite modest (0.14% vs. 0.35%).

Recent Stock Moves

Rise of the China Stock Market

When you are judging the success of your portfolio against benchmarks, which conceptually is a simple exercise, the question soon arises:

1) who are you comparing yourself against?

2) what currency is your benchmark denominated in?

Whether you want to invest there or not, China has had a major rally, and the Chinese Yuan is stable against the US dollar (in the range of 6 Yuan / dollar and 6.4 Yuan / Dollar over the last 3 years) as opposed to other currencies like the Euro and the Japanese Yen which have cratered in dollar terms.

The incredible rise in stocks in Chinese stock prices has mostly gone “under the radar” of US media.  Recently they connected the stocks in Hong Kong with stocks on mainland China and not only have prices risen substantially, the same stock trades for different prices in each location.  Per this WSJ article

Shares of Chinese companies listed in Hong Kong look like a steal compared with shares of the same companies that are listed in Shanghai. Such stocks on average trade at a 32.89% discount in the former British colony, according to the Hang Seng China AH Premium Index.

Typically, under a concept called “arbitrage”, the price of equivalent items in different markets are narrowed when investors take steps to capture the “easy money” of buying that same good cheaper in a different place.  A very simple example is that you can’t have gasoline selling for $4 in one state and $3 in an adjacent state; everyone just crosses the border to buy the cheaper gas until the price differential narrows.  Gaps of a couple of percentage even across exchanges is enough for investors to jump in and take advantage; a 32% differential is extreme.

This rally isn’t due to a perception that the economy in China is getting better; in fact it seems to be getting worse.  The rally has been enhanced by structural moves that allow more investors into the market (largely retail mainland investors) and lets them buy stock on margin, as well.  Per this WSJ article:

Margin lending has more than tripled in the past year to a record 1.7 trillion yuan ($274.6 billion)…The practice isn’t unique to China, where margin debt equals 3.2% of total market capitalization, compared with 2.3% in the U.S. But when compared with the value of stock that is freely traded, making it accessible to ordinary investors, the percentage for China rises because state entities own more than half of the market.  Research by Macquarie Securities Group shows China’s margin-debt ratio at 8.2% of the free float. That easily exceeds the peak of 6% reached in the late 1990s in Taiwan, the second-highest level globally in recent years.

Thus if you didn’t have a proportionate share of your portfolio invested in Chinese stocks, you were a “relative” loser, although there are many reasons to believe that this rally isn’t sustainable.  This goes back to the original question of how benchmarks are defined.

Individual Stock Moves

In one of the portfolios I follow there have been significant and immediate moves in several of our stocks.  These stocks were related to China or the the technology industry.

Linked In (LKND) recently had an earnings call and their stock price plunged by over 20% in one day.  The cause of the drop wasn’t the earnings themselves (they beat expectations), it was their “forward guidance”.  For stocks with a high price / earnings multiple like Linked In, the market needs to have continued rapid growth to justify the high stock price today.  In fact, Linked In currently doesn’t book profits, primarily due to their high amounts of stock based compensation (stock given to executives in lieu of cash).  Linked In’s guidance talked about currency headwinds (meaning that if they brought in the same revenues overseas it would “count less” towards net income because of the rise in the US dollar) and also some one time acquisition costs from recent companies they’ve purchased.

Amazon (AMZN) had their last earnings call where they continued to show no profits on a GAAP basis and yet their stock rose 6.8% due to other factors that analysts apparently found compelling.  Note that a 6.8% gain for a company the size of Amazon is a large increase in market capitalization (over $10 billion) in a single day.

China Life Insurance ADR (LFC) has almost doubled from around $40 / share to $80 / share as part of the overall China rally discussed above.  While a seemingly sound stock this performance gain is not tied to any fundamentals in how the company operates; this growth is tied to the giant overall rally.

Wynn Resorts (WYNN) dropped more than 10% in a single day after earnings were released.  Wynn has a property in Macau (China’s only location with legal gambling) and it has been hit hard with a recent crackdown on high-roller gamblers by China’s communist leaders.  Note that the scale of gambling in China dwarfs Las Vegas by any measure (total market, amount bet per player, etc…) and thus properties in China have been proportionally more lucrative than their US equivalent.  It is not known whether this will be a long term reduction of high rolling gamblers or a short term hit; that depends on inscrutable Chinese government polices.  Left to their own devices, it is highly likely that Chinese would continue to gamble at record rates.  Wynn also has long running board issues and governance issues as well.  At risk is their dividend, which “income investors” price highly in an era of virtually zero yield on debt (without taking on significant risk).

Westpac (ADR) – the Australian bank slightly missed earnings and their stock went down almost 5%, but then recovered a bit and was down 3%.  The CEO said that flat earnings won’t be tolerated in a later interview.  Unlike those companies with little or no GAAP profits (Amazon, LinkedIn), a company like Westpac won’t usually fall as much with a minor earnings miss because it has a lower P/E ratio and incredible future profit growth isn’t already “baked in” to the stock price.

Seeing large moves in single stocks can be viewed as a sign of a bull market in its last stages.  Since we invest for the long term we don’t pull in and out of the market based on short term moves but it is definitely something to consider; stocks with limited earnings and high P/E ratios or tied to giant rallies like is occurring in China today should be on some sort of watch.

Cross posted at Chicago Boyz

Buying CD’s Through Your Brokerage Account

For many years at this site I have advocated buying CD’s through your brokerage account (Fidelity, Vanguard, E-Trade, Schwab, etc…). If you buy a CD through your own bank you will usually get a far lower rate for what is a completely commoditized product (they are all guaranteed through the FDIC, after all) than what you can get if you shop around in a brokerage.

CD_Yields

This NY Times little data graphic found in their business section makes this point starkly. Let’s look at the differences between the “average” CD that your bank would offer versus what you can get from these other banks offering the highest yields:

– 6 month CD (0.16% average, 1% for highest paying CD)
– 1 year CD (0.27% average, 1.21% for highest paying CD)
– 5 year CD (0.87% average, 2.25% for highest paying CD)

In an era of ZIRP the difference between almost nothing (0.16%) and 1% is very significant. Someday if interest rates rise we may not have to scrape for nickels like this but in today’s environment you need to vigorously watch expenses, risks, and get returns where ever you can (without taking on more risk).

Portfolio Six Updated March 2015 – And It’s Tax Time

Portfolio Six is our newest portfolio, at 3 1/2 years. The beneficiary contributed $1500, the trustee contributed $3000, for a total of $4500. The current value is $4530, for a gain of $30, or 0.7% or 0.3% / year across the life of the fund. You can go here for details or download the spreadsheet at the links on the right.

In 2014 we earned $122 in dividends, for a yield of over 3%. In an era of no interest on deposits, that is very good. We sold one stock in 2014, Yandex, the Russian search engine, for a slight loss at $35. The stock subsequently tumbled down to $14 with the impact of Russian sanctions and the crash of the Russian ruble.

Two of the stocks are oil stocks – Exxon Mobil and Royal Dutch Shell. When oil prices fell from over $100 / barrel to under $50 / barrel (which no one saw coming, at least not the formal analysts) these stocks fell. However, they are both well run companies and pay solid dividends and we plan to hold them for the longer term, unless new adverse events occur.

Two of the other stocks remain under pressure – Coca Cola Femsa, which sells Coca Cola and other beverages in Mexico and Central America, has fallen with the decline in the Mexican Peso vs. the US dollar. Mexico is a good long term growth market but this is on watch. Seaspan, the Chinese shipper, also fell but their very high dividend (7.3%) is still holding up.

Baidu (the Chinese internet company) and Procter and Gamble are both doing well.

Portfolio Two Updated March, 2015 – and It’s Tax Time

Portfolio 2 is our second longest portfolio, at 10 1/2 years. The beneficiary contributed $5500 and the trustee $11,000 for a total of $16,500. The current value is $24,497 for a gain of $9,397 or 57% or 7.4% across the life of the fund. Go here for details or download the spreadsheet from the link on the right.

During 2014 we sold 4 stocks; 2 are near their sales price, Urban Outfitters went up about 20% since then, and Yandex halved in price. So we are about even on that.

During 2014 the portfolio generated $449 in dividends; that’s a yield of about 1.9%. That’s pretty good when you consider that cash yields pretty much zero nowadays.

For stocks on watch – we still have TransAlta (Canadian utility) which has a high dividend and also some stocks that have had big gains, such as Toyota Motor and of course Facebook. Statoil and the 2 Canadian banks also have hit problems due to the commodity price crash (especially oil) and the rise of the US dollar which makes holding stocks denominated in Canadian dollars and Norwegian Kroner less valuable.

Portfolio One Updated March, 2015 – and it’s Tax Time

Portfolio One is our longest lived portfolio, at 13 1/2 years. I remember the first day we invested very well – it was right after 9/11/01, and the markets were closed for a few days. The beneficiary’s mother asked me if investing was the right thing to do and I said that we had a long run out in front of us.

Portfolio One has a value of $34,875. The beneficiary contributed $6500 and the trustee contributed $14,500 for a total of $21,000. The gain has been $13,875 or 66% since inception, which works out to approximately 6.9% / year. You can see performance here or use the link on the right sidebar.

It’s tax time. The brokerage sends a nice form. Over the years this has gotten easier as they have the cost basis on the stock for each sale and whether it is a short or a long term gain. Apparently you have to buy the higher level Quicken if you need to do any individual stock sales which probably means that the average American filer doesn’t have much at all in terms of stock gains or losses (in a non-retirement account) and that is sad. Likely in the old days all you had to do was leave your money in a bank account and earn some interest but nowadays I don’t even receive a tax form for interest for these accounts anymore because we literally earn 2 cents / year for the cash on hand in these individual accounts.

We had dividends of $816.17 and long term losses of ($165) and short term losses of ($801). In 2014 we sold Twitter, CNOOC, Urban Outfitters, Yandex, Philip Morris and China Petroleum. Not that we have the benefit of hindsight at the time we make sales like this but of the 6 we sold all but one (Twitter) are below the price right now of where we sold them.

Of the stocks we currently hold, most are pretty far above their cost basis, except for Statoil (the Norwegian oil company) which was hit like all oil companies by the fall in the price of oil and then there was a double whammy because the US dollar appreciated against the Norwegian Kroner which means that the stock price hit is magnified in US terms (it did better on the local exchange if you were a Norwegian holding your investments in Kroner). Our most recent tranche of Exxon is also down but overall that is a good stock to hold for the long term with a nice dividend and a ruthless and focused executive team.

The dividends number is nice. Every year this portfolio earns almost $900 in dividends, on about $34,000 invested in stocks of average, (the cash returns interest, which is zero),for about 2.6% yield. Since cash returns zero as we discussed above this is how you earn any sort of income anymore – you need dividends back from your stock. Qualified dividends receive a lower tax rate – it doesn’t impact the beneficiary as much as it impacts us – but for some reason not all dividends qualified. It turns out that you have to hold the stock for 60 days to receive the tax benefit and often there is a first dividend payment before we hit that date.

I pass on all this information to the beneficiary and now they are adults and they need to do their own taxes. That is a sign of adulthood when you finally realize how much taxes you pay every year to social security, medicare, the Federal government, the State government, etc…