Budget Basics that could Benefit Individuals and Governments Alike

With U.S. government debt at record levels and a large tax cut recently announced while corporate profits are soaring, I often reflect fondly on the movie “Dave,” starring Kevin Kline. The movie warms my heart because it shows us what could be – within the realm of government budgets (and politics). While I’ll leave the political commentary to someone else, I will say that politicians and our government could benefit from a return to budget basics.

In the movie, the White House Chief of Staff decides to use a stand-in for the President during a public photo opportunity. Things get interesting when the actual President suffers a massive stroke at the time of the publicity event. Looking to hold onto power, the Chief of Staff has the Presidential double, a small business owner named Dave, continue to fill the Commander in Chief’s shoes. While Dave has a big heart and a do-good attitude he also starts to use his new-found power. He first tests these waters by calling his friend and accountant Murray to the White House to review the annual budget. After reviewing the government ledger, Murray declares that if “[he] ran his business this way, he’d be out of business.”

There’s no doubt that the U.S. financial system is a much more complicated structure than an individual household or small business, but as the movie “Dave” suggests, it can still benefit from the simple principles you and I use regarding our own financial affairs. One such principle is debt management. As it stands, U.S. debt to gross domestic product (GDP) is around 105%. Gross domestic product (GDP) is the total dollar value of all goods and services produced over a specific time period. While GDP is a measure of the size of our economy it also describes how much the U.S. produces or earns.

The point is that a higher GDP (i.e. earnings) suggests the government can handle higher debt levels. The same principle applies to an individual: someone with a larger salary can typically handle a higher level of debt, all else equal. But when you divide debt by income or GDP – the debt to GDP ratio mentioned above – lower is usually better. For example, most banks will consider an individual a high credit risk if their total debt level to gross income is above 36%. Now compare that to 105% of U.S. debt to GDP and you can see that our government might do well to start reducing its reliance on debt.

Looking at the historical record, U.S. debt to GDP has averaged 62% since 1940. Today’s levels are well above that and the second highest in our history. Debt to GDP reached an all-time high in 1946, at 119%, when the U.S. issued a significant amount of debt to fund our efforts during World War II. Given the serious threat to world stability during the 1940’s, most would argue the additional debt issuance was a risk worth taking. However, today’s elevated debt levels come during a time of relative peace and following nine years of U.S. economic expansion – the second longest on record.

Shifting back to budget basics, most would agree that times of prosperity and stability are ideal periods in which to reduce the deficit and thus national debt. Or at least not add to existing levels.  Unfortunately, the U.S. government has not followed these principles in recent years. Granted, we’ve had some extenuating circumstances such as the Financial Crisis but we’ve also had steady if not subpar GDP growth since then. Most economists – and budget basics – would argue for increasing taxes or at least holding them steady towards the later innings of an economic expansion, when corporate profits are high. However, this time around Congress passed a tax bill that significantly reduced company taxes.

To be fair, there are well documented benefits to running a budget deficit (for a country) and cutting corporate taxes. However, if deficits continue over the long-term, debt levels can mount, ultimately becoming a headwind to future economic growth and prosperity. As interest rates climb from currently depressed levels, so will debt servicing costs. On top of higher interest expense tied to rising yields, the historical record has shown that large tax cuts can boost inflation – especially when implemented towards the end of an economic expansion – and thus contribute further to rising interest rates. At the same time, lower taxes reduce the government’s revenues and make weathering the next recession more difficult.

While the recent tax bill is clearly a near-term positive for companies, employment, and the economy, it can also bring long-term benefits if our politicians implement sound financial policies that balance the budget and bring down government debt levels. In short, our Congressional and Executive leaders might do well to take a page out of the movie “Dave” and return to some budget basics. They might also enjoy a little break in the process.

 

 

 

 

 

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Why Stock Buybacks are Significant and What to Make of Recent Trends

Company stock buybacks recently surpassed 2007’s prior record of $172 billion. As of the first quarter 2018, buybacks from the S&P 500 Index constituents reached $178 billion, up about 34% year-over-year. This compares with $24 billion in stock buybacks at the market bottom in 2009.

As the name implies, stock buybacks (also known as share repurchase programs) happen when companies buy back their own shares. A firm uses its cash position to repurchase company stock either in the open market or directly from select shareholders. These programs reduce the number of shares outstanding for the company in question and thus increase the ownership stakes of its remaining shareholders. The end result is more profits or earnings per share (EPS) per shareholder.

In general, stock buyback programs are viewed favorably by Wall Street. These programs help neutralize shareholder dilution that comes from excessive stock option issuance. Many management teams go further and announce buyback programs that more than offsets dilution from stock options.  In these cases, existing shareholders see their ownership stakes grow, and with it, their portion of earnings per share.

Another positive attribute of share buybacks is their affect on key company financial metrics such as earnings per share (EPS), return on equity (ROE), and earnings growth rates. These ratios are used by professional investors to determine the health of a company and are usually part of their investment decision process. Because share buybacks often boost a company’s financial profile, these programs can lead to more interest among institutional investors and thus increased demand for the stock. Higher demand from large investors typically translates into a higher stock price. With higher ownership stakes and larger earnings per share accruing to remaining investors, stock buybacks offer shareholders a compelling, two-fold benefit.

Investor perception also plays a significant role in share buybacks. Many argue that because a company’s management team has inside information regarding a firm’s growth prospects, a share buyback announcement is a signal that a stock may be undervalued – otherwise management would choose to spend the company’s cash on more profitable investments. This positive signal alone can cause a stock’s price to rise.

There is a downside to share buybacks, however. In recent years, record-low interest rates have prompted many companies to issue large amounts of debt to fund their share buyback programs. While this has had the effect of boosting near-term earnings growth and increasing existing shareholders’ ownership stakes, it could come at the cost of longer-term returns. Although interest rates remain low, as yields increase- debt servicing costs are likely to rise. These higher debt burdens – taken on to buyback company shares – could crimp a company’s ability to invest in value-enhancing initiatives such as technology investments or new manufacturing facilities, and ultimately reduce long-term earnings and cash flow growth.

Likewise, stock buybacks are a more flexible alternative than issuing a dividend. Many contend that management teams prefer share repurchase programs to dividend payments because they can easily suspend buyback activity with limited negative ramifications. In contrast, dividend cuts are viewed quite unfavorably by investors and are likely to significantly pressure a stock price. When a company issues a new dividend it suggests confidence in the firm’s market position, growth prospects, and cash flows. Thus, when dividends are cut or eliminated it signals deteriorating company fundamentals ahead.

Given the short-term benefits and minimal near-term risks associated with share buybacks, more companies are engaging in these programs than ever. Similar to individual investments, repurchase programs are most beneficial when a management team buys its firm’s stock at low levels and watches it appreciate in value over time. Although the investing principle of buy low and sell high is well understood, many corporate directors fail to follow this basic rule of thumb. The historical record indicates that seasoned company management teams are just as likely to buy at peak valuation levels and refrain from share buyback programs at market bottoms.

Although company management teams have a poor track record when it comes to timing share buyback programs, many are excellent stewards of their firm’s growth prospects and market positions. This suggests that as individual investors we would do best to focus on high-quality investments with long-term track records of delivering value and leave the market timing to speculators.

Carrie Tallman, CFP®, CFA™
Guest Contributor 
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What a Rising Rate Environment Could Mean for Bond Funds

After the yield on the 10-year U.S. Treasury Bond – a widely used economic bell weather – bottomed in July 2016, interest rates have risen substantially through March of this year.  The recent upward pressure on yields has pushed bond prices lower.  Strong economic growth, ongoing interest rate hikes from the Federal Reserve, and recent political developments could mean higher yields ahead.  Given the current environment, we’d like to take a closer look at bonds and bond funds.  We’ll examine how they work, a key risk metric to consider, and how these investments might perform if interest rates continue to rise.

Bonds are a type of fixed income investment given the regular cash flows a bondholder receives.  Similar to your home mortgage but with the roles reversed, investors who own bonds are loaning money to an entity (usually a corporation or a government) in exchange for a variable or fixed interest rate over a specified period of time.  This interest rate is known as the bond coupon and it varies based on the credit worthiness of the entity and the length of the payback period, among other factors.

While a bond’s coupon rate, or its stated yield at issuance, remains fixed for the life of the bond its price or value on the open market will vary based on prevailing interest rates.  When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.

How sensitive a bond’s price is to a change in interest rates is measured by a term called duration.  Specifically, duration is a measure of interest rate risk.  It indicates how much a bond’s principal value will rise or fall due to a change in interest rates.  Measured in years, a bond or bond fund with a higher duration will be more sensitive to changes in interest rates than a lower duration bond or bond fund.  As a result, a portfolio of bonds with a higher duration will fall more in price as interest rates rise than a portfolio with a lower duration, all else being equal.  Fortunately, bond mutual funds or ETFs report their portfolio duration and investors can use this metric to gauge short-term risk.

I say short-term risk because while a jump in interest rates – as we’ve seen recently – will weigh on a bond fund’s near-term performance, the higher current income that comes as a result of an increase in interest rates will often offset much of the decline in a bond fund’s value over the long-term.  This is one benefit of owning multiple bonds or a fixed income fund versus an individual bond.  Because a portfolio of bonds or a bond fund doesn’t have a single maturity date (instead it contains many bonds with different maturity dates), it can provide more income flexibility.  For example, in a rising rate environment, as some bonds in the portfolio mature, the manager can reinvest proceeds from those securities into new bonds that now have higher yields.  In turn, this pushes the portfolio’s yield up and helps to offset price declines.  In particular, bond funds can offer significant diversification benefits given their exposure to many individual bonds with different durations and credit profiles often for a low fee.

While a bond fund’s duration will indicate how much it declines (or rises) in price when interest rates rise (or fall) over a given period, it also indicates how much of a boost it will get from new, higher yields.  Bond funds with higher durations – which are more sensitive to interest rates – typically offer higher current yields to compensate for their higher risk profiles.  So while bond portfolios with higher durations will experience sharper price declines when interest rates rise, they’re also more likely to benefit from higher current income over the long-term.  At the same time, bond funds with shorter duration – which are less sensitive to interest rate changes – won’t benefit as much from higher current income associated with rising interest rates, but they won’t fall in price as much either.

The point is that bond duration is a useful risk metric.  When a fund has a higher duration it tells us that its price will fall more dramatically when interest rates rise as compared to a lower duration fund, but it should benefit more from higher current income tied to higher yields.  The key, however, is your investment time-horizon.  As an investor, you’ll be able to benefit from the higher current income of a longer duration bond fund only if your time-horizon exceeds the fund’s duration.  When it does, higher income over the long-term should offset near-term price declines.

This dynamic – of higher income offsetting falling bond prices – is related to the nature of bonds and is nicely illustrated by the Bloomberg Barclays U.S. Aggregate Bond Index.  According to Charles Schwab, since 1976 over 90% of this index’s total return has come from income payments rather than price changes.

While most investors should fair well with a bond fund that is aligned with their investment horizon, diversification is another important consideration.  As stocks have historically delivered the strongest long-term returns and have outpaced inflation since the early 1900’s, bond investments are best used when there is a specific income need.  When this is the case, having a mix of shorter and longer-duration bond funds can help an investor take advantage of a changing interest rate environment and mitigate sharp price swings.  In today’s environment, owning bond funds with varying durations – in proportion to one’s income needs, investment time horizons, and risk tolerance – an investor should be better able to take advantage of rising interest rates.  For example, let’s take a client with 20% of his bond holdings in a short duration fund, 20% in an intermediate duration bond fund, and 60% in a long duration bond fund.  If interest rates were to rise sharply, the lower duration fund would see a small if negligible decline in value. In some cases, it may make sense for the investor to sell some of those shorter duration securities and use the proceeds to add to their long duration bond fund, which would now have a higher current yield.

In addition to duration and price sensitivity, Parsec’s Research Committee considers many other factors when constructing a client’s fixed income portfolio.  We also look at where we are in the credit cycle, the underlying quality of each bond asset category, valuation levels, and inflation sensitivity, among others.  Although thorough and well thought out research is critical to meeting your financial goals, staying invested for the long-term is even more important.  When appropriate, doing so with a fixed income portfolio can help you better weather significant price swings and ultimately benefit from current income.

Thank you,

The Parsec Team

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I Hate Debt

Don’t we all??  I worry about placing myself in a situation where an unexpected event (car accident, illness, et cetera) could create a financial disaster.  As a result, I carefully monitor the level of both short- and long-term obligations I have. 

With interest rates at historic lows, I decided to take a closer look at refinancing my house.  I have refinanced two times already; should I do it again?  Some of you may be considering the same thing, so I thought I would talk a bit about how I made my decision.

It is important to understand what you are trying to accomplish.  In my regard, I want to pay off my house within 15 years, while keeping the monthly payment at a reasonable level.  Others may want to tap home equity so that they can pay down loans with higher interest rates or do some repairs to the home.  If this is the case with you, calculate in advance how much you need. 

The next step is to take a look at your credit report.  Some people have had some dings from the Great Recession.  Resolve any reporting issues in advance of applying for a loan.  It will save you a lot of aggravation later.

Now, let’s figure out if it is feasible to refinance.  I used the calculators that are available on the bankrate.com website.  Here is a link:  http://www.bankrate.com/calculators.aspx. They have a great mortgage amortization calculator that shows you total interest paid over the life of the loan.  You can also see the impact of extra amounts paid toward principal. 

Using this tool, I entered my current interest rate and loan terms.  I analyzed the impact of the extra payments I have been making toward principal each month.  Then, I entered a 15-year term but with a lower interest rate. 

I compared the total interest expense with my current rate vs. a lower estimated rate.  The difference in total interest paid for my current loan vs. the lower interest rate loan is about $5,000, as long as I continue to make extra payments toward principal.  Closing costs and refinancing fees add up, so I suspect that net difference between the two loans would be much lower. 

As long as I continue making extra payments toward principal, I will accomplish my goal of paying off the loan within 15 years.  The lower interest rate loan would also require a larger monthly payment.  I am not comfortable with that.  With my current loan, I can keep my lower payment amount, giving me some security in the event of a serious financial crunch. 

Lower interest rates can be very enticing.  In the long run, though, you could sacrifice financial peace-of-mind just to save a few dollars.  A careful analysis of your personal situation can help you make the right decision.  If all of this seems overwhelming, we are always here to help.  Your financial advisor is just a phone call away.

Cristy Freeman, AAMS
Senior Operations Associate

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