Stock Market Got You Down? Time to Focus on Fixed Income: Jarvis® Update September 16, 2022

Does the volatility in the stock market have you down? We think it's time for investors to focus squarely on fixed income securities. We cover this and much more in this week's Jarvis Update. I'm your host, Brian Dress, Director of Research here at Left Brain, joined as always by our CEO and Chief Investment Officer, Nolan Langford. Nolan, welcome to the program.

Thank you, Brian, and I'm looking forward to some good old-fashioned football. We got a great Thursday night lineup, so let's get to it.

Yes, Nolan. Hopefully I'm not in tears tomorrow after the Chiefs game. We'll see how it goes. We're going to jump right into our preview. So I'm sure you've heard we're in the throes of a potential recession here. So the market's starting to digest a lot of that news. We've got two topics for you as usual. The first topic is we're calling Markets Are Testing Our Patience. And the second topic is our continued focus on fixed income instruments. Before we get into all of that, a couple of announcements for you. Of course, we produce this show for you, the individual investor, whether you have a 401(k) or an IRA, if you manage your own money or you work with an advisor, we'd love to give you a second opinion in a difficult market here. Uh, take a look at the number below on the screen. Give us a call if you want a second opinion and want to talk a little bit more about your portfolio and how we might be able to help you achieve your financial goals. Also, if you're an institutional investor, we've got something for you as well. And that's our research service. That's 8 to 10 full-length stock reports per month. And if you want access to our library of hundreds of reports, uh, take a look at the link below. Either way, sign up for our bi-weekly newsletter. This week we're going to be on, and there's plenty to talk about. Uh, sign up at the link below if you want to get on our mailing list to receive our content in your inbox every Saturday morning. And of course, finally, thank you to all the viewers that have been with us. We've had a number of loyal viewers since the beginning. But the number is starting to creep higher and we'd like to know more about you. If you have a comment, drop it below, like and share the video if you find it useful. And of course, subscribe so that you can get a notification every time the next video comes out. With that, we'll jump into the market recap. All three indexes that we follow are down. S&P was down 2.6%, NASDAQ as well, down about 2.6%. And then the Russell was actually an outperformer. This is a theme we've told you over the last few weeks. The Russell was an outperformer at -1.2%. So We had acceleration to the downside, a lot of volatility, a lot of news this week. Part of that news is the 10-year Treasury, it's up around 3.5%, so that's a high, uh, a high print for the last year. And the 2-year is closing in on 4%, so interest rates are continuing to move higher. We had a hot inflation print in the CPI, Consumer Price Index, this week, and that really, uh, rankled investors. Uh, that came in at 8.3%. We were looking for a down print, Nolan, what are your initial thoughts on this week's action and what can we make of the inflation picture?

So there's a lot to digest there. You said a few things that really caught my attention. The first one is that there was outperformance in the Russell 2000. And for those that have been following us for a while, I'm sure you're aware that's the index for small company stocks. And it's many, many weeks that small companies have performed better than mid or large companies. And I think that is notable. Small companies tend to be US-centric, so not a lot of foreign exchange exposure there. And then you also get some uplift not only from valuations, but they do have the opportunity to get purchased. One of the things that has been really hurting the market is growth. Growth has been really tough to come by for all companies, but particularly if you're a company with multi-billions of dollars in sales. If you can't grow organically, then the shares have really been impacted. And one of the ways for you to boost your growth is to go out and buy other companies. Small companies tend to be easy to digest for big companies. And so maybe that's a little bit of cause for the, those shares to have performed better. So the other one, as you mentioned at the beginning, a whole litany of issues, inflation, recession, the 2-year being up near 4%. So interest rates are on the rise. You didn't mention Russia and Ukraine, uh, the issues with China. And anytime we have a lot, a lot of issues in particularly when the market has sold off, that just tells me there's also a lot of opportunity that exists as well, both in the stock and the bond market. And I know investors really don't care to hear much about the stock market these days. Something tells me a couple of years hence, we really won't remember this period. For today's show, we are going to talk about the opportunities that exist in the fixed income market, because the good news for investors is now You can actually buy bonds with stock market type yields. We're finding really high quality bonds in the 7% range. And if you're willing to take a little bit more credit risk, we're seeing a lot of bonds that I find attractive even in that 8% range.

Well, Nolan, the flip side of market volatility is when prices go lower, the opportunities get more exciting. So with that, we'll move right into topic 1. So topic 1, again, we're calling Market Testing Our Patience. So of course, stocks and bonds have been weak all year, so there's been no place to hide if you're a stock investor, if you're a bond investor. I guess the first question I would say, Nolan, and in a period of market volatility, it can be difficult emotionally for investors. How would you counsel people to handle this current investment environment?

If you're working with an advisor and you're working with an active manager, there are things to do. If you're somebody that's passive or you're working with an advisor who just has you in index funds or exchange-traded funds, might wanna rethink it. There are things to do. And you're right, stock and bond portfolios, just about all of them are down this year. But I'll give you an example. If you're in a taxable account and you have shares that are down this year and you have unrealized gains, you can actually swap those shares, one stock for another, realize the gain, and reduce your tax burden this year, or at least hopefully get a capital loss that you can take to reduce your tax burden. You can do the exact same thing with bonds to the extent you have bonds that are in your taxable account as well. So if you purchased a bond at the beginning of the year, let's say you bought a 10-year corporate bond and let's say that coupon was 5%. So your 5% yield to maturity is what you were getting. Very likely with where interest rates are, that bond could be priced today at $0.85 on the dollar. Now, as long as you hold it to maturity and that bond doesn't default, you're going to get back $0.100 on the dollar and your yield to maturity would have been 5%. So you can sort of close your eyes, but you can also actively manage it. You can sell Bond 1, realize that 15% loss, take the tax write-off, and the exact same day you can buy a like-kind bond, another 10-year bond priced at $0.85 on the dollar with the same 5% coupon, inevitably your position is the same, but you've taken a taxable loss this year to reduce your tax burden. So there's loads of things that you can do both on the bond and the stock front.

Nolan, it's— I'm glad you mentioned that, that technique there. It just gives a great opportunity for us to highlight the importance of professional management. A lot of these ideas and techniques aren't something that comes right to the mind of an individual investor. And I think that's somewhere we can really help. How do you contrast fixed income or bonds from stocks in this market?

Hopefully most investors are aware for stocks, we're looking about a 10% rate of return over time. Just means money doubles in approximately 7 years. It doesn't work like clockwork. Sometimes it's much shorter, sometimes it's much longer. But if you go back to World War II, it's about 10%. And for bonds, the number has been about 5 to 6%, depending on the instrument. And then cash returns, although they've been almost zero recently, if you go back a ways, 2% to 3% is what you can expect. However, with the sell-off in bonds, it creates an interesting opportunity. As I mentioned at the top of the show, there are very attractive high-quality bonds where you can actually buy them now and you can lock in a total return to maturity, 7% to 8%. So, that gives you very close to stock market-like returns with a fixed rate of return and a fixed income stream. Not all is lost. The fact that rates are up, bonds are cheaper and they become more attractive. So, a lot of investors who maybe their patience is being tested in the stock market, instead of doing something rash, like going into cash or something worse, a discussion can be had. Does it make sense to swap from stocks to bonds? And still pick up really attractive returns in my opinion.

[Speaker] All right, thank you, Nolan. Let's move on to topic 2. So topic 2 is a little bit of a continuation of what we've been talking about, and it's called focusing on fixed income securities. The direction of the stock market over the last year has been murky at best. Investors may be tiring of the volatility around stocks. I know I'm sort of tiring of it. I understand the long-term value of stocks. You know, in the short term, it can be difficult, again, emotionally, Again, interest rates are rising. That's creating a whole new set of opportunities in the bond market. If you've already had bonds, how do lower prices impact you?

So again, if you have a bond and you just hold it to maturity, you're going to get back your promised interest payment and you're going to get back the principal at the end as long as the issuer does not default. So you can pretty much close your eyes and kind of go on about your business. I know in the meantime you're looking at your statement, it doesn't look so great, but remember, those are unrealized losses. You were promised an interest payment. Payment yield to maturity at the beginning of the outset of the bond, and you're going to get that right on through. There's a lot to kind of be patient about in that respect. I think what's more interesting and telling is if you're an investor and you go to your advisor or you're looking, you have your money in a retirement plan at work, and you may be thinking, oh, I want to be more conservative, let me go to bonds. That's not what we're talking about. You're generally going to have the option to do your bond exposure through a bond mutual fund. Which is very different than what we're talking about in a fixed-rate security. The one that we're talking about has a start date, it has an end date, and then there's a coupon payment that happens twice a year. Last week we showed a Starbucks bond and the maturity was, I think, a 10-year maturity. So as long as I hold it, I know what my return is going to be and my income stream is fixed. That's not the same as if I own the ABC Bond Fund. Nothing is fixed there. Remember, that's a portfolio of bonds that the manager buys and sells. The income is not fixed. It changes monthly depending on the bonds he has in there, and there is no maturity date. And in this environment, when rates are actually going up, it's not a great bond investment to hold. So be very careful. If you're one of those people that has your bond exposure that way, give us a call or talk to your advisor and think about moving from that to something that's, that's quite a bit more fixed. And I'm going to say the exact same thing in the stock market as well. If your stock exposure is some sort of mutual fund, that's very different. If you're saying just hold it, it'll come back. In this environment where things are very, very uncertain, you're much more comfortable holding some stock. You're very comfortable with the, you know, the business outlook. Maybe it pays a dividend. You know, the historic valuation. If I own ABC stock, I know its outlook, it's cheap now relative to its outlook. Your degree of confidence to be able to hold or add to that position is much higher than if I own some generic mutual fund.

Excellent. No one— and just to hammer that point home, when we talk fixed income securities here, we like individual bonds. They have a start date and an end date. There's a fixed parameter around how it works. So can you talk about a bond that fits that criteria for us?

So this last week, I think the last time we spoke, we spoke about a bond from Starbucks. This week we're showing a bond from Oracle, a software company. They've been around almost as long as Microsoft, but they specialize in databases. And years ago they bought Sun Microsystems and other technology firms. And here recently they've done a recent purchase of a company called Cerner, which specializes in digital medical records. And because of that purchase, they had to issue a lot of bonds several years ago. One of the ones that they issued is one of the ones we're going to look at today. I believe the coupon is 4%. It's a 2034 bond. And when we looked this morning, this bond could be purchased for 85 cents on the dollar. So the yield to maturity, if I hold this bond to the end, 2034, my yield to maturity is going to be 6 Now I can buy $10,000 worth of these bonds for $8,500. So I'm buying them at a discount. What we really like is the components of my 6% return. So I'm going to get the 4% from the interest payment that they pay me. And then the other percentage I'm going to get when the $0.85 on the dollar matures to the full $0.100 on the dollar. And if you do this in a taxable account, there's also a tax benefit. Normally, these interest payments in the taxable account are taxable as ordinary income. But when we buy this bond at a discount, $0.85 on the dollar, and it appreciates to $0.100 on the dollar, that is taxed at capital gain rates. The highest capital gain rate is 20%, unlike the highest ordinary tax rate, which is 37%. So there's also some tax benefit as well to buying this discount bonds. And we really like that in this environment. There's a lot of ways to structure a portfolio using discount bonds, and I can either buy a high coupon trading closer to $0.100 on the dollar, or I can get a 6% yield to maturity, as an example, with a 3% coupon bond trading at $0.70 to $0.80 on the dollar. So I'm getting a much bigger discount, and a larger percentage of my return comes from capital gain instead of ordinary income. So certainly in this, there's always a lot to think about when you think about bonds. But in this environment where interest rates are changing, there's a lot more to do and a lot more to think about when structuring these fixed income portfolios.

Thanks, Nolan. We're running out of time here, but we definitely want to just emphasize again for you, we're putting together a whole, a whole litany of bonds that we think fit the profile of good opportunities in the current environment to find out if they're a good fit for you. Again, call the number on the screen below and we'd be happy to have a conversation, decide whether these type of instruments are a fit for your portfolio and your goals. So with that, Nolan, we'll thank the viewers for being with us again and we'll see you again next week.