Listener Questions: 11% Yields, Guacamole, 401(k) Withdrawals

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Hello, this is Jack Howe. The Barron Streetwise Podcast is on vacation this week. I know, I'm as outraged as you are. But I was thinking we'd answer a couple of listener questions. No guests, no overarching theme. Our audio producer Meta's here. Meta, what do you think of that idea?

I think that sounds great.

I should note that we're recording this while the results of the U.S. election are still being tallied, so by the time you hear this, you might be delighted, you might be distraught, you might be day drinking. Think of this not-quite-episode of the podcast as something to distract you, maybe even inform you, while keeping your drinking hands free. Meta, what's our first question?

It's from Alex, who lives in Michigan.

Okay, let's hear it.

Hi, Jack. Thank you for choosing my question. I really enjoy your expertise and Meta's patience with your jokes.

Hang on, let me do some quick arithmetic on where that leaves me, Alex. You started off with something nice about me, but then it transitioned to a backhanded compliment. And if I'm not mistaken, Meta got the compliment and I got the backhand. I think that gets me back to square. It's not bad. Please continue, Alex.

I found your episode on private equity very interesting, and I'd like to know if you think buying shares of business development companies offer small investors a good substitute for large private equity funds. Are BDCs an alternative investment, or are they just finance company shares in Halloween costumes? Thanks.

Thank you, Alex. BDC stands for business development company. It's a type of financing company that's designed to spur investment in small businesses. And I don't mean mom-and-pop businesses. Small in this context means businesses valued at less than $250 million. BDCs can provide equity or debt financing, which is another way of saying they can take an ownership stake in companies or they can lend money and charge interest. Mostly they lend money. They don't have to pay taxes on their profits like normal corporations do. They do have to pass nearly all of those profits along to investors as dividends. Why would investors buy BDCs? As you mentioned, Alex, they're a lot like private equity funds, only they're not reserved for sophisticated investors. Anyone can buy them, and there's no requirement to hold them for years. Many BDCs trade publicly just like stocks. I recently counted close to 50 of them. The main reason investors buy BDCs is for the yield. Which typically ranges from high to preposterously high. For example, Ares Capital, ticker ARCC, is one of the biggest BDCs. It recently yielded over 11%. Think of that. The 10-year Treasury yields less than 1%. If you want to take on a lot more risk, there are junk bonds. A Bank of America index of those recently yielded around 5.5%. Relative to either of those, the 11% yield on Ares is so high it feels like it should come with a ski mask and a getaway car. And there are much higher BDC yields out there. So why are the yields so high? Two main reasons. First, the companies BDCs invest in are typically risky, either because they're young or they're troubled, so they have to pay relatively high interest on loans. Second, BDCs can use leverage, which can increase returns and increase risk. In fact, 2 years ago, Congress passed legislation that allowed BDCs to double the amount they borrow relative to their assets. If that sounds risky, it is. The main risk for BDCs is that if the economy turns bad, their financially shaky borrowers can fall on hard times. And not be able to pay back what they owe. BDCs under those circumstances can take losses on their loans. They can be forced to cut their dividend payments, and their shares can fall in anticipation of that, meaning BDC shareholders can see the value of their shares decline long before loan losses pile up. And those share price drops can be violent. Back in February, Ares traded at over $15 a share. Then the pandemic hit, and by late March, Ares had plunged below $9 a share. Fortunately for investors who've hung on, Ares is back to $14 and change. And maybe this year's example is an extreme one, but the takeaway is when times get tough, BDCs can lose value even more quickly than the stock market. There's an upside to BDCs that has to do with something called interest rate risk. If you own fixed-rate bonds or mutual funds with fixed-rate bonds, their value might fall as prevailing interest rates rise. Interest rate risk can actually be highest for bonds that sound safest. For example, long-term Treasuries have virtually no credit risk because the government can always make more money to pay what it owes, but they have plenty of interest rate risk. Also, they have inflation risk. Which is the risk that their low yields won't keep up with the rising cost of living. BDCs, on the other hand, have limited interest rate risk because their loans typically have floating rates that are just higher if prevailing interest rates rise. I suppose you could argue that they also have limited inflation risk because the yields are so high, but they have loads of credit risk, and the leverage they use, that only increases the risk. Regular listeners know that I don't like most niche asset classes, especially ones that come with chunky fees, and that includes BDCs. If your question is, does my portfolio need— and if the next thing you say isn't stocks, bonds, or cash, or inexpensive mutual funds that hold these things— my answer is probably no. You can do just fine without it. Sometimes the people who collect the fees will object and point out that their investment has a low correlation with stocks or bonds, and that this means that mathematically it can be used to reduce overall portfolio risk. And my answer to that is usually, first of all, long-term savers can't spend correlation. And second, correlations have a way of changing abruptly at just the moments they're needed most. In other words, an investment that typically doesn't move like stocks can nonetheless crash when stocks crash. All told, if you're an experienced trader who expects the economy to continue improving and you're looking for something that can ride that improvement higher even if interest rates rise, and you'd like that something to pay you high current income and give you stock-like liquidity, BDCs might have a place in your portfolio. But if you're a regular saver wondering whether you're missing out, you're not. Over the past 10 years, that high-yielding BDC I mentioned earlier, Ares Capital, has had average yearly returns— that's dividends plus share price changes— of about 8%. The S&P 500 index has done 5 points better. Matt, I know I took way too long on those BDCs. I'm going to go faster from here on. Who's next?

Let's hear from Steve from Fire Island, New York.

Right, this one's been in the holster for a little while, but it's timely now. Let's hear it.

As a millennial, cash has been dead to me for a while, but it seems COVID has accelerated the trend dramatically with a massive pickup in digital spending. Regardless of the pandemic trajectory, it seems the movement towards mobile payment is here to stay. What do you think? I like PayPal as a winner here, but would you play it through a younger company like Square, an incumbent like MasterCard, or a tech giant like Apple? By the way, I must say I'm a little disappointed you had the CEO of Chipotle on your podcast and did not have the guts to ask why they still charge for extra guacamole. Missed opportunity. Keep on fighting the good fight. Thanks, Jack and Meta.

Steve, I'm glad you asked about digital payments. Meta and I are doing a live video episode of this podcast on November 9th at 1 PM Eastern time, and we'll be speaking with Visa CEO Alfred Kelly. You can sign up for free at events.barrons.com/streetwise. If you can't make it, Steve, don't worry, we'll feature parts of the interview in that week's regular episode. As for Chipotle charging extra for guacamole, have you seen the price action on wholesale avocados over the past couple of years? I think avocados might be the new Bitcoin. I'm pretty sure charging extra for guacamole is now standard procedure. Del Taco just added fresh guacamole to its menu and they charge for it, I'm not gonna begrudge burrito sellers a little profit guacamotive. Meta, I didn't hear you laughing at that one. You might want to check your audio levels.

Oh yeah, hang on.

One more question, and this is from Chuck and Ruth in Georgia. They wrote their question, they didn't record it. Meta, I know you greatly prefer to hear listener questions, but Chuck and Ruth seem like nice people. What do you say I read their question and we can just imagine what their voices sound like?

I guess so, just this once.

Okay, I'm gonna imagine that Chuck's voice sounds super duper deep, like the guy in the Oak Ridge Boys during that song Elvira who does a part where it goes Giddy-up, ba-boom, ba-ba-boom, ba-ba-bow-wow. I gotta do that one first thing in the morning to get down there. What do you think about Ruth?

I think Ruth sounds like Dolly Parton.

I think that makes them a perfect couple. Meta, why don't you see if you can countryfy things while I read their question?

You got it.

Okay, Chuck and Ruth ask about how important it is to have a 6-month emergency fund, especially now during the pandemic. They mentioned special rules this year about withdrawals from 401(k)s and IRAs and whether that's a good way to raise an emergency fund. And they ask whether they should raise funds by selling stocks on days when the market is up. They write, does this seem like sound advice to you? Thank you for your question, Chuck and Ruth. Everyone should have an emergency fund. Personal finance specialists typically recommend 3 to 6 months' worth of living expenses 6 months' worth is a good idea if the economy looks shaky like now, or if you work in an industry with a lot of layoffs, or if you're self-employed with sporadic income, or if you live off income from stocks and bonds and don't want to have to sell during a downturn. To calculate a typical month of living expenses, just add up all the necessary stuff you pay for each month, like housing, food, payments on debt, but not the extras you could cut in a pinch, like meals out. Keep the money somewhere safe and handy, like in an FDIC-insured money market account at a bank, and you might wanna keep a pinch of it in cash at home. Now, you mentioned withdrawals from retirement accounts. As part of the CARES Act passed earlier this year to provide pandemic relief, savers can qualify for special tax treatment on withdrawals from certain tax-deferred retirement accounts like 401(k)s, 403(b)s, and IRAs. They can take out up to $100,000 this year and avoid paying the typical 10% penalty for early withdrawals. You just pay whatever income tax is due, and you can spread the tax over 3 years to break up the cost. There are special provisions for 401(k) loans too. If you have an employer who offers them and if you're sure you want to repay the money. Even if you're not sure and you decide to take a withdrawal, the special rules for this year might allow you to change your mind anytime over the next 3 years and return the money and get back whatever you shelled out for taxes. There are a lot of details I'm not covering here. To see the IRS guidelines on the program, just Google Coronavirus-related relief for retirement plans and IRAs. That webpage can also tell you whether you qualify for this year's special treatment on withdrawals and loans. Some of the ways to qualify are pretty specific, like being laid off, or you, your spouse, or a dependent being diagnosed with COVID-19. Some seem more open to interpretation, like suffering Adverse consequences as a result of being quarantined. I recommend you avoid withdrawing or borrowing money from your retirement accounts if you can help it. You'll keep your money growing tax-deferred, and you'll avoid paying regular taxes on the distributions. If you need to save up for an emergency fund, try to do that out of your earnings. If you're already experiencing an emergency, you might not have a choice. If that's the case, at least you might be able to avoid the early withdrawal penalty and have a shot at returning your withdrawals over the next 3 years if your fortunes change. As for whether to sell stocks and bonds after big up days, don't worry about the timing. The important thing isn't whether yesterday or today was a big up day. It's whether tomorrow will be, and there's no way to know that for sure. Thank you, Chuck and Ruth from Georgia, and Steve from Fire Island, and Alex from Michigan. And thank you everyone for sending in your questions. Please keep them coming. Just tape on your phone using the voice memo app and send it to jack.hough@barons.com. Thank you for listening. Meta Lutzhaft is our producer. Meta, let's speed through the rest of the outro using high-speed banjo music, if you please. Sure. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, please write us a review. If you want to find out about news stories and new podcast episodes, you can follow me on Twitter. That's @jackhoug. See you next week.

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