19391 BOS Summer '13 Rev

© 2013 Bingham, Osborn & Scarborough | Perspectives

Vol. 27, No.3 Summer 2013

Thoughts on Bonds: An Interview with Rich Golinski, Chief Investment Officer

Rich Golinski, CFA Principal, Chief Investment Officer

Given the many concerns about bonds these days, we thought this would be a good time to check‐in with our Investment Committee for their

perspective on this important issue. In this Q&A format, we ask Rich Golinski, Chief Investment Officer and head of the BOS Investment Committee, some of the questions we’re hearing from clients. So with that as an introduction, let’s jump right in.

Q: Rich, I’ve been reading in various places that bonds are risky. Is this true?

Rich: There is great variety in the bond world. Some bonds are very risky while others are quite conservative. The key is to understand the difference between

the two and to develop portfolio strategy accordingly. At BOS, we’ve defined bonds’ primary role as helping to stabilize portfolios during times when stocks prices are falling. This leads us to focus on the more conservative end of the bond spectrum – higher quality and shorter maturity bonds – even though this typically means accepting a lower yield than riskier bonds offer. While the bonds in our clients’ portfolios can still decline in value in adverse market environments, these declines should be more modest than the losses incurred by riskier bond portfolios. Moreover, any bond losses

should generally be much smaller than the losses incurred in stocks during major stock market sell‐offs.

Q: OK, I’m willing to concede that bonds aren’t as risky as stocks but why should I continue owning them given their low yields and many potential risks including rising interest rates, inflation, Federal Reserve policy and municipal defaults?

Rich: While these many concerns cannot be dismissed, it is important to remember why we believe bonds play an important role in diversified portfolios. We use bonds to help reduce the severity of portfolio losses during major stock market declines and to provide some portfolio income. The need for investments that offer both risk reduction and income remains high. Carefully managed bond portfolios can still provide these benefits of stability and income within a diversified portfolio, and we therefore continue to see an important role for bonds in client portfolios.

Q: Why not sell my bonds, keep the proceeds in cash, and reinvest in bonds after interest rates increase?

Rich: We believe that you’re likely to earn a higher return by staying in bonds than by switching back‐and‐forth between bonds and cash. Bonds provide an incremental yield advantage over cash which, at present, is approximately 1% to 2% for the high‐quality, shorter‐maturity bonds we recommend in client portfolios. In order to generate a higher return with the “move‐to‐cash” strategy, interest rates would have to rise by enough to offset bonds’ yield advantage and you would have to identify correctly the right time to get back into bonds. Given bonds’ yield advantage and the difficulty of correctly predicting the timing and magnitude of interest rate changes, the strategy of staying in bonds is likely to generate higher returns.

In This Issue Thoughts on Bonds ............. 1

A Letter from Ed Osborn ..... 3

Abenomics and the

Challenge of Deflation ........ 4

Firm Notes .......................... 6

Perspectives


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Perspectives | Summer 2013

Q: Is there anything else we can do in our portfolio to address the potential for higher interest rates?

Rich: Over the past couple of years, we’ve adjusted the bonds in our clients’ portfolios to reflect a more challenging investment environment. We have reduced Treasury Inflation Protected bonds (TIPS) and hedged more of the currency risk in foreign bonds. We have also modestly reduced the average duration/maturity of our clients’ bond portfolios. We anticipate recommending additional adjustments as risks and opportunities in the bond market evolve.

Q: We’ve heard that PIMCO funds are performing poorly and that their main fund is too large to manage. Should we sell the PIMCO bond funds in our portfolio?

Rich: We recommend maintaining your investments in PIMCO bond funds. It’s important to put PIMCO’s recent performance in context. Year‐to‐date through June 30th, PIMCO’s flagship bond fund, the PIMCO Total Return fund returned ‐3.02% which was about a half percent lower than the ‐2.44% generated by its benchmark, the Barclays Aggregate Bond Index. While this PIMCO performance was a bit disappointing, it follows calendar year 2012 when Total Return dramatically outperformed the Barclays bond index by more than six percentage points (+10.36% vs. +4.22%). Investors must be willing to accept inevitable periods of short‐term underperformance in order to have the opportunity to earn higher returns over time from PIMCO funds.

On the issue of whether PIMCO is too large, this question is particularly relevant for PIMCO Total Return which, with $270 billion in assets, is the largest mutual fund in the U.S. While this is indeed a huge amount of money, it represents only about 1% of the $28 trillion U.S. taxable bond market. Given Total Return’s still small size relative to the overall bond market and PIMCO’s skills and experience managing bond portfolios, we believe Total Return can continue to add value relative to their benchmark.

Q: Isn’t it a foregone conclusion that interest rates will rise a lot in the near‐term?

Rich: No. While the long‐term trend in interest rates is almost certainly higher than today’s extraordinarily low levels, the trend over the shorter term (e.g., next twelve months) is far less apparent. Historically, the two most important drivers of rising bond yields have been rising inflation and rising short‐term interest rates. Both of these indicators are very low at present and neither appears poised for a big jump in the near‐term. Inflation, as measured by the CPI, is up just 1.8% over the past 12 months through June and core inflation rates are even lower. As for short‐term interest rates, these are largely set by the Federal Reserve through its management of the federal funds rate. The Fed appears committed to maintaining a near‐zero funds rate through at least next year.

Q: What about the Detroit bankruptcy? Should we continue to own municipal bonds?

Rich: We believe that investors in higher tax brackets should continue to own municipal bonds in taxable accounts. The vast majority of municipalities in the country are nowhere close to the dire condition of Detroit and there is no reason to expect an imminent surge in municipal bankruptcies.

That said, the long‐term implications of the Detroit bankruptcy for municipal bond investors are less clear and we will be watching developments in this case closely. It will be up to the courts to decide how the reductions in Detroit’s debts are shared among the major constituencies including bond holders, current and former city employees, and service providers. Given the complexity of the legal issues and the broader national implications, it appears likely that the Supreme Court will eventually decide these issues. A silver lining for municipal bond investors is that Detroit’s high profile bankruptcy is likely to increase the focus of municipalities around the country on their own unsustainable employee pension and retiree health care costs. “Let’s not become another Detroit” could increasingly become the new mantra.

Q: Thanks, Rich.


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Rich: Before we close, I would like to take the opportunity to express my appreciation and gratitude to Ed Osborn who officially retires from the firm this year. Ed led the firm’s investment function from the firm’s founding in 1985 through 2010 when I assumed the Chief Investment Officer responsibilities. I have thoroughly enjoyed my 13+ years working with Ed and greatly appreciate the generosity with which he has shared his time, knowledge, and insight. A sincere thank you, Ed, and all the best to you in your retirement.♦

Email Rich at [email protected]

A Letter from Ed Osborn

Ed Osborn, CFP® Principal

At the end of August I will be fully retired from Bingham, Osborn & Scarborough, LLC, except for a limited presence in our Healdsburg office and an ongoing ownership in the firm. It

has been almost thirty years since I left the practice of law and co‐founded the firm, and yet it seems like yesterday. What has not changed is that the future is still ahead of us. Bingham, Osborn & Scarborough, LLC is a vibrant firm, filled with passionate, dedicated people, with outstanding skills, who are committed to our clients. It is characterized by a belief that this will never be only a job, but instead is a worthwhile and important endeavor worthy of our life’s work and best efforts, and capable of improving people’s lives. Our goals are to be the best at what we do, to make a difference, and to be contributors to the good of the Commonwealth. That requires the upmost honesty, complete integrity, and the willingness to sacrifice short‐term profits for the long‐term good of our clients, and only secondarily, for the good of the firm itself.

It has given me a wonderful work life, and I will be forever grateful to all of my colleagues who have made it possible. It has been an honor to work with each and every one of them. I am especially grateful to Bob

Bingham and John Scarborough, who live by these values and joined with me in believing that we could actually build a lasting entity that we and our employees could be proud of, and that would be a positive force in the world of finance. That legacy is carried forward by all of the existing partners and employees of the firm.

What have I learned? That ideals are real and worth living; that in the end it is people that matter; that if you want people to do an outstanding job, then give them a job that is worth an outstanding effort, and the responsibility and freedom to do it; that doing your best and working hard is important; that courtesy and common decency are the bedrock of us working together; that threats or intimation are seldom as effective as encouragement and a helping hand; that diversity is a strength and excellence comes more often from different strengths than common methodologies; that it is far more important to listen than to lecture; that trust is more productive than suspicion; that none of us knows everything; that arrogance is a weakness; that although competence and hard work are prerequisites for success, it is equally a product of luck and good fortune; that none of us have earned all that we have, but rather owe a great deal to Providence and each other; that none of us, no matter what our salaries, are better or more deserving than the least paid employee among us who does his or her job well; that if you want coffee, you should make it yourself (clients and guests excepted).

To you, our clients, I owe a special debt of gratitude. It has been my great privilege to advise many of you. I have done my best, but no matter what I have done, I have always learned far more from you than I have taught. You have made all the years worthwhile. Wherever I go, I will carry with me memories and lessons from all of you.

I look forward to the future of Bingham, Osborn & Scarborough, LLC. It is in the best of hands, and I am enormously confident in its leadership. In September I switch from being an active partner at BOS to being a client of the firm. (Yes, BOS will be managing my portfolio.) I’ll try to be a reasonable client, but I promise to keep them on their toes, just like you kept me on mine.


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Once again, thanks for everything and the very best in the years to come. ♦

Email Ed at [email protected]

Abenomics and the Challenge of Deflation

Jamie Osborn, CFP® Portfolio Manager

Shinzo Abe’s Liberal Democratic party swept into power with a supermajority in the lower house of Japan’s Parliament in December of 2012. Since his election, the value of the Nikkei index has increased

by nearly 60% and the value of the yen has fallen by around 20% relative to the US dollar. These are dramatic market movements for any country, but particularly dramatic for Japan, which has still not recovered from the Nikkei Index collapse in 1990 that triggered a deflationary spiral starting in 1998.

To understand the impact of a deflationary spiral, it is important to understand that modern capitalist economies are built on the notion of the “multiplier effect”. The idea is that wealth is not a fixed value but is instead multiplied as it moves through the economic cycle from consumers to businesses to employees who in turn become larger consumers. Henry Ford is famous for this idea—he was ridiculed by his fellow business owners for paying employees at rates much higher than prevailing wages. His response was that he wanted to pay his employees enough so that they could afford to buy the cars they were making. By increasing wages he was able to increase his consumer base and everyone became richer.

When this virtuous cycle is functioning, inflation is a natural byproduct and serves to incentivize the wealthy to reinvest their accumulated assets in economic activity. But in a deflationary environment, the virtuous cycle breaks. Businesses don’t foresee prospects for further growth, so they pursue increased profits by reducing costs. But reducing costs inevitably leads to lower wages (real or nominal) which leads to reduced

consumption, less demand and even dimmer prospects for further growth. The result is that instead of prices increasing each year (through inflation), prices actually decrease.

While this might sound appealing to the consumer, deflation is exceptionally destructive to an economy. When a consumer knows that an item will be cheaper if they wait one year to buy it, they have a tendency to put off purchases. By putting off purchases, they further reduce demand for the product, forcing the seller to reduce the price further. The combination of reduced demand and reduced pricing causes a decrease to economic activity and reinforces a self‐destructive cycle.

The impact deflation has had on Japan’s economic cycle is represented clearly in numbers such as corporate retained earnings – the amount of revenue that is neither spent nor invested by businesses but is added to proverbial “war chests” for a rainy day. In 2011, Japanese corporate retained earnings were 29%, relative to 16% for their counterparts in the US. While this may be good policy for individual companies, it is disastrous for an economy as a whole.

And this is where Japan found itself when Shinzo Abe began campaigning on a platform of aggressive interventionist economic policy that he called his “three arrow” approach (and which is taken on the popular name of “Abenomics”). His goal (as with any stimulus program) is to provide a “kick‐start” to an economy in order to boost short‐term growth. By increasing both consumer demand (through stimulus) and inflation expectations, the idea is to further encourage business investment by making savings less attractive. The hope is that this re‐starts the virtuous cycle.

Abe’s first arrow was introduced shortly after taking office—the creation of a $105 billion dollar stimulus package to create additional demand in the economy and encourage private investment. Then, on April 4th, the governor of the Bank of Japan “BoJ” (the equivalent of our Chairman of the Federal Reserve) announced the second arrow—a policy of doubling the money supply within two years. Abe also announced that the BoJ would buy long‐term bonds more aggressively (a corollary to Bernanke’s Quantitative Easing policies) to encourage investors to buy more risky assets and spur


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Nikkei Index in Yen & Dollars vs. DFA Large Cap Value

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

11/30/2012

12/31/2012

1/31/2013

2/28/2013

3/31/2013

4/30/2013

5/31/2013

6/30/2013

Nikkei 225 (Yen)

Nikkei 225 (US$)

DFA US LargeValue

1: Source: www.finance.yahoo.com, July 25, 2013

further investment in the economy. The stated objective was to produce an inflation rate of 2% within two years.

The market reaction has been dramatic, as evidenced by the appreciation in the stock market and depreciation in the value of the yen. Whether the market reaction presages long‐term economic growth remains to be seen. Though it is much too early to pass judgment on Abenomics, there are a few encouraging signs. Japanese GDP grew by 4.1% in the first quarter. Furthermore, the GDP growth was headlined by increases in personal consumption and better‐than‐expected export growth. Also, the Consumer Price Index (CPI) for 2013 excluding food and energy (a broad measure of core inflation) is positive for only the second time in the last 15 years. These are the types of economic results that analysts will follow closely to see if Abenomics takes hold long‐term.

Breaking a cycle of deflation would be an impressive achievement on its own. However, Japan faces a particularly unique economic challenge that affords no simple solution— demographics. The working age population has declined by 8% since 1995 and is projected to fall even more dramatically over the next 15‐20 years. It is reasonable to ask: is a decline in consumer spending a result of deflationary pressures or a result of the decline in the number of consumers? Unless the government intends to establish a permanent stimulus program, it is hard to see from where the long‐

term increased demand will come —and therein lies the enhanced risk of these policies.

To address these risks, Shinzo Abe has recently begun revealing limited details about the “third arrow” of his economic reform targeted at structural reform of the corporate sector to incentivize a reversal of the excessive retained earnings trend. By getting the corporate sector to invest their retained earnings (particularly in increased wages), Abe hopes to unleash both consumers and businesses as cooperative partners in promoting a virtuous economic cycle.

Abe has been purposefully vague in his initial proposals. But – in a discouraging sign—the ideas currently being floated in the Japanese press or by Abe’s supporters are much less ambitious than the more radical proposals that many leading economists suggest are necessary. These more aggressive proposals include, but are not limited to: reducing depreciation allowances; punitive taxes on retained earnings; relaxed immigration policies; incentives to reintroduce women into the workforce following childbirth. Without reforms that change the trendline for future growth, Abenomics may prove, at best, nothing more than another failed Japanese stimulus program (there have been many precursors since the 1990 collapse).

The question begs itself, what does this mean for my portfolio? The answer is not as clear as one would hope. While the Japanese stock market skyrocketed in the first part of the year, returns for US investors were much more moderate because of the plummeting value of the yen. In fact, since December 1, 2012, a US dollar invested in the Nikkei 225 has slightly underperformed an investment in DFA’s US Large Cap Value fund. Furthermore, the depreciation of the yen (and a burgeoning currency war) has dramatically hurt Emerging Market stocks which have underperformed all other equity classes this year.

A model BOS portfolio currently allocates 16.4% of its foreign investments to the Japanese market. For the average BOS client, invested at 50% stocks, this would

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In This Issue

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mean a 2.2% portfolio exposure to Japan. Going forward, we remain concerned about increased volatility in currency markets and have begun hedging the Foreign Bond holdings of many clients to the US$ to reduce that volatility (this was also done in response to concerns about the Euro). However, as the world’s third largest economy, we believe that Japanese holdings should remain a significant part of a broadly diversified portfolio.

We will continue to monitor the ongoing economic indicators in Japan and the ancillary effect on Japan’s neighbors, and we wish Shinzo Abe the best of luck in successfully hitting his target with his third arrow. ♦

Email Jamie at [email protected]

Firm Notes

Copies of the Bingham, Osborn & Scarborough, LLC Form ADV and Code of Ethics Available.

As a Registered Investment Advisor, our firm offers each of its clients, annually and at no cost, an updated copy of our form ADV. This is a disclosure document detailing the background, business practices and philosophy of the firm and its principals. In addition, we also offer our clients a copy of our firm’s Code of Ethics. If you would like to receive a copy of either our form ADV or our Code of Ethics, please contact Eileen Gamboa at our San Francisco Office, (415) 781‐8535 or [email protected].

Thoughts on Bonds ............. 1

A Letter from Ed Osborn ..... 3

Abenomics and the

Challenge of Deflation ........ 4

Firm Notes .......................... 6

Documents

19391 BOS Summer '13 Rev