Giving Your Child an Allowance
- Created on Monday, 27 January 2014 10:31
I earned my first allowance of $2 per month by doing weekly chores. As an 8-year-old, my chores included making my bed, emptying my garbage can, dusting and vacuuming my room. My dad would have surprise “military” inspections to check that we were doing our chores properly.
When parents consider giving their children an allowance, one of the first decisions is usually whether to connect an allowance to household chores. But many parents find themselves spending more time trying to determine whether chores were completed or done up to family standards. Looking back, I see now that my father gave us plenty of notice for those “surprise” inspections, so he could try to avoid the stress of having to deny giving us our allowance.
My wife and I both agreed that it was important to teach our children how to manage their money at an early age, rather than waiting for the “right time.” We also knew that we wanted to play an active role in our children’s financial education.
So, we decided to give an allowance as a teaching tool, not as a reward for doing chores. Over time, we saw how this decision allowed us to spend our time and energy teaching financial discipline and having conversations with our children on their three money management choices: spend, share or save.
We knew we made a good decision the day my 6-year-old daughter took a $10 bill from her Lion King purse and put it into an animal shelter donation box. (Initially, I was tempted to break open the box.) This gift was overly generous on her part, as the $10 represented months of saving. What I remember most, though, was the proud look on her face as she looked up at my wife and me and said, “I just helped the animals. It was my share money.” At age 6, she was already learning that with every dollar, we have a choice — spend, share or save.
Copyright © 2014, The BAM
Bond Funds Aren’t Naturally Riskier Than Individual Bonds
- Created on Monday, 13 January 2014 11:16
In spending significant time talking to clients and wealth advisors about fixed income, one common misconception is that bond funds are more exposed to interest rate risk than laddered individual bond portfolios. The logic basically starts and ends with the observation that individual bonds can be held to maturity while bond funds don’t necessarily hold all bonds until they mature. Because all individual bonds can be held to maturity, as the logic goes, it doesn’t matter if their prices go up or down in the interim. This does indeed sound logical, but as it turns out, laddered individual bond portfolios and bond funds with similar-maturity bond holdings have almost identical exposure to interest rate risk. There simply isn’t much of a difference, yet the incorrect point of view is all too common within the industry and can lead investors to take excessive interest rate risk in individual bond portfolios without understanding the implications.
Comparing Returns and Volatility
I’ve found the best way to illustrate my point is with real-world data comparing the returns and volatility of a laddered bond portfolio with a hypothetical bond fund portfolio. In my example, I construct a laddered bond portfolio by allocating equal investment dollars to bonds maturing from one through 10 years. At the end of each year, the portfolio effectively invests the proceeds from the one-year bond that matured into a 10-year bond and repeats this process each and every year. This is a good proxy for how bond ladders are actually constructed in practice.
Separately, I construct a “bond fund” portfolio using three-, five- and 10-year bonds, with this portfolio constructed to match the duration and convexity (the two primary measures of the interest rate risk in a fixed income portfolio) of my laddered bond portfolio. Each year, the bond fund portfolio reallocates among its three choices to match the duration and convexity of the laddered bond portfolio. Note that none of the positions in this second portfolio ever mature.
If laddered bonds are truly safer than bond funds, these two portfolios should have significantly different risk-adjusted returns. The table below shows the average annual returns and volatility of both portfolios over the period of 1993 through 2013, which is the longest data set I had to work with.
As the data shows, the returns and volatility are virtually identical. At the end of the day, that’s basically all that matters.
Note, however, that individual bonds can still have advantages relative to bond funds. It’s just that those potential advantages have nothing to do with individual bond portfolios having less interest rate risk than bond funds. I covered the potential advantages and considerations in a previous blog.
Copyright © 2013, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.
Positive Developments for Municipal Bond Investors
- Created on Monday, 23 December 2013 13:49
Public pension underfunding at the state and local level has rightly received an enormous amount of attention over the past few years. Most public pension funds are significantly underfunded when pension liabilities are valued using economically reasonable assumptions. In fact, Moody’s has calculated total underfunding to be roughly $1.8 trillion as of 2011, meaning the total value of pension fund assets is roughly $1.8 trillion less than the amount these funds owe to current and future retirees. From a municipal bondholder’s perspective, fundamental questions become whether the size of the pension underfunding might impair an issuer’s ability to pay back its bonded debt and exactly how states and municipalities will be able to reduce the amount of underfunding.
While I’d still say we’re in the second inning of a nine-inning game (with this guy pitching), recent developments in Detroit, Illinois and elsewhere are starting to shed some light on potential paths forward. Two of the biggest developments have been 1) the possibility that federal bankruptcy law might supersede state constitutional protections against the impairment of pension benefits and 2) that several states and municipalities (including the state of Illinois) have passed legislation that either partially or fully suspends cost-of-living adjustments on pension payments. While it’s painful to see anyone receive less than what they were expecting, especially since a large portion of the underfunding blame falls on politicians who promised too much and contributed too little to the pension funds, these developments are positive from a municipal bondholder’s perspective.
Why Bondholders Should Care
One of the thorniest aspects of the pension debate is how states could possibly reduce benefits when certain states had explicit constitutional language protecting these benefits from being impaired. Many states interpreted this language to say that these protections extended not only to those already receiving benefits but to any current public employee. Federal Bankruptcy Judge Steven Rhodes, who ruled that Detroit was eligible for federal bankruptcy protection, has now clearly stated that pension benefits could be impaired regardless of state constitutional protections. This viewpoint will no doubt be subject to significant legal challenges, but he becomes the second federal judge that I’m aware of to make this point.
Cost-of-living benefits are commonplace in many public pension arrangements. They can be either fixed in nature (i.e., the pension benefit increases by a fixed percentage each year) or linked to an inflation index like CPI. One might think that suspending this benefit would do little to reduce pension underfunding. However, a quick numerical example shows why this isn’t necessarily true. If I owe someone a fixed amount of $100 in 10 years, today’s value of what I owe is about $74 (anyone interested in the details behind this calculation, let me know). However, if I owe someone $100 in 10 years grown by CPI, today’s value of what I owe is about $93! This is 26 percent more than what I owed in the fixed $100 scenario.
A Word of Caution
As I noted above, it’s still early. Virtually every single change to public pension benefits that I’m aware of has been or is subject to appeal and additional litigation. It could be the case that some of these initial rulings get overturned or reinterpreted. Investors looking for high-quality municipal bond portfolios are wise to continue to focus on high-quality municipal bonds with above-average pension funding.
Copyright © 2013, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.