Fixed income and home dividends are steady forms of protection in the event of deflation, however that doesn’t always mean that they’re the best investment.
A couple of years ago, I shared with you that I am increasing my fixed income allocation by buying individual bonds, CD’s and bond funds.
I made some calls stating that I am increasing my fixed income exposure. However, after an year and a half, I ended up selling most of these fixed income instruments. I got out of them over the past three months or so.
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I purchased fixed income, in order to have an allocation to an asset class that would zag when stocks zig. I wanted to be protected in the event of a deflation, which would torpedo economies and business profits. The super low expected returns were the price to pay for that protection. I take diversification seriously.
When I purchased these fixed income instruments, I also had a vague idea that I may be needing that money within the next five years or so. Conventional wisdom is to place money that you will need within five years or so in fixed income. On the other hand, I also wanted to get some diversification away from equities. The results from the past two years show that I achieved diworsification in this portion of my assets.
Related: Smart Beta and Fixed Income: A Surprisingly Perfect Match
As I reviewed what I was doing, I realized that these instruments were not generating good expected returns. While diversification is great in theory, I was essentially diversifying my future expected returns away instead. As someone in their early 30s, who will likely end up generating income for most their lives, I have decades ahead of me. So having a 15% – 20% allocation to fixed income is probably too much for me, based on future expected returns.
In addition, as I now have ten years of good earnings under my Social Security history, I also can expect to see a decent retirement check several decades from now. That future stream of social security checks is an asset that is part of my long term fixed income exposure.
As I was looking at the dismal future expected returns on my fixed income instruments, I was also looking at my expenses. My largest expense items over the past decade have been taxes and housing.
After reducing taxes as much as possible over the past four years, I decided that I had to do something about my next largest recurring expense – housing.
After doing some research, we decided that based on price to rent ratios, my local real estate market is attractive for buying. You may want to read my last report on Rent Versus Buy and How to decide which one is best for you.
I ended buying a house with the proceeds from my fixed income instruments several months ago. The fixed income was used for the down payment of the residence, as well as a few of the mortgage payments. I financed the rest with a 30 year mortgage. The most interesting part is that our housing expense today is roughly equivalent to what it would have cost to rent it. The only difference is that I am essentially paying rent to myself.
The best part about owning your home is the so called “housing dividend”. The “home dividend” is the right to live in your home. Plenty of analysts completely miss the point of housing, because they only focus on the price appreciation part. By ignoring the home dividend, they end up reaching incorrect conclusions.
This purchase will not make me rich. However, it provides a better return on investment than a bond yielding 2% – 3%. I believe that if I were to rent my house, I would generate a gross yield of 6.50% – 7.50%. (Gross Yield = 12 times rent divided by the purchase price of the house) I believe that the annual price appreciation of 3%/year will be offset by costs for property taxes, maintenance and insurance.
Therefore, I believe that this house has an expected return of 7% a year. If we get no price appreciation during the holding period, the expected return will be around 4%, which still beats my fixed income dollars. Also, the nice thing is that a portion of my monthly housing payment goes towards building ownership in my home, rather than being 100% wasted by going to the landlord’s pockets.
The future returns in housing may be lower than anticipated however, if I end up spending more on maintenance than expected. In addition to that, it is quite possible that this house will take up more of my time. My time also has a cost, since it could have been used elsewhere.
The one thing that is certain however is the fact that my fixed income yielded less than the mortgage I am paying. Therefore, it makes little sense to keep fixed income yielding 2% – 3% but have a mortgage debt yielding 3% – 4%.