An update on my fixed income exposure

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. Well, 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.

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.

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%/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%.

I used money invested in low yielding fixed income for the down payment. Since my new monthly housing expenses so far are close to what I would have been paying by renting, I think I that there isn’t a high opportunity cost to this transaction.

Plenty of other bloggers are against owning a home. They believe that they are better off renting the smallest housing unit possible, and using the down payment to invest in the stock market. Real estate varies from location to location, which is why this thinking works in some places, but not in others. In our case, the housing expense for renting versus buying is roughly equivalent. The down payment ensured that too.

Perhaps I could have invested the downpayment in stocks, and rented ( accomplished by selling the fixed income and buying stocks with the proceeds, rather than put the money towards a downpayment for a house). Despite the fact that ownership and rent expenses are roughly equivalent for me, there is an opportunity cost to that amount of cash.

Perhaps I am ”naive”, but it seems “safer” to own my home and live in it than to have the money invested in the stock market and use the income to pay for expenses in retirement. Or at least it feels safer to tackle one of my largest expenses, and be relatively independent from the vagaries of the stock market for this portion of net worth. If you are striving for financial independence, you should also want your "returns" to be generate from various sources.

Given the low expectation for investment returns over the next decade, I think that buying and owning that home at a decent valuation versus owning a collection of dividend paying stocks is probably a moot point over the next decade.

Of course, this whole analysis is dependent on my personal situation, and the area I live in. If I lived in San Francisco or New York City, chances are that the inputs would have been starkly different.

If we discuss longer term periods however, it is very likely that returns on equities will be higher.

It is very well possible that the opportunity cost of owning that home is that I could have been richer by the dividends and capital gains my portfolio would have otherwise generated.

On the other hand, if my portfolio does not do as well as expected, owning that home would seem like the smarter decision.

To Summarize:

1) Owning a house has similar cost to renting in my situation, due to low price to rent ratios
2) Due to 1), I am essentially paying rent to myself and building equity in the process
3) Owning a house is a better use of capital than investing in fixed income today
4) It makes no sense to borrow for a mortgage at 3%/4%/year ( for 15/30 years), but invest in fixed income for 2% - 3%/year in investment accounts
5) It is safer to own the home for the predictable return from the "housing dividend", rather than invest the money, and use the stock dividends to pay for home expenses.
6) Owning a home is for long-term investors only, willing to hold for a decade (which is similar to long-term dividend investing)
7) Owning also provides better control over the housing situation than renting. Hence it could be argued that unless you own your home, you cannot really call yourself financially independent.

I would love to hear your thoughts on this decision. Please feel free to email me back.

Relevant Articles:

- Rent Versus Buy - How to decide which one is best for you?
- Does Fixed Income Allocation Make Sense for Dividend Investors Today?
- Entering Wealth Preservation Mode
- Fixed Income for dividend investors