This is a guest post (part 3 in a 3-part series) by Sam, author of Financial Samurai, “How to Engineer Your Layoff,” and founder of the Yakezie Network. Part 1 is A primer on the most important economic metric and Part 2 is A primer on the most important economic metric (part 2).
TREASURY YIELDS AND YOUR NET WORTH
Feeling financially emboldened yet? The easiest way to track the 10-year Treasury yield is on Yahoo Finance. Now that you can speak more eloquently about economics and the stock markets, let’s drill down to how the 10-year Treasury yield can help you make the proper net worth asset allocation.
I’m a big believer in not only diversifying your stock portfolio but also in optimizing your net worth as it grows in value. Once you build a sizable financial nut that is spitting out a viable passive income stream, your goal is to protect it like Sparta!
Most home buyers take out a mortgage to finance their property purchase, and understanding that the 10-year Treasury yield is closely correlated to mortgage rates is critical information for them. When the 10-year Treasury yield was at 1.6 percent, for example, one could lock in a 30-year, fixed-rate mortgage at 3.5 percent or a 2.5 percent 5/1 ARM. With the 10-year yield now over 2.6 percent, mortgage rates have risen commensurately by roughly 50 basis points to 100 basis points.
When Treasury yields are low, the demand for borrowing money increases. Much of the demand for cheap money goes toward property. As demand increases, so do property prices all else being equal. In a low-interest-rate environment, one should look to lever up and buy real assets which have the potential for appreciation such as property. Nothing is guaranteed (as we all know from the housing crisis), but cheaper mortgages means the opportunity cost of not owning property increases as rents rise.
Treasury Yields have risen violently in 2013 from 1.66 percent to as high as 2.98 percent recently. And while 2.98 percent is still low by historical standards, the pace of increase caught many home buyers and bond holders by surprise. This is why bond funds got smashed during the summer of 2013. Such a quick increase in rates should serve to dampen demand and price increases in real estate until the economy “catches up” to new, higher rates. Remember to always think about increases at the margin.
By keeping track of the latest 10-year Treasury yield, you think much more rationally and much less emotionally during a property-purchase or property-sale situation.
My current property asset allocation: 35 percent of net worth. Goal is to reduce the weighting to 30 percent by selling one of my rental properties due to a rebound in property prices and my desire to simplify life. Real estate is my favorite investment class for building long-term wealth.
With the 10-year yielding 50 basis points (bps) more than the S&P 500 dividend yield and the S&P 500 at record highs, I am no longer 100 percent allocated toward stocks (equities) in my rollover IRA. I’ve decided to limit my equity exposure to 75 percent equities and 25 percent bonds within my investment portion of my net worth.
One of the saddest situations was when retirees in 2007 to 2009 saw their portfolios get decimated by 30 to 50 percent. I wrote a post in 2012 on GRS entitled, Finding Hope In The Bleakest Of Situations where I, too, lost about 35 percent of my net worth in a matter of months after 10 years of 50-percent-plus savings. Everybody thinks they are stock market geniuses in a bull market. But as Warren Buffett once said, “Only when the tide goes out do you see who’s naked.” Don’t confuse brains with a bull market!
The historical performance of the S&P 500 is, thankfully, up and to the right. But there are nasty corrections in between. We’ll never know for sure when the next bear market cycle will be, which is why we should reduce exposure to stocks the closer we are to retirement.
My current stock/bond asset allocation: 30 percent/10 percent of total net worth. If the 10-year Treasury yield breaks 3 percent, I’ll be shifting to a 25 percent/15 percent allocation.
Safe assets include money market accounts and certificates of deposit (CDs) up to $250,000 per individual or $500,000 per married couple thanks to FDIC insurance in case your bank goes under. You can open up multiple CD or money market accounts with different financial institutions if you have more than the $250,000/$500,000 to spread around. It is always important to have a portion of your net worth in safe assets because bad things happen in the markets all the time if you invest long enough.
About 25 percent of my net worth is currently allocated in 7-year CDs yielding a blended 4 percent annual return. This was a fantastic rate when the world was coming to an end in 2008 to 2009, but not so much now that we’ve been seeing double-digit returns in the stock market for the past several years. A 4 percent CD yield is still much greater than the current 10-year yield of approximately 2.7 percent, but CDs also don’t have a chance for principal appreciation.
When your CDs expire, invest in CDs that provide an interest-rate equivalent to at least the 10-year yield or greater due to inflation. The best CD rate I can currently find is a 7-year term at around 2.35 percent. As a result of low CD interest rates, I’m looking at CD-investment alternatives to boost return.
My desired CD allocation over the next three years: 25 percent of net worth going down to 15 percent or less.
Cash is a safe asset that deserves a section of its own. They say “cash is king,” but not so much in a bull market as we are experiencing now. Cash should be viewed mainly for emergency liquidity purposes. Cash provides no return and the amount you have should be dictated by your daily or monthly operational needs. Given CDs are FDIC insured, holding too much cash is a sub-optimal strategy since you could be earning at least 2.35 percent risk-free.
To determine how much cash is enough, calculate a realistic emergency fund amount based on cash withdrawal rates over budget for the past three years. Of course, if you are expecting a large upcoming expense such as a wedding, graduate school tuition, a relocation, or an investment, allocate more cash accordingly.
Bottom line: The lower the interest rate on the 10-year Treasury, the lower the return on less risky asset classes. Reallocate your net worth toward higher-yielding asset classes.
TREASURY YIELDS AND LOANS
So far we’ve been focused on using cheap money to invest in other assets that can potentially provide greater returns. But what if you are not ready for investing and are still digging yourself out of a debt hole?
In this current low-interest-rate environment, now is absolutely the right time to shop around for lower rates. The worst kind of loan is a credit-card loan because the average interest rate on credit cards is around 15 percent. Despite a drop in Treasury yields over the past 10 years, credit card interest rates have remained fairly stable. As a result, profit margins have expanded if we assume default rates stayed steady. If you’ve been responsible in paying your credit card bills on time, I urge you to call your credit card company now and negotiate a lower rate today.
Mortgage rates and car loan interest rates are much more closely tied to interest rates partly due to fierce competition. The car industry went through near death and needed to entice consumers to buy during the 2008-to-2011 period. As a result, zero percent car loans for three years were common just to move the product. I’m a big advocate of never taking out a car loan. I truly believe a car is the Number 1 personal finance killer for people today. To compound buying a depreciating asset with a loan that charges interest is just wrong.
One of the best rules of thumb for buying a car is to spend no more than 1/10th your gross income on the purchase price of a car. The 1/10th rule helps motivate you to save and earn more if you want a certain type of car. The rule also keeps people from overly destroying their finances since a car is guaranteed to depreciate and takes money away from investing.
Banks realized they were too strict in their mortgage-lending practices in 2010 and 2011, and they are now more aggressive in mobilizing their overcapitalized balance sheets. Unfortunately, industry reports are showing that the refinance boom is temporarily over with a spike in interest rates in 2013 due to perceived tapering by the Federal Reserve. With the nomination of former UC Berkeley professor Janet Yellen as the next Fed Chair, we should see a continued accommodative Federal Reserve based on her record. Watch the 10-year yield closely and consider calling your mortgage broker to check the rates if the yield goes below 2.5 percent again.
Unless you are taking out a loan to buy an asset that has a chance of appreciating, please keep borrowing to a minimum despite low rates.
If you keep track of the 10-year Treasury yield and master its underlying meanings, you should be able to get a much stronger handle on your finances. Use the latest 10-year Treasury yield as a benchmark for every single investment you make to help take emotion out of the equation. The goal is to one day build a large enough net worth so that your money is generating perpetual passive income based on your personal risk tolerances.
What is your asset-allocation strategy and how did you decide on it? If you have any questions on the 10-year government bond yield please feel free to ask.