A Study of Real Real Returns - Nominal Return Real Real Return
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A Study of Real Real Returns
The generation of real wealth Nominal Return
depends on the bottom line.
Real Real Return
$100
1983 1988 1993 1998 2003 2008 2013
Volume 21, August 2014Unconventional Policies, Market Surprises and Other
Signs of the Times
Investors could be forgiven for scratch- and away from investment amid wor- yellow metal rose 10.5% in the first half
ing their heads over the collisions be- ries about its growing debt load has of 2014. Benchmark U.S. stock market
tween consensus views and actual weighed on its economic growth, not indexes recently hit record highs, while
market and economic performance to mention global commodities prices. bond yields of some of the eurozone’s
since our report a year ago. After a ban- Japan’s monetary reflation weakened most troubled economies are not far
ner year for stocks and high-yield bonds the yen versus the dollar and boosted off those of U.S. Treasuries. Issuance
in 2013, investors were almost uniformly inflation expectations and asset prices of riskier “covenant-lite” loans has been
advised to stay the same course in 2014, last year, but structural reforms needed running at double its 2007 level. As the
given the U.S. Federal Reserve’s an- for meaningful and sustained long-term reach for yield grows and asset prices
nounced tapering of its asset purchase economic growth remain to be seen. In rise, so too do associated risks.
“Inflation may appear tame, but investors should keep in mind that QE and
rock-bottom interest rates in most of the developed world can’t go on indefinitely
without consequence.”
program and the eventual rise in bench- Europe, despite the recent European If central bankers typically take key in-
mark interest rates. But if the Fed has Central Bank measures to boost bank terest rates down on elevators and up
repeatedly over-estimated inflation and lending, disinflation persists. Elsewhere, on escalators, there’s a risk that QE
economic growth in recent years, Wall emerging markets look poised for a and zero-level rates can potentially turn
Street has also misfired: stocks have modest recovery in 2015 after four years asset reflation into more generalized
had a rough ride higher so far in 2014, of declining growth, with emerging mar- inflation, especially if the economic re-
particularly the growth stocks that were kets asset prices already rising smartly covery does finally pick up steam. An-
supposed to benefit from the still elusive midway through 2014. But it’s far from other threat to investor returns comes
acceleration in U.S. growth. And after clear that reforms in a handful of big, from new and sharply higher invest-
stumbling 2% in 2013, the total return fiscally challenged developing countries ment income tax rates. Then there are
of the Barclays U.S. Aggregate Bond In- grappling with current-account deficits investment expenses and fees. The
dex unexpectedly climbed 3.93% in the will continue, given a renewal of cheaply challenges to investors looking to gen-
first half of 2014. Indeed, U.S. Treasury financed, speculative inflows. erate returns after inflation, taxes and
bond yields spent the first six months of expenses—the real real return—are
the current year noticeably lower than Inflation may appear tame, but inves- considerable. The market context is
they were at the end of 2013, even as tors should keep in mind that QE and also challenging. But a thorough un-
the Fed has steadily reduced its “Quan- rock-bottom interest rates in most of derstanding of the various challenges,
titative Easing” (QE). the developed world can’t go on in- and the vehicles available to navigate
definitely without consequence. Inter- through them, should help investors
Internationally, China’s economic reboot estingly, after gold’s 12-year bull-run chart a promising course.
toward more domestic consumption came to an end last year, prices for the
2 | A Study of Real Real ReturnsThornburg’s View of Real Real Returns
As we’ve noted before, nominal returns are returns facilitates informed investment payer Relief Act of 2012, or ATRA, was
a misleading driver of an investor’s invest- decisions, which in turn improves the anything but for top earners. It raised the
ment and asset-allocation planning. That’s odds of accumulating real wealth. highest marginal income tax rate to 39.6%
because they are significantly eroded by from 35% for individuals with incomes
taxes, expenses and inflation. Moreover, The chart below illustrates the erosion of over $400,000, and $450,000 for married
allocation strategies that heavily rely on nominal returns from taxes, expenses and couples filing jointly. These taxpayers were
nominal returns may take insufficient ad- inflation. It uses the nominal returns of additionally subject to a hike in qualifying
vantage of different investment vehicles the S&P 500 Index and real-world data dividend and long-term capital gains taxes
that potentially offer valuable diversifica- for the past 30 years. to 20% from 15%.
tion benefits, which can shelter portfolios
during the inevitable periods of market But top earners weren’t the only ones sub-
volatility and help position them for sub- Capital Punishment ject to tax hikes. Those with adjusted gross
sequent upturns. Examining the real real income of at least $200,000, or married
returns of individual asset classes over Significant increases in investment taxes joint-filers making $250,000, also paid a
longer periods can help investors build in 2013 have taken a huge bite out of new 3.8% tax on “unearned” net invest-
more successful portfolios. More broadly, nominal returns for investors in the top ment income above those thresholds as
understanding the importance of real real income tax bracket. The American Tax- part of the Affordable Care Act (ACA).
Growth of a Hypothetical $100
S&P 500 Index from December 31, 1983 to December 31, 2013
$2,500 Nominal
Nominal Return Return:
11.09%
Expenses $2,346
Dividend Taxes After
$2,000 Expenses:
Capital Gains Taxes 10.54%
Inflation $2,020
Real Real Return After
Dividend
Taxes:
$1,500 9.58%
$1,554
After
Capital
Gains
Taxes:
$1,000
8.96%
$1,311
Real Real
$500 Return
After
Inflation:
5.97%
$570
$0
1983 1988 1993 1998 2003 2008 2013
Results reflect past performance and do not guarantee future results. The performance of an index is not indicative of any particular investment. Investors may not
make direct investments into any index. Sources are provided at the end of this study.
A Study of Real Real Returns | 3Still, the hit was clearly hardest for people to 6.2% last year from 4.2%. Individuals But there’s no guarantee the benign in-
in the top bracket, as this additional tax on earning $200,000 or married joint-fil- flation environment will last. Consumer
net investment income applies to interest ers with income of $250,000 had to pay prices jumped 0.4% in May of 2014 from
payments on corporate and U.S. govern- the “Additional Medicare Tax,” which the month before, the biggest climb in
ment bonds, a category taxed at the same was also mandated by the ACA, of 0.9%. more than a year. On an annual basis, they
rate as ordinary income, raising the total Limitations on total itemized deductions rose 2.1%, the fastest 12-month increase
tax levy to 43.4%. It also swelled the total and personal exemption phaseouts took since October 2012. The rise in prices
tax take on qualified dividends and long- effect in 2013 on adjusted gross income was broad-based, from electricity to food,
term capital gains to 23.8% from 15%, an of $250,000 for singles and $300,000 for transportation, medical care, apparel and
eye-popping 59% jump. joint-filers. other items. It also built on the 2% an-
nual rise posted the month before. April’s
Tax rates do, of course, change over time, Last year’s tax hikes and additional lev- pace matched the U.S. Federal Reserve’s
as does the tax treatment of different types ies are significant and complex. Investors 2% inflation target, a level it considers
of investment income. Over the last three should consult a financial or tax advisor. conducive for price stability and economic
decades, the highest marginal income tax growth. The Fed’s preferred measure, the
rates have run from 28% to 50%. In cal- personal consumption expenditures price
culating real real returns, we use the maxi- Inflation’s Taxation index, has also been rising briskly, climb-
mum marginal rate in effect at a given time. ing 1.8% in May from the year before and
We assume that dividends were taxed at If investment income tax rates rose marking its fastest pace since October
the maximum rate in the year they were re- steeply on top earners, affected inves- 2012, as well.
ceived. As for capital gains—the difference tors may at least take a little solace in the
between the price paid for an investment relatively mild bite out of their nominal In response to the 2008 financial crisis,
and the higher price at which it was sold— returns from inflation, which economist the Fed that year slashed key interest rates
we assume they are long term, the tax treat- Milton Friedman has called “taxation nearly to zero, and has kept them there
ment of which is more favorable than that without legislation.” Prices for goods and ever since. It also launched three suc-
involving short-term capital gains. services in the United States rose just cessive rounds of QE asset purchases—
1.5% in 2013, substantially less than the expanding its balance sheet from $800
Apart from the purposes of this study, 1.7% pace in 2012 and less than half of billion in 2007 to $4.3 trillion today—
investors should also be aware of the the 3.0% in 2011. That means the decline in an effort to defibrillate the moribund
other tax increases beyond those raised in the purchasing power of a dollar—and economy. (See our March 2014 article,
on investment income. The Social Secu- so in the real return from an investment “Quantitative Easing’s Elusive Targets” at
rity tax rate paid by employees increased portfolio—has moderated. www.thornburg.com/articles.) Although
the economy was lifted out of recession
in 2009, it has limped along at an annual
Tax Changes That Took Effect in 2013
growth rate of just over 2% ever since.
2012 Maximum 2013 Maximum Nonetheless, the Fed in January began to
Type of Tax Applies to: trim its asset purchases, and is expected
Rate Rate
to end them completely this fall. The Fed
Tax on Ordinary Ordinary income, including interest isn’t expected to raise interest rates until
Income income generated outside of tax- 35% 39.6%
the second half of 2015.
advantaged accounts
Tax on Qualifying Qualifying dividends earned on Some question whether it will have to
Dividends stocks held outside tax-advantaged 15% 20% move sooner on rates, given the lag be-
accounts tween rate hikes and the time it takes for
them to ripple through the economy and
Tax on Long-Term Gains on investments held longer check price pressures. Federal Reserve
Capital Gains than 12 months 15% 20% Bank of St. Louis President James Bull-
ard on June 26 added to the speculation by
Unearned Income The lesser of net investment income suggesting the “economy could tolerate at
Medicare Contribu- or the excess of modified adjusted least a little bit of the central bank getting
tion Tax gross income over a threshold based N/A 3.8% back to a more normal stance” on mone-
on filing status tary policy. “I don’t think financial mar-
kets have internalized how close we are to
Source: Internal Revenue Service our ultimate goals,” Mr. B ullard added.1
4 | A Study of Real Real ReturnsReinforcing the point on the same day, just to equilibrate the balance between no doubt welcome an increase in rates, as
Federal Reserve Bank of Richmond Pres- pressure on current resources and pressure they have suffered a negative real return
ident Jeffrey Lacker said: “Even if growth on future resources.”2 between inflation and near-zero nomi-
remains relatively subdued, as it has been nal yields on the securities. Whether the
over the past five years…you can reach a Investors in short-term instruments such Fed will raise rates at the pace necessary
situation in which real rates need to rise as T-bills and money market funds will to keep potential above-target inflation
in check without choking off the modest
economic recovery remains to be seen.
In the meantime, investors should factor
Growth of The Federal Reserve’s Balance Sheet in the threat of inflation into their long-
1/1/2003 – 7/9/2014 (in Trillions) term planning.
5.0
4.5
Expense Erosion
4 .0
3.5 This study employs a 0.50% rate for in-
vestment expenses, which we consider
3.0
a reasonable long-term proxy for overall
2.5 expenses of varying types of investments,
2.0 from higher-cost international equities to
lower-cost asset classes such as U.S. gov-
1.5
ernment bonds. We don’t apply this rate to
1.0 real estate, of course. On homes held more
0.5 than a year, we deduct the typical 6% com-
mission. Though we can’t build them into
0.0
7/03 7/04 7/05 7/06 7/07 7/08 7/09 7/10 7/11 7/12 07/13 07/14 our calculations, as homeowners know,
maintenance expenses on housing can run
Source: Bloomberg
into the thousands of dollars a year.
A Picture of Inflation
$200,000 25 Yrs: $200,196
Thegold areain the
graph shows theequiva-
lent of $100,000in 2013
$150,000 dollars, based onCPI, for
2013: $100,000 each year. So, $100,000
in 2013 had the same
purchasing power as
$100,000 $7,692in 1925.
No Real Gain.
The blue area represents
This amount is a projection based upon
The United States goes off needed just to
$50,000 the 30-yr average rate of
the gold standard in 1971
1925: $7,692 stay even 2.82%, showing 2013’s
with inflation. $100,000 inflating to
$200,196 in 25 years.
$0
1925 1935 1945 1955 1965 1975 1985 1995 2005 2015 2025 2035
Source: Calculated by Thornburg Investment Management using data presented in the Ibbotson SBBI® 2013 Classic Yearbook, ©2013.
All rights reserved. Used with permission.
WSJ.com, June 26, 2014
1
WSJ.com, June 26, 2014
2
A Study of Real Real Returns | 5Nominal Outcomes and Net Results
Big Bites Out of 2013’s terms. As for commodities, the U.S. re- bonds were also hit hard, with the nom-
Outsized Gains covery wasn’t nearly enough to boost inal 1.5% drop turning into a real 5.2%
prices for energy and base metals. Anemic loss. The real real losses in 2013 on muni
Last year proved extraordinary for equi- growth in Europe, Japan, and especially bonds, intermediate-term government
ties, while the rebound in real estate that China’s ebbing from its erstwhile red-hot bonds and T-bills all came in around 2%.
began in 2012 continued to run strong growth rates also hurt the commodities The real real loss on commodities deep-
through 2013. But both high-grade fixed complex, which shed 10% on the Dow ened one point to 11% last year.
income and commodities tumbled. The Jones-UBS Commodities Index last year.
nominal numbers were striking. The S&P
500 Index soared 32%, while the smaller But 2013 also proved surprising in the 30-Year Trends
stocks comprising the Russell 2000 Index big impact on those nominal returns from Stirred, Not Shaken
sky-rocketed 39% and the international last year’s sharp tax hikes. After inflation,
stocks within the MSCI EAFE Index expenses and taxes, the real real return Equities consolidated their position as
drove it 23% higher. At 11%, nominal re- on S&P 500 Index was just under 25%, the best-performing asset class over the
turns in real estate entered into the double a drop of nearly eight percentage points last three decades in both nominal terms
digits for the first time since 2004. from the nominal return, while almost and after adjusting for taxes, inflation and
“QE, ground-level interest rates and expectations the economic recovery would
gain traction largely fueled the big gains in share prices. But the same factors
pulled the rug out from under fixed income: If the Fed was confident enough in
the recovery to signal the beginning of the end of QE, interest rate hikes couldn’t
be too far off, undercutting existing investment-grade bonds.”
QE, ground-level interest rates and ex- nine points were chopped off the top-line expenses. Bonds, meanwhile, saw their
pectations the economic recovery would return of the Russell 2000 Index. The returns ebb in both nominal and real real
gain traction largely fueled the big gains MSCI EAFE Index lost six points for a terms in the 30-year period through 2013.
in share prices. But the same factors real real return of almost 17%. Real estate Though in the case of municipal and long-
pulled the rug out from under fixed in- shed three points for a bottom-line return term government bonds, their returns
come: If the Fed was confident enough last year of 7.8%. were still materially positive, and their
in the recovery to signal the beginning of gains, along with those of stocks and real
the end of QE, interest rate hikes couldn’t Meanwhile, the negative nominal re- estate, have continued into the first half
be too far off, undercutting existing in- turns of fixed income and commodities of 2014.
vestment-grade bonds. Long-term gov- were exacerbated once taxes, inflation and
ernment bonds tumbled a nominal 11%, expenses were taken into account. The The S&P 500 Index posted an average
while municipal bonds stumbled 2.6%, worst-performing category, long-term annual nominal return of 11.09%, and a
and high-end U.S. corporate bonds fell government bonds, saw its nominal 11% real real return of 5.97% in the 30 years
1.5%. The near-zero yields on Treasury loss deepen to a negative 14% return on through 2013, again making U.S. large-
bills left their returns flat in nominal a real real basis. High-grade corporate cap stocks the best-performing asset class
6 | A Study of Real Real ReturnsErosion of Total Returns Over 30 Years
in a Taxable Account, as of 12/31/2013
Real Real Nominal
Return Return
U.S. Large-Cap Stocks
(S&P 500 Index) 5.97% 11.09%
International Stocks
(MSCI EAFE Index) 4.97% 9.84%
U.S. Small-Cap Stocks
(Russell 2000 Index) 5.00% 9.81%
Municipal Bonds
3.63% 7.12%
(Barclays Muni Index)
Long-Term Gov Bonds
(20-yr Treasuries) 3.08% 9.44%
Corporate Bonds
(Barclays U.S. Corporate Index) 1.95% 8.46%
Intermediate Gov Bonds
(5-yr Treasuries) 1.59% 7.37%
Real Estate/Single Family 0.80% 4.38%
T-Bills -0.87% 4.01%
Commodities
(Dow Jones–UBS
-2.90% 0.46%
Commodity Index &
Dow Jones Future Price Index)
-4% -2% 0% 2% 4% 6% 8% 10% 12%
30-Year Average Annual Returns
Real Real Return Capital Gains Taxes Dividend/Interest Income Taxes Expenses Inflation
Methodology: This chart shows how fees, taxes on dividends and capital gains, and inflation erode real wealth. The amount at the far right shows the nominal return of an invest-
ment, while the area in gold r eflects the amount eaten away by fees (in our example, fees of 50 basis points (0.50%) were applied to the investment, with the exception of real es-
tate, which includes a one-time 6% commission). The impact of taxes on income from the investment (either dividend or interest income) is represented by the area in teal. Taxes on
capital gains provide a further drag on performance and are represented by the area in green, while the silent tax of inflation, in burgundy, can often turn a positive nominal return
into a negative real real return. Sources and descriptions of each index and asset class are provided at the end of this study.
Past performance does not guarantee future results.
A Study of Real Real Returns | 7in our study. U.S. small-cap stocks and it seems clear the decades-long bond bull time. Equities, by contrast, generate most
international stocks ran neck-and-neck market since the 1982 peak in interest of their returns from capital gains, which
in nominal returns, with each gaining rates is effectively over. are not taxed until they are actually re-
just over 9.8%. But in real real terms, the alized—as the stocks are sold. Again,
Russell 2000 Index edged out the MSCI Although residential real estate enjoyed a qualifying capital gains and dividend in-
EAFE Index, 5% to 4.97%, becoming nice jump in 2013, its three-decade aver- come are now effectively taxed at the to-
the second-best performer over the 30- age annual nominal return increased just tal 23.8% rate for individuals making at
year period. Interestingly, in last year’s marginally last year to 4.38%, while its least $200,000 a year, or couples making
results, long-term government bonds net return inched up to a still low 0.8%. $250,000. While a significant increase,
actually outperformed in nominal terms Commodities, which have had a strong that’s still nearly 20 points less than the
these two stock categories, but with an run so far in 2014, continued to lag badly new total levy on interest income of top
average annual nominal 9.44% return in the longer timeframe, with a nominal earners that’s generated outside of tax-
over the 30 years through 2013, they return of just 0.46% and a real real nega- advantaged accounts.
failed to do so again. tive return of 2.9%.
Despite the long-run outperformance of
Long-term government bonds shed three- What accounts for equities’ long-run out- equities, investors would be well-advised
tenths of a point off their 2012 net gain, performance? Certainly in recent years, not to put all their money into that, or
producing a real real average annual return the extraordinary monetary stimulus has any single, asset class. As recent times
of 3.08% over the three-decade timespan. helped equities and artificially boosted have shown, returns dispersion among
Municipal bonds, meanwhile, remained demand for long-term government bonds, asset classes can vary dramatically from
the top performer within fixed income, pushing down their yields and total re- year to year. Fixed-income returns, par-
with a 7.12% nominal and 3.63% average turns. The source and timing of returns ticularly of investment-grade paper, often
annual real real return during the period. also, of course, have a significant impact. correlate negatively with equity returns—
T-bills again proved a losing proposition, Bonds generate most of their return from in other words, they move in opposite
as their nominal 4.00% return shrank to interest income, and for taxable bonds, directions, which helps smooth portfolio
a real real 0.87% loss. Given the Fed’s fi- the income is taxed in the year in which volatility. Lastly, consistent income from
nancial repression in recent years and its it is received, at higher ordinary-income a well-managed compilation of bonds can
repeated guidance that benchmark inter- tax rates. Moreover, if taxes are paid an- anchor portfolios.
est rates will remain low for some time nually from interest income, it reduces
after the slated end of its QE program, the amount available to compound over
Real Real Returns
Annual Returns after Taxes, Inflation and Expenses as of 12/31/13
Small Co Int’l Municipal Long-Term Corp Intermediate
S&P 500 (Russell 2000) (EAFE) Bonds Govt Bonds Bonds Gov Bonds Real Estate* T-Bills Commodities Inflation
30 Years 5.97% 5.00% 4.97% 3.63% 3.08% 1.95% 1.59% 0.80% -0.87% -2.90% 2.82%
20 Years 4.85% 4.88% 1.98% 2.20% 1.83% 0.93% 0.76% 0.74% -1.11% -1.92% 2.37%
15 Years 0.94% 4.07% 1.07% 1.86% 1.32% 0.69% 0.76% 0.54% -1.50% -0.39% 2.37%
10 Years 3.28% 4.58% 3.15% 1.36% 1.37% 0.37% 0.35% -0.60% -1.84% -3.51% 2.37%
5 Years 12.38% 13.86% 7.89% 3.16% -1.93% 3.62% -0.33% -1.38% -2.48% -1.52% 2.08%
1 Year 24.55% 30.03% 16.54% -4.47% -14.39% -5.18% -3.37% 7.78% -1.96% -11.36% 1.50%
Sources and descriptions of each index and asset class are provided at the end of this study.
* For the one-year real real return, the 6% real estate commission was not deducted.
Performance data quoted represents past performance and does not guarantee future results.
8 | A Study of Real Real ReturnsThe Upshot of Real Real Returns for Planning
Alongside the appropriate investment then taxed at the ordinary-income tax time. While the real real return of corpo-
mix, portfolio construction must take rates in effect. If the rate is lower than that rate bonds in a taxable account was 1.95%
into account tax, inflation and ex- in effect during the accumulation phase, over the past 30 years, it jumped to 2.99%
pense considerations to maximize real this can produce significant savings. As in a tax-deferred account. The 1.04% dif-
wealth generation. Even small moves to noted, beginning in 2013, the maximum ference may seem small, but it’s actually
optimize portfolio allocation and effi-
marginal rate for interest income became far larger than the differentials between
ciency can significantly improve returns 39.6%. When taxes are deducted from equity returns in taxable and tax-deferred
over time. an account each year, this reduces the accounts. Furthermore, over 30 years of
amount available for reinvestment. In compounding, the financial impact of
tax-deferred accounts, income and capital such a difference, which is also quite evi-
Tax-Deferred Accounts Versus gains are allowed to compound without dent in the real real returns of taxable and
Taxable Accounts taxation, having a potentially profound tax-deferred long- and intermediate-term
cumulative effect. bonds, adds up significantly.
The type of account in which investments
are held can have a huge impact on their On the equities front, the taxable dividend
real real returns. In an IRA or employ- Performance of Asset Classes in yield of U.S. large-cap stocks is relatively
er-sponsored retirement account, taxes Different Types of Accounts low, so the average return differential be-
on interest, capital gains and dividend tween the two account types is minor. The
income are deferred until an investor re- The chart below shows the performance same applies to U.S. small-cap and inter-
ceives account distributions, which are of the study’s various asset classes over national stocks.
Tax-Deferred Account vs. Taxable Account: Real Real Returns
7%
Taxable Account Tax-Deferred Account
30-Year Average Annual Real Real Returns as of 12/31/2013
6% 5.97%
5.49%
4.97% 5.00%
5%
4.30% 4.28%
4% 3.92%
3.08% 2.99%
3%
2% 1.95% 1.96%
1.59%
1%
0%
U.S. Large- International U.S. Small- Long-Term Corporate Intermediate
Cap Stocks Stocks Cap Stocks Gov Bonds Bonds Gov Bonds
(S&P 500 Index) (MSCI EAFE Index) (Russell 2000 Index) (20-yr Treasuries) (Barclays U.S. (5-yr Treasuries)
Corporate Index)
Performance data quoted represents past performance and does not guarantee future results.
Methodology: The chart above shows how the real real return of investments can shift when held in a tax-deferred account. In the tax-deferred account, taxes are deferred until the
end of the 30-year period. Sources and descriptions of each index and asset class are provided at the end of this study.
A Study of Real Real Returns | 9What accounts for the disparate impact In the example, we compare yields for sixth of the U.S. economy and imposes
on real real returns of bonds in the two two hypothetical bonds—a taxable bond significant new taxes on investment in-
types of accounts? Remember that inter- yielding 5.50% and a municipal bond come. Marginal income tax rates also in-
est income is taxed annually in taxable yielding 4.00%. The municipal bond is creased sharply for top earners in 2013. In
accounts, and at an individual’s highest generally more sensible for an investor in response to the financial crisis, financial
marginal income tax rate. So the long- the higher tax brackets, while an investor sector regulation has increased markedly
run erosion in returns from bonds held in in the lower tax brackets would be better and retarded loan growth and banks’ div-
tax-deferred accounts isn’t nearly as exten- off with the taxable bond. idend distributions, crimping economic
sive as it is in taxable accounts. recovery and shareholder returns. Mean-
while, monetary policy entered uncharted
Asset Allocation territory with the Fed’s near-zero interest
Taxable or Municipal Bonds? rates and unprecedented QE, the unwind-
Asset allocation is a primary driver of in- ing of which remains an untested work in
Investors should consider the implications vestment outcomes. When possible, allo- progress. It’s likely the Fed’s balance sheet
of tax rates in determining whether taxable cation should emanate from a long time will remain exceedingly large, as Chair-
or municipal bonds make the most sense horizon. Too often we see investors stung woman Janet Yellen recently suggested,
for their portfolios. Municipal bonds are in their pursuit of short-term returns. In “for some time.”3
fewer in variety and generally pay lower the aftermath of the financial crisis, many
interest rates than taxable bonds, but the investors grew fearful of risk and shifted While inflation may not currently seem a
interest is usually free from federal taxes portfolios to cash. Only after a strong rally threat, its potential to become one to in-
(though it may be subject to the Alterna- in late 2012 and early 2013 did they rotate vestors’ real returns, not to mention peo-
tive Minimum Tax). back into equities. If they had held onto ple’s purchasing power, can’t be dismissed.
their equity positions, they would have Investors must also remain cognizant of
A simple way to compare these returns is more than fully recovered. For example, new regulatory and tax regimes involving
to calculate the taxable equivalent yield, since its previous high point in October health care, financial services and other
which shows what a taxable bond would 2007 through the first half of 2014, the sectors. They should pay special atten-
have to yield to equal the tax-free yield of S&P 500 Index has produced annualized tion to the impact from higher individual
a municipal bond. The formula: returns, with reinvested dividends, of marginal income tax rates and new taxes
5.7%. Those investors who bought at the on investment income. Such changes can
Tax-free yield market bottom in March 2009 through dramatically affect broad economic as well
June 2014 would have realized annualized as individual portfolio performance—and
1 - ordinary income tax bracket
returns of nearly 25% and a cumulative re- the generation of real wealth.
turn of 224%.
Taxable Equivalent Yield
Comparing 5.50% Taxable and 4.00% The same challenge of poor timing— Shortsighted and Farsighted
Municipal Bonds investors chasing performance after asset
8%
prices have already risen and fleeing after Investors should also keep in mind the
Muni prices have already fallen—applies just potential effects of three common timing
7% Taxable Bond Taxable as much to fixed-income investors, who and time-horizon points.
Bond 6.15% Bond Muni tend to purchase bond funds at the wrong
6% 5.50% 5.50% Bond
5.00%
time, just as interest rates are about to rise Actively managed mutual funds buy and
5% and prices are about to fall. Most inves- sell securities, potentially generating prof-
tors are best served by allocating to both its that must be paid to investors as capital
4% equity and fixed income, enabling them gains distributions. Those who purchase a
3%
to ride out volatile markets psychologi- fund shortly before such distributions are
cally and financially. paid without having participated in most
2% of the preceding gains still suffer the tax
implications if the purchase was made for
1%
Political Risk a taxable account. This is especially im-
0% portant for purchases late in the calendar
35% Rate 20% Rate Changes in tax, regulatory, fiscal and year. Before a purchase, investors should
monetary regimes can have a severe im-
For illustration purposes only. Not representative of
any actual investment. pact on the economy and the markets. The
ACA, passed in 2010, affects roughly one- 3
Bloomberg.com, June 18, 2014
10 | A Study of Real Real Returnsask their investment managers if a near- distributions from them. Liquidity con- ferent asset classes. A spike in inflation
term capital gain distribution is in the siderations are also a key component of would do much the same by undermining
pipeline. Also, investors are usually better comprehensive financial planning. the purchasing power of investment re-
served by placing higher-turnover equity turns. As the Fed slowly exits its ultra-easy
funds in tax-deferred accounts, and low- monetary policy, investors should closely
er-turnover funds in taxable accounts. consider whether it is doing so in a timely
The Bottom Line
way so as to avoid a build in inflationary
The benefits of tax-deferred accounts are Investors often focus only on nominal re- pressures or asset price bubbles. Expenses,
well known. But investors also need to turns for portfolio construction, without of course, eat into returns as well.
“Investors should pay special attention to the impact from higher individual
marginal income tax rates and new taxes on investment income. Such
changes can dramatically affect broad economic as well as individual portfolio
performance—and the generation of real wealth.”
consider their short- and longer-term li- considering the impact on inflation, taxes Well beyond nominal performance, inves-
quidity needs. For example, young people and expenses. Tax rates can change. As tors should evaluate the potential real real
saving for a down payment on a house we saw in 2013, new and sharply higher return of asset classes. Optimal portfolio
shouldn’t use a tax-deferred account, as taxes can seriously erode real returns. That construction and the generation of real
federal regulations heavily penalize early impacts the relative attractiveness of dif- wealth depend on it. n
A Study of Real Real Returns | 11Important Information for the periods covered under The Jobs and Growth Tax The S&P 500 Index is an index consisting of 500 stocks
Relief Reconciliation Act of 2003. The tax deferred ac- chosen for market size, liquidity and industry grouping,
This information should not be considered tax advice. Any count scenario applied the highest marginal tax rate at the among other factors. The S&P 500 is designed to be a
tax statements contained herein are not intended to be end of the 30-year period. leading indicator of U.S. equities and is meant to reflect
used, and cannot be used, for the purpose of avoiding tax the risk/return characteristics of the large-cap universe.
penalties. Please consult your independent tax advisor as Index & Asset Class Descriptions
to any tax, accounting or legal statements made herein. The Russell 2000 Index measures the performance of the
Bonds are debt investments in which an investor loans small-cap segment of the U.S. equity universe. The un-
Statements contained herein are based upon information money to an entity (corporate or governmental) which bor- managed index is a subset of the Russell 3000® Index
furnished from independent sources. While we do not rows the funds for a defined period of time at a fixed inter- representing approximately 10% of the total market capi-
guarantee their correctness, we believe them to be reliable est rate. Bonds are subject to certain risks including loss talization of that index. It includes approximately 2000 of
and have ourselves relied upon them. of principal, interest rate risk, credit risk, and inflation risk. the smallest securities based on a combination of their
Diversification does not ensure a profit or guarantee The value of a bond will fluctuate relative to changes in in- market cap and current index membership. Small-cap
against a loss. terest rates; as interest rates rise, the price of a bond falls. stocks are subject to greater volatility than large-cap
stocks.
Alternative Minimum Tax (AMT) – A federal tax aimed at Government bonds, or Treasuries, are negotiable debt obli-
ensuring that high-income individuals, estates, trusts, and gations of the U.S. government, secured by its full faith The MSCI EAFE (Europe, Australasia, Far East) Index is an
corporations pay a minimal level income tax. For individu- and credit and issued at various schedules and maturities. unmanaged index. It is a generally accepted benchmark
als, the AMT is calculated by adding tax preference items Income from Treasury securities is exempt from state and for major overseas markets. Index weightings represent
to regular taxable income. local, but not federal, taxes. Treasury bill data is based on the relative capitalizations of the major overseas developed
a one-bill portfolio containing, at the beginning of each markets on a U.S. dollar adjusted basis. The index is cal-
Quantitative Easing – The Federal Reserve’s monetary month, the bill having the shortest maturity not less than culated with net dividends reinvested in U.S. dollars. There
policy used to stimulate the U.S. economy following the re- one month. Intermediate government bond data is based are special risks associated with international investing,
cession that began in 2007/08. on a one-bond portfolio with a maturity near five years. including currency fluctuations, government regulation,
Long-term government bond data is based on a one-bond political and economic risks, and differences in liquidity.
The Consumer Price Index (CPI) measures prices of a fixed
portfolio with a maturity near twenty years.
basket of goods bought by a typical consumer, including Compared to the other investments in this study, sin-
food, transportation, shelter, utilities, clothing, medical Municipal bonds are debt obligations issued by states, cit- gle-family homes are relatively illiquid. Property values can
care, entertainment, and other items. The CPI, published ies, counties, and other governmental entities. Municipal fluctuate and there are no guarantees. Gains on the sale of
by the Bureau of Labor Statistics in the Department of bonds offer a predictable stream of income which is free a property may be taxable at the federal, state, or local
Labor, is based at 100 in 1982 and is released monthly. It from federal and, in some cases, state and local taxes, but level. Real estate data in this study uses U.S. Census
is widely used as a cost-of-living benchmark to adjust may be subject to the alternative minimum tax. Because of Bureau’s Survey of Construction single-family homes sold.
Social Security payments and other payment schedules, these tax savings, the yield on a muni is usually lower than For the one-year real real return, the real estate commis-
union contracts, and tax brackets. CPI is also known as that of a taxable bond. Higher grade munis have higher sion was not deducted. For longer periods, a 6% commis-
the cost-of-living index. degrees of safety with regard to payment of interest and sion was applied to approximate the economic reality of a
repayment of principal and marketability in the event you typical real estate investment transaction.
Sources must sell before maturity. This study uses the Barclays
A commodity is a physical good – such as food, grain, oil,
Municipal Bond Index as a general representation of the
Real real returns were calculated by Thornburg Investment natural gas, and metals – which is interchangeable with
investment grade municipal bond market.
Management using data obtained from the following another product of the same type, and which investors buy
sources: A corporate bond is a debt security issued by a corporation. or sell in an active market, usually through futures con-
Corporate bonds are taxable and have more credit risk tracts. If you buy a futures contract, you are basically
Tax rate data are from the IRS. compared to Treasuries. This study uses Barclays U.S. agreeing to buy something that a seller has not yet pro-
Inflation/Consumer Price Index–Urban (CPI-U) and Corporate Investment Grade Index, which is a general rep- duced for a set price on a specific future date. The futures
Treasuries data were obtained from the Ibbotson SBBI resentation of the investment-grade corporate bond market. market is extremely liquid, risky, and complex. Commodity
2014 Classic Yearbook, © 2014. All rights reserved. Used prices can be affected by uncertainties such as weather
The Barclays U.S. Aggregate Bond Index is composed of and war and there are no guarantees against losses. In
with permission. approximately 8,000 publicly traded bonds including U.S. this study, commodities are represented by the Dow
Commodity data were obtained from Global Financial government, mortgage-backed, corporate and Yankee Jones-UBS Commodity Index, from 1999 to present. Prior
Data. bonds. The index is weighted by the market value of the to that, returns are represented by the Dow Jones Futures
bonds included in the index. Price Index. The index is designed to be a highly liquid and
Real estate data were obtained from the U.S. Census diversified benchmark for commodities traded on U.S. ex-
Bureau. A stock is a share in the ownership of a company. As an
owner, investors have a claim on the assets and earnings changes. For purposes of this study, it is assumed that
Corporate and municipal bond data were obtained from of a company as well as voting rights with the shares. commodity exposure is obtained through a vehicle tracking
Barclays. Compared to bonds, stock investors are subject to a the index and not by purchasing the underlying futures
greater risk of loss of principal. Stock prices will fluctuate, contracts.
Index data for the S&P 500, MSCI EAFE, and Russell
and there is no guarantee against losses. Stock investors The performance of an index is not indicative of the perfor-
2000 were obtained from FactSet.
may or may not receive dividends. Dividends and gains on mance of any particular investment. Unless otherwise
Tax rates were obtained from the Internal Revenue an investment may be subject to federal, state or local in- noted, index returns reflect the reinvestment of income
Service. The taxable account scenario applied the highest come taxes. dividends and capital gains, if any, but do not reflect fees,
marginal tax rate in each calendar year allowable per the brokerage commissions or other expenses of investing.
Cov-lite (Covenant Light) – Loan agreements which do not
IRS to compute hypothetical dividend and interest taxes. Investors may not make direct investments into any index.
contain the usual protective covenants for the benefit of
The study assumes that all equity dividends are qualified
the lending party.
Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or summary
prospectus containing this and other information, contact your financial advisor or visit thornburg.com. Read them carefully
before investing.
© 2014 Thornburg Investment Management, Inc. 8/15/14
Thornburg Securities Corporation, Distributor | 2300 North Ridgetop Road | Santa Fe, New Mexico 87506 | 877.215.1330 TH1401You can also read
