Opinion - FA Playbook

Op-ed: All types of investors can improve their financial situation in the current environment

Dave Gilreath, partner/founder, and Tiffany VanHook, vice president/wealth manager, at Sheaff Brock Investment Advisors, LLC
Key Points
  • Pandemic cut your income but expect to earn more in 2021? This might be a good time to convert your traditional individual retirement account to its Roth equivalent.
  • Middle-class and upper-class investors may want to consider adjusting their bond holdings to lower risk.
  • Investors may also consider lightening up on growth stocks and adding shares of their polar opposite — value stocks.

The coronavirus pandemic has obviously caused a great deal of financial hardship for many investors. However, it has also created new opportunities to position for gains. What's more, investors of all stripes have been forced to find ways to reduce risk and preserve assets.

Whether you're a middle-class investor trying to compensate for lost wages or a wealthy individual seeking to reduce tax exposure, the current market and interest rate environments suggest some key moves to consider making now.

For example, if the economic impact of the virus has cut your income this year and you expect to earn more next year, this might be a good time to convert your individual retirement account into a Roth IRA — assuming this works with your long-term financial planning.

While IRA contributions are made with pre-tax money, contributions to Roth IRAs are made with post-tax money, so there's no tax on qualified withdrawals. Unlike IRAs, Roths involve no required minimum distribution. Therefore, a Roth IRA conversion gives you the flexibility to lower taxable income in retirement and allows your assets to grow tax-free.

Yet, as a Roth conversion involves withdrawing the tax-deferred assets in your IRA, it triggers ordinary income tax on the value of these assets, so it's best to have the cash outside of your IRA to pay the tax.

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Roth conversions are a particularly good idea if you expect your income tax rate to be higher in retirement or you want to avoid RMDs from IRA assets, which begin at the age of 72. Another reason to convert to a Roth this year is if your IRA asset value was hit hard by the shutdown and you reasonably expect it to be higher in years to come.

Middle-class and upper-class investors may want to consider adjusting their bond holdings — including those in their 401(k) plans, if possible — to lower risk. Credit risk in the bond market is currently quite low because the Fed has backstopped virtually all bonds.

But interest rate risk may never have been higher. If the interest rate paid on the 10-year Treasury bond (.65% early this month) were to increase 1% two years from now, this would mean that selling current bonds on the secondary market would bring a loss of 7% of principal. If the rate on the 20-year Treasury (1.18% early this month) were to rise 1% in two years, you'd lose 15% of your principal.

So reducing your bond exposure is a good idea. One alternative is preferred stocks, a fixed-income asset where loss of principal due to credit risk is less likely for the foreseeable future because the lion's share of issuers, financial institutions, have never been stronger.

Also, preferred shares tend be less sensitive to interest rate moves than they are to credit, so rising rates would be less of a threat to principal.

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Though traded as shares, preferred stocks function more or less as bonds but have much higher yields in the form of dividends — often as high as 5% or 6% annually. Yet, as these investments are stocks subject to value swings, the average investor's risk tolerance would probably dictate limiting preferred-share holdings to 10% or 15% of a total portfolio.

Investors may also consider lightening up on growth stocks and adding shares of their polar opposite — value stocks.

 As of early June, value stocks were down 11% for the year, though they have risen since March. The spread between the annualized trailing 10-year return of value stocks and that of growth stocks as of early this month was at the same extreme level as in early 2000.

In the ensuing three years, value stocks significantly outperformed. Fast forwarding to 2020, in the 30-day period ending June 10, the S&P 500 Value Index outperformed the S&P 500 Growth Index by 2.5%. Though one month hardly makes a trend, this may mean that the value bird is starting to sing.

Signals of a potential rise of value stocks over growth stocks are also evident in the stark differences in key valuation attributes of the S&P 500 Value Index ETF (SPYV) versus those of the S&P 500 Growth Index ETF (SPYG). The value index stocks have recently traded at one-third the growth stocks' price-to-book-value, one-third their price-to-sales ratio and one-half their price-to-cash-flow ratio, according to Morningstar.

Consider borrowing money to buy reliable dividend-paying stocks and then pocketing the net gains after paying the loan interest.
David Gilreath and Tiffany VanHook
partner/founder and v.p./wealth manager, Sheaff Brock Investment Advisors, LLC

Yet they've been paying three times the growth stocks' dividend. Along with the month of outperformance, these valuation differences might be signaling a changing of the guard regarding the value-growth dynamic.

Another option is an equities strategy enabled by the current low interest rates. So, consider borrowing money to buy reliable dividend-paying stocks and then pocketing the net gains after paying the loan interest.

This isn't a perennially viable strategy, but the currently wide spread between good dividend yields (the ratio of price to dividends — essentially, what investors must pay for dividends) and the interest rates on loans makes it viable now for investors who have good credit and available collateral but lack unfettered cash.

Meanwhile, for ultra-wealthy individuals concerned about the impact of estate taxes, current low interest rates make this a highly opportune time to set up a grantor retained annuity trust (GRAT), used to bypass estate taxes.

Estate planners often set up these trusts when individuals have used up their lifetime estate and gift tax exemption ($11.58 million per individual) and need other ways to avoid estate tax on estates that are earning far more than they're spending.

The retained annuity from assets held in GRATs is based on a variable rate known as the hurdle rate, set for each month for GRATs established and funded in that month. This rate has declined in recent months as the Fed has pushed rates downward and, combined with the market decline, this has created a perfect opportunity for large estates to use these trusts.

The lower the hurdle rate (aka, the IRS Section 7520 rate), the more wealth is passed on to trust beneficiaries without estate tax. And hurdle rates are historically quite low these days. For example, the hurdle rate for this month is 0.6% (down from 2% in January).

If you set up a five-year GRAT and funded it with $1 million this month, and it earned 7% each year, it could pass on virtually all of this growth, above 0.6% per year. If managed correctly regarding key technical points, the amount of the trust's gains received at the end of the term by beneficiaries estate-tax free could potentially be about $250,000.

Regardless of whether you're just getting by or you're looking for smart moves to give away millions, the current environment suggests ways for a wide range of investors to improve their financial situations.