How Do Incentive Stock Options (ISOs) Impact Alternative Minimum Tax (AMT)?

How Do Incentive Stock Options (ISOs) Impact Alternative Minimum Tax (AMT)?

 

One of the most common areas where we see clients introduced to Alternative Minimum Tax is when Incentive Stock Options (ISOs) enter the financial picture.  To learn more about AMT and how it is calculated, so you can avoid a shock, check our blog post from last week.

ISOs can be a tremendous benefit to creating wealth, but they are often misunderstood and can pack a large surprise if not appropriately planned for.  Here are a few key terms to get us started:

  • Grant Date/Amount– Original date and number of shares awarded
  • Vesting Date– The date at which you are allowed to exercise your options
  • Exercise Price– Price paid for options, usually discounted from the current share price.
  • Bargain Element– Difference between exercise price and fair market value (FMV); drives potential AMT liability

ISO preferential tax treatment is attained when the shares are sold one year after exercise and two years after grant. When this criterion is met, the gains upon the sale will be considered long-term capital gains, as opposed to short-term gains which are taxed at current income rates.

 

Qualifying vs Disqualifying Disposition:

 

Qualifying Disposition
  • Exercise and sell one year after exercise and two years after grant – AMT liability in the year you exercise, and gains are considered long-term capital gains
  • Exercise and hold – AMT liability in the year you exercise but no additional immediate tax liability because the shares have yet to be sold

 

Disqualifying Disposition:
  • Exercise and sell within one calendar year – no AMT liability and gains are taxed as regular income
  • Exercise and sell within 12 months, across two calendar years – AMT liability in the year you exercise, and gains are taxed as regular income
  • Exercise and sell more than one year from exercise but less than two years from grant – AMT liability in the year you exercise, and gains are split between regular income rates for the bargain element and capital gains depending on holding period

 

The AMT tax liability mentioned in the scenarios above is determined based on the difference between the exercise price and the fair market value (FMV) of the shares on the date of exercise. AMT may result in a larger tax bill than a typical year without exercising options and thus will directly affect your household’s cash flow.  The good news is that when you end up paying AMT related exercising ISOs, you will likely receive an AMT tax credit, which can be used to offset your federal income tax bill in future years.  This is a great reason why involving a CPA to help keep track of all the moving pieces is highly recommended.

The 83(b) Election is an alternative approach to divesting company stock. If your company allows, you have 30 days from the grant date to notify the IRS and your company of the 83(b) election. This involves paying tax on the exercise price from the grant at regular income rates; there would be no AMT implication and depending on when you sell the shares, you would later realize short- or long-term capital gains. For shares which you expect to increase in value, this can provide a fantastic tax break. This is however considered a risky approach because the shares could lose value and you would have overpaid on taxes by making this election.

Please reach out to us if you would like to work through your specific situation.

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.

 

What Is Alternative Minimum Tax (AMT) And Does It Affect You?

What Is Alternative Minimum Tax (AMT) And Does It Affect You?

 

Alternative Minimum Tax (AMT) is not something everyone is exposed to, but when you are, it can often create confusion and add a layer of complexity to financial planning that many are not prepared for.  This article will help outline how AMT may affect your financial situation.

The Alternative Minimum Tax was created in the 1960s with the intention of preventing taxpayers with substantial income from utilizing various deductions in order to dodge the traditional federal income tax system. The AMT system runs parallel to federal income tax for individuals, trusts, and estates. Corporations were also once subject to AMT until this was repealed by the Tax Cuts and Jobs Act in 2017. AMT is calculated to determine if taxpayers are paying their “fair share” in a given tax year. For individuals, the AMT system recalculates income tax using fewer deductions and exemptions – for example the standard/itemized deduction – and then adds back specific tax preference items to an individual’s gross income. 

A few of the preference items that we often see that affect AMT are listed below. There are several other influencing factors which are less common, and for the sake of this article, have been left out. IRS Form 6251 has the full details.

  • Capital gains from exercise of stock options (i.e., Incentive Stock Options)
  • Qualifying exclusion for small business stock
  • Interest on private activity bonds
  • Deductions for accelerated depreciation

Once the Alternative Minimum Taxable Income (AMTI) is calculated, the annual AMT exemption is applied to determine what amount is subject to AMT rates. In 2021, the AMT exemption is $73,600 for single filers and $114,600 for married filing jointly. The exemption begins to phase out for single filers at $523,600 and at $1,047,200 for married filing jointly.

After determining the minimum tax base, the AMT tax rate of 26% is applied on the first $199,900 (as of 2021).  Amounts above this figure are then subject to the second and final AMT tax rate of 28% to determine your overall AMT liability. After all is said and done, you will owe the higher of the two, traditional tax liability or AMT liability.

One of the most common areas where we see clients introduced to AMT is when Incentive Stock Options (ISOs) enter the financial picture. ISOs are often awarded by companies in lieu of direct compensation (i.e., annual salary), as a way to incentivize an employee to help grow the value of the company. Please check our blog upcoming blog post for specific details regarding Incentive Stock Options and the impact of AMT.

The majority of taxpayers don’t encounter AMT, but when they do, it can be a complete surprise.  Here at Merriman, we take a comprehensive approach to fully understand your financial landscape. In most situations, it is wise to involve a CPA when facing the AMT due to the complexity and varying timelines that affect cash flow. Please reach out to Merriman if you would like to discuss your situation in greater detail.

Watch for our upcoming blog post which will go into further detail about Incentive Stock Options (ISOs).

 

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.

Thinking Through Cryptocurrencies | Part 3

Thinking Through Cryptocurrencies | Part 3

 

It seems like everyone nowadays is talking about cryptocurrencies. Whether it’s the proselytizers on CNBC or the techie next door, it feels as if everyone is either talking about or buying into this next big thing.

Trying to adequately explain an emerging technology and it’s economic impact in less then a few thousand words is bound to neglect certain facets of the subject. This series attempts to cover the technical specification of cryptocurrencies, how they can be viewed in an investment environment, the narratives that accompany this new technology, and the future impact, applications, and risk of the cryptocurrency universe.

If you missed Part 1 or Part 2, check them out.  In Part 3, we consider what the future could look like.

 

 

What Might the Future Look Like?

Cryptocurrencies are experiencing a golden age where new types of assets and new uses for blockchain technologies are emerging every day. However, in this case, widespread use does not automatically translate to amazing long-term investment returns. Sustaining long-term high investment returns requires a combination of low supply and high demand.

When it comes to low supply, there is certainly a limit to the amount of a given cryptocurrency. However, new cryptocurrencies can and have continued to be created. Dogecoin was launched in 2013 and now has a circulation value which has exceeded $80B. Polkadot was launched in 2017 and has a circulation value that has exceeded $10B. When supply dwindles and prices rise, entrepreneurial spirits enter markets and create supply, especially when the barriers to entry are relatively low.

Cryptocurrencies have a few hurdles ahead of them. The most notable of these is the possible environmental impact of cryptocurrency mining. According to Digiconomist, the annualized carbon footprint of Bitcoin mining is comparable to the country of Hungary and is growing every year. As more and more individuals flock to the cryptocurrency space, the power necessary to rectify transactions grows. There are new cryptocurrency assets such as Cardano that seek to use optimized protocols to decrease the power required. However, because most cryptocurrencies utilize a proof-of-work methodology, there is a lower limit on the computation required for the cryptocurrencies to remain secure. This means that there will always be a certain energy requirement for these cryptocurrencies.

Bitcoin has also made a name for itself in non-reputable markets such as money laundering, drug trade, and even human trafficking. Blockchain analysis company Chainalysis tracked just under $930,000 worth of Bitcoin and Ethereum payments to specific addresses associated with child sexual abuse material. This was a 32% increase in payments from 2018 and a total of a 310% increase since 2017. Financial institutions in the U.S. filed over 2,000,000 suspicious activity reports (SARs) in 2019. The increasing use of cryptocurrencies in illegal transactions makes it harder for U.S. organizations to trace the financial trail.

Chainalysis also reported on Bitcoin use in terrorism financing. Known terror organizations would create campaigns to “donate to the jihad” with QR codes leading to Bitcoin addresses.

It’s important to point out that while these illegal organizations did use Bitcoin, there are other non-cryptocurrency methods that they could have used. Before Bitcoin, and even today, many black-market or illicit deals are done in cash. Former Treasury Secretary Larry Summers endorsed an idea published by Harvard president emeritus Peter Sands to all but get rid of cash. A case study in Missouri looked at the mid-1990s transition from distribution of federal welfare via cashable check to a preloaded debit card. Researchers found that crime in areas that moved away from cash dropped roughly by 10%.

Another inherent risk to the cryptocurrency markets that has increased its probability of late is Bitcoin or other cryptocurrencies becoming illegal to own. China has recently banned financial institutions from offering services involving cryptocurrencies. The U.S. government also showed its ability to pursue Bitcoin transactions after the Colonial Pipelines hack in spring of 2021. The hack, which yielded hackers $4.4 million was recovered as the government pursued the digital addresses associated with the hackers. The combination of Chinese regulation and the ability of governments to track and recover stolen or ransomed cryptocurrency assets is a direct blow to the claim that cryptocurrencies are outside of government control.

So where does this leave the average investor when it comes to Bitcoin? As an emerging asset class, it’s possible that the Bitcoin narrative is a self-fulfilling prophecy. In a period of low interest rates and inflation concerns, there are some good arguments as to why putting a small portion of a portfolio in cryptocurrency assets might provide some benefit, just as a small allocation to gold can provide benefits in certain macroeconomic environments.

Cryptocurrencies are volatile and may provide some correlation benefit with a small, value-tilted portfolio. The recent rapid increase in price across the cryptocurrency universe is fairly concerning as no other time in history has seen an asset class that has grown at such a rapid rate relative to inflation. It is also important to remember that in the case of gold rushes, it was the merchants who traded in goods who on average made the most profit, not the miners themselves.

We at Merriman do not shy away from new or emerging asset classes. Historically, we have either started new funds or have been some of the first investors in an asset class. The research and portfolio management team at Merriman has been monitoring the cryptocurrency market for many years.

As long-term investors, we try to develop our portfolios to maximize the probability of getting higher returns than the market. While Bitcoin and other cryptocurrency assets have shown extremely high returns for the past decade, this is not necessarily indicative of future returns. As said on almost every investment document, “Past performance is no guarantee of future results.”. At this moment in time, the cryptocurrency market is too risky and speculative to recommend in our portfolios. This stance may change in the future are the market evolves. Even though we do not recommend holding cryptocurrencies in our portfolio, it is OK to buy a little with some play money. It’s fine to play roulette at a casino as long as you only bet what you are willing to lose.

At Merriman, we will continue to monitor and research cryptocurrency assets so that if an expected return benefit appears, we can implement it for our clients.

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Opinions expressed by Merriman are based on economic or market conditions at the time this material was written.  Economies and markets fluctuate.  Actual economic or market events may turn out differently than anticipated.  Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made.  Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.  Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place. All composite data and corresponding calculations are available upon request.

Thinking Through Cryptocurrencies | Part 2

Thinking Through Cryptocurrencies | Part 2

 

It seems like everyone nowadays is talking about cryptocurrencies. Whether it’s the proselytizers on CNBC or the techie next door, it feels as if everyone is either talking about or buying into this next big thing.

Trying to adequately explain an emerging technology and it’s economic impact in less then a few thousand words is bound to neglect certain facets of the subject. This series attempts to cover the technical specification of cryptocurrencies, how they can be viewed in an investment environment, the narratives that accompany this new technology, and the future impact, applications, and risk of the cryptocurrency universe.

 

Recent Market Conditions

Economist Robert Shiller, the 2013 Economics Nobel Prize co-recipient, noted a similarity between the current Bitcoin movement and the bimetallism movement of the late 1800s. Shiller’s recent book Narrative Economics focuses on the stories or ideas that we tell ourselves that influence our economic decisions.

The narrative of Bitcoin is a fascinating story to tell. It starts with intrigue as the founder (or founders) of Bitcoin, Satoshi Nakamoto, has never been identified or even confirmed to exist. This creates a great human-interest story and helps to grab the attention of individuals.

We follow the human-interest story by delving into the complexity of cryptographic hash functions and network protocols that few understand. This complexity and need for experts to understand presents the next draw of Bitcoin.

Similar to young people of the late 1800s and their enthusiasm with the abstruse monetary economics of bimetallism, Bitcoin advocates take pleasure in the fact that it is only a select few (including themselves) that understand this complicated subject.

Bitcoin and cryptocurrencies have also caught the eye of various pop culture icons. In January of 2020, Bitcoin rose 20% in a matter of hours after Elon Musk famously changed his Twitter Bio to #bitcoin. Jack Dorsey, the CEO of Twitter and Square, has been a vocal supporter of Bitcoin and even sold his very first tweet in the form of a Non-Fungible Token (NFT) for 1,630 Ethereum (or $2.9 million). This allure of seeing individuals with household names using cryptocurrencies provides yet another boost in the awareness and interest created by the narrative of Bitcoin and cryptocurrencies.

Add to this the fact that in the past eight years (11/5/15 – 4/26/21) Bitcoin has had an annualized return of 82%. This has led to many sites and brokerages promoting advertisements showing these high levels of returns without mentioning the fact that Bitcoin has also suffered three 75% corrections in the 10+ years of its existence. Unfortunately, our human brains were wired millions of years ago and tend to value recent information over past information. Throughout history, this wiring has led to commodity fads. One of the earliest and most spectacular was “tulip mania,” a three-year period in the mid-1600s when tulip bulbs appreciated at an annualized rate of 200% per year.

While we have seen many of these types of narratives before, the combination of them in Bitcoin provides something attractive and seemingly new; and the ease and accessibility has never been higher, facilitating high demand. Financial applications such as PayPal can give just about anyone with a few bucks access to buying this exciting new asset class.

 

Stay tuned for the last installment where we discuss the future of cryptocurrencies. And if you missed our first installment, you can find it here

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Opinions expressed by Merriman are based on economic or market conditions at the time this material was written.  Economies and markets fluctuate.  Actual economic or market events may turn out differently than anticipated.  Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made.  Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.  Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place. All composite data and corresponding calculations are available upon request.

Thinking Through Cryptocurrencies | Part 1

Thinking Through Cryptocurrencies | Part 1

 

It seems like everyone nowadays is talking about cryptocurrencies. Whether it’s the proselytizers on CNBC or the techie next door, it feels as if everyone is either talking about or buying into this next big thing.

Trying to adequately explain an emerging technology and it’s economic impact in less then a few thousand words is bound to neglect certain facets of the subject. This series attempts to cover the technical specification of cryptocurrencies, how they can be viewed in an investment environment, the narratives that accompany this new technology, and the future impact, applications, and risk of the cryptocurrency universe.

 

What Is a Cryptocurrency?

The first cryptocurrency, Bitcoin, was originally imagined as a system of value exchange that could bypass institutions and instead allow users to make transactions on a peer-to-peer basis. For such a network to succeed, there had to be a way to verify the veracity of the transaction for both parties.

This is where the revolutionary technology called the blockchain comes in. The blockchain can be visualized as its name suggests: a chain made up of individual blocks of transactions. At its heart, this is what Bitcoin is: a series of transactions leading up to the current moment. When an individual buys Bitcoin, they are simply adding their name to the transaction list (or ledger), saying, “I have bought x number of Bitcoins.” Of course, it’s not as simple as adding a line.

Bitcoin works by having computers (or nodes) confirm and document transfers. When a transaction between Person A and Person B occurs, this transaction is sent out over the Bitcoin network. These nodes then verify that Person A has the right amount of Bitcoin to transfer to Person B by looking at the blocks of historical transactions on the chain. Once the majority of nodes on the network (50%) verify that a transaction can take place, it is added to the blockchain transaction log.

This verification process is where Bitcoin miners come into the picture. Miners provide the computers and computer power needed to verify transactions. They provide this service and get “paid” for it by having the opportunity to mint a new Bitcoin. To mint a new Bitcoin, a miner must verify 1MB worth of transactions and find a solution to a cryptographic hash function, which is the difficult part. The Bitcoin miner who verifies the transactions and is the first one to determine the target hash is the one who gets to include a new transaction for themselves, essentially minting a Bitcoin. While cryptocurrencies differ in the exact way that they go about transactions and the minting of new coins, the Bitcoin method is a solid enough base to understand cryptocurrencies at their base level.

 

Where Do Cryptocurrencies Fit in the Investment Landscape?

Cryptocurrencies, especially Bitcoin, are sometimes referred to as digital gold. Like gold and other currencies, they are something that derives their value from the belief that they can be exchanged in the future for something else of value and that the future value will be greater than the present value. The term that is frequently used is “a store of value.” Perceptions of value can change much more quickly than physical objects, which leads to the volatility that has always been present in currency markets, digital and fiat.

One of the advantages of cryptocurrencies, unlike gold or silver, is the ability to store value in an even more concentrated physical form. A 100-gram gold bullion cost about $6,000 dollars in 2020. This gold bullion could be slipped into your pocket or placed in a safe. A small flash drive, smaller than the gold bullion, could essentially hold billions of dollars in Bitcoin.

As with gold, there is a physical limit to the number of Bitcoins that can be produced. There can only be 21 million Bitcoins in the current Bitcoin network. So far, almost 19 million have been mined. Many believe this commodity-like supply will result in the value of Bitcoin rising with inflation—or possibly even faster.

Cryptocurrency advocates have discussed how this feature also makes digital currencies immune to the hyperinflation that can result from governments printing money. On the one hand, that is true. However, on the other side of the coin, the creation of a new Bitcoin or other cryptocurrency via mining injects new money into the supply. And as has been seen with gold historically, short-term, localized abundance of even a limited supply commodity can result in hyperinflation. The famous 1849 Gold Rush in California is a perfect example of the phenomenon. The prices for various goods like eggs, bread, and boots in the local area rose to more than three times the original price. Allowing for the lower accuracy of CPI data from the late 1800s, there is general consensus that the various gold rushes of the era from the U.S., Australia, and South Africa all resulted in increased inflation rates. So, while cryptocurrencies may be more immune from government influence, it is unlikely that they are immune to supply and demand shocks.

Other types of cryptocurrencies, such as Ethereum or Cardano, offer different use cases by allowing the creation of new cryptocurrency assets or non-proof-of-work methods. The full effect of these other types of cryptocurrencies remains to be seen. One Ethereum-based crypto asset that has seen a lot of recent attention is the rise of Non-Fungible Tokens (NFTs). These tokens represent a unique digital item and are not interchangeable. This has created a marketplace for artists to sell digital items with the authenticity guaranteed by the blockchain. Many of the applications of varying alternative cryptocurrencies are still being figured out at this time. It has yet to be seen whether these become alternate stores of value or simply new, more efficient ways to transact.

 

Watch for the next installment where we discuss cryptocurrencies and recent market conditions.

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.

It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Opinions expressed by Merriman are based on economic or market conditions at the time this material was written.  Economies and markets fluctuate.  Actual economic or market events may turn out differently than anticipated.  Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made.  Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.  Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place. All composite data and corresponding calculations are available upon request.

The Role of Bonds

The Role of Bonds

 

In Berkshire Hathaway’s most recent annual shareholder letter, Warren Buffett shared his dire forecast for bond investors:

 

And bonds are not the place to be these days. Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.

Thus far, Warren’s negative outlook has proven correct with the yield on the 10-year U.S. Treasury bond rising to 1.74% through the first quarter, leaving bond investors with a negative (3.4%) return.* And with inflation expectations heating up, it is certainly difficult to build a bullish case for bonds. However, most individual investors do not have all their investable assets in bonds. Buffett only considers the investment merits as a standalone investment. Given that most of our clients own bonds within a diversified mix of equities, real estate, and other asset classes, we thought this would be an opportune time to revisit the role bonds play within the portfolio.  

In its most basic form, a bond is a loan to a government entity, corporation, or individual consumer. The investor in a bond is the lender and expects to receive back the original principal along with interest over the life of the loan. Bonds have two main characteristics: quality and maturity.

Quality is a measure of credit risk or the likelihood that the entity will repay the loan. High-quality bonds carry lower interest rates to reflect the low risk of default. In Buffett’s example above, he discusses the U.S. Treasury bond, which has the highest quality and thus a lower interest rate. On the other end of the spectrum, a corporation with a “junk” credit rating will have a much higher interest rate to compensate investors for the additional risk of default. 

Maturity is a measure of interest rate risk. Using bond terms, duration provides an estimate of how sensitive a portfolio of bonds is to changes in interest rates. As an example, if interest rates rise across all maturities by 1%, a bond portfolio with a duration of 10 years can expect to lose 10% in value without including interest payments. The interest rate risk increases with duration and vice versa.

Now that we have the basics in place, let’s discuss more specifically the role bonds play in a diversified portfolio. MarketWise is designed to produce the highest risk-adjusted returns, taking into consideration the long-term expected returns, volatility, and correlations produced by the different asset classes. Bonds play a critical role in that mix. We invest in high-quality U.S. government bonds with short to intermediate (two to five year) maturities with the sole purpose of mitigating risk and providing stability. For taxable accounts, we invest in municipal bonds, which play a similar role while producing tax-free interest. We also own Treasury Inflation Protected Securities (TIPS), which provide protection during inflationary environments. 

The main function of bonds in a portfolio is downside protection. If stocks always went up, there would be little need for bonds or any other asset class. But as we were recently reminded last March, stocks do go down, and when they do, bonds provide that counterbalance, as they typically rise in value during equity bear markets or economic recessions. In fact, since 1976, there have been eight years in which stocks were lower. In each of those years, bonds finished higher to help cushion the blow. This allows us to rebalance during those periods and sell bonds when they are up and buy stocks when they are down in value.

Bonds also have very low overall correlation to stocks. During negative months for stocks, that correlation drops even further. But that also does not mean bonds always have negative returns when stocks are up. In fact, bonds are slightly positively correlated to stocks during up periods. We recently saw this in 2020 with both stocks and bonds finishing with positive total returns for the year. 

So, despite the lower expected returns for bonds going forward, it is important to understand the characteristics of bonds and why we own them. That said, our team continues to research ways to improve the fixed income slice of the portfolio. Over the past several years, we added two specialized asset classes in Alternative Lending and Reinsurance to increase returns that are uncorrelated to both equities and bonds. Going forward, we will continue to investigate ways to enhance the role that bonds play within the portfolio.

 

 

Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such.  Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products.  The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.  All composite data and corresponding calculations are available upon request.