Real estate has been incredibly expensive for quite some time now and buyers are having trouble saving enough for a proper down payment. Still, there is an urgency for people to get into the house they want while interest rates hover around record lows.
Announcer: The views and opinions expressed in the program are not necessarily those of this radio station or its sponsors, and should not be construed as legal, tax or investment advice. You should always consult the appropriate advisor before making any financial decision. All rights reserved. Now, AM 1220 KDOW presents New Focus on Wealth with certified financial planner, Chad Burton, drawing from his 20-year background in finance and investing to help you make sense of your money matters.
Announcer: New Focus on Wealth. Get a new focus on personal finance, wealth management, Wall Street and the economy. Now, your host for New Focus on Wealth, Chad Burton.
Chad Burton: Welcome into the show. I am your host Chad Burton, certified financial planner. Do you have a money question for the show? Love to hear from you. Shoot me an email. It’s email@example.com. That’s firstname.lastname@example.org. One of the things I want to talk about is what’s called intra-family loans. I’m seeing a lot of this lately because you have a couple of things going on.
Chad Burton: Number one, you have real estate prices are expensive and people are having trouble saving enough money to be able to create the proper down payment to get a decent mortgage. Yet, there’s still an urgency for people to get into the home they want because interest rates are so low. Prices are high, but interest rates are so low. Really, when you buy a home, you’re buying the mortgage, right? You’re buying the affordability of that mortgage.
Chad Burton: As long as you stay put, well, in 10 years the mortgage that feels a little bit stretchy right now, a little bit tough right now, isn’t going to hurt as bad because your wages should go up with inflation. Unfortunately, I see a lot of people consistently swap houses. They swap cars constantly. They take any other equity they have and they constantly get the expensive house.
Chad Burton: Every single year, every couple of years, they’re selling a home, getting a more expensive home and they’re constantly stretching for a decade long then there’s a real estate crush and they lose it all. I don’t want people to do that. I want them to get into the house that they can afford and anything that you get into now, I’d say just be willing to stay there for 10 years if you go through some sort of a correction.
Chad Burton: It’s going to be interesting because with this whole world of stay at home and work, there’s going to be certain areas of the U.S. that rally, continue to push ahead on real estate prices. Places that are affordable. There are certain areas that are extremely expensive, like potentially the Bay Area. I don’t know. I could be wrong about this, but if all of a sudden, if I’m an employee and I’m in a home, a 1500 square foot home that I’ve purchased, that I can barely afford the mortgage for this three-bedroom house and I’m struggling even though I’m making a pretty decent income.
Chad Burton: If my company says, “You can work from home forever now,” well, I’m going to look for where the schools are better, where the housing’s cheaper, where the lifestyle’s a little bit better, less traffic. That’s just me. Maybe you love the Bay Area. I don’t know, but same thing could happen in Seattle. There are certain places that have gone up, that are still going up as people move out of very expensive places and so there could be a lot of what’s called intra-family loans going on.
Chad Burton: I’m going to try to do a job of explaining how some of this works today. What I always want to say is when you do these types of situations, you want to always consult a tax advisor and an attorney, or at least one of these websites that deals in these intra-family mortgages, these intra-family loans. I’m going to start this by going over an email I got, because I think it explains several different situations all wrapped up in one question.
Chad Burton: The long story of this email is this lady said to me, “My son currently lives in a home in New York.” It turned out it was suburbs of New York, so about an hour and a half away from the city, because the values kind of surprise me. She said, “The value of this current home is $450,000. The current loan is 190,000. He wants to put an offer in on a new four-bedroom home. They have a second baby on the way.” All right? The four-bedroom home is $490,000 that he wants to put an offer on.
Chad Burton: The situation is, is that the suburbs are going up in value and it’s still very competitive. They’re getting these all-cash offers on these homes. The son, she said wants to be competitive with an all-cash offer. He’s asking to borrow $490,000 so that he can put an all-cash offer on this home, buy it and then turn around and sell the home that he’s in. Now, I said, “Well, if it’s not that much of a loan, so why can’t he just qualify for a new loan?”
Chad Burton: The issue was, is he’s furloughed right now. He’s going to go back to work, but he’s furloughed. A mortgage broker already told him, “No. There’s no way that you could qualify for both loans.” He’s in a situation where he needs to move. He needs another bedroom and needs to do an all-cash offer. The lady asked, “Can we give him $490,000 to buy his house and then he can sell his existing house, do a cash-out refinance and pay us back?” This is where all of the problems start.
Chad Burton: I’m afraid that a lot of people create a nightmare situation like this really on the daily in the United States right now. First of all, I mean, it’s great that these people are in such a good financial situation that they’re willing and able to find the cash to give a short-term loan to the son, to get him into a house that they want to get in to the family. The son, he’s only going up 40 grand in the value of a home, but he gets an extra bedroom, so that’s good. Okay. I get why he’s doing it.
Chad Burton: There are so many problems here. First of all, if you write a check to somebody for $490,000 and you don’t do this with a proper note, right? A note is a form of I’m going to give you this. You pay it back. It’s a contract, right? A note, a promissory note, basically your mortgage is a promissory note to the bank that you borrowed the money from. In this situation, there has to be a note involved because if you write that check and you don’t do anything, that’s considered a gift and you have to file a gift tax return. All right?
Chad Burton: You don’t want to do that because if you file a gift tax return, there’s no taxes due, but it eats away into the amount of money that you can pass away to your family members after you die. That could be a huge mistake, especially if the estate tax laws change again and we go way back down in terms of how much you can leave to your heirs. You don’t want this to be considered a gift. Now, and then if the son turns around and pays you back, well, if there’s no note repayment, then that’s another gift.
Chad Burton: Then there’s potentially two gift tax return. It can really be a nightmare. It’s really kind of a pain. Now, the other piece to this is that in 2017, there’s a whole bunch of laws that changed when it comes to your mortgage and what you can write off. Right? First of all, the limits went down. In this case, it’s not a big deal, but the limit is now between your debt for your first and second home. You can’t write off interest on debt that’s over 750 grand.
Chad Burton: That’s not an issue here, but now you can only write off acquisition debt or anything that was used to drastically improve the property. If he does all of this work and he buys this home with some short-term loan that’s not tied to anything, and he goes back and sells his existing home, pays off that mortgage and then tries to do some sort of a cash-out loan on this new house to try to give the money back to his parents.
Chad Burton: If there’s no proper note tied to this, and he’s just pulling cash out and that cash is not used for the original acquisition or major improvement to the property, guess what? That new mortgage might not be tax deductible to the son. There are so many issues here if it’s not done correctly. Now, the type of loan that they’re really talking about is called delayed financing. They can’t do that really in this situation.
Chad Burton: What a delayed financing issue is, is let’s say you’re in a really good situation where personally, you want to buy a new home. You can afford to buy it in an all-cash offer, but why would you want to do that when mortgage rates are so low? That’s kind of silly. What you do is, you sit there and you do one of two things. You either take some existing cash and you buy this property and then you do delayed financing and you pay yourself back.
Chad Burton: That can still qualify for tax deductible acquisition debt, but you can’t do that and pay somebody else back. It has to be paying yourself back or paying off some other loan. For example, we have a lot of clients when they have large stock portfolios and they want short-term money and they don’t want to pay capital gains taxes, do a collateralized loan, really low interest rates. Interest only. They’ll use the money for short term. They’ll do a delayed financing. They’ll pay back their own portfolio.
Chad Burton: That’s fine. In this scenario, it’s not okay. We’re going to talk about delayed financing, intra-family mortgages when we get back after the break. If you want to shoot me an email, it’s email@example.com.
Announcer: You’re listening to New Focus on Wealth on AM 1220 KDOW.
Chad Burton: Welcome back into the show. I’m your host, Chad Burton, certified financial planner. All right. Today, we’re talking a little bit about what’s called intra-family mortgages or intra-family loans. There’s some actual estate planning benefits that you can do for this. Right now we’re talking about a situation where somebody wanted to give or do a short-term loan to their son so they could buy a house, then turn around, sell their existing home, pay off that existing mortgage, and then pay back the parents by refinancing.
Chad Burton: That was a lot easier to do prior to 2017. Then all the rules changed in terms of what you can deduct when you take out a loan of equity and it’s not used for the original acquisition of the home, or to do a refinance or to do major capital improvements. You can’t just do it the way they want to do it. They can’t just here, write a check. You use the money for a little short period of time. You write off. You sell the existing home, pay back that mortgage, give me that money and then go to the bank and say, “I want to do a cash-out refinance on my new home.”
Chad Burton: There’s a thing called delayed financing where that works. Again, the delayed financing the loans where you buy a home for all cash, and then turn around within … a lot of times, it’s within six months, you can do delayed financing, but you can only do it to pay yourself back. Not somebody else. Not a gift. You can’t use it to pay back a gift. There’s also specific tax rules to say from the date of purchase of the property to when do this delayed financing, how much time is legally able to pass and you can still call this acquisition debt and write it off under the new rules.
Chad Burton: You have to consult a tax advisor when you do these things, especially when you’re doing intra-family loans. I already explained that just giving the money to somebody and then having them give it back to you without some sort of a note tied to a property can create a gift tax return that can cost money to people after somebody dies. Not right now, but it creates a giant headache and it can cost your heirs money after you pass away in the form of estate taxes. What has to be done is what’s called an intra-family loan or an intra-family mortgage. All right?
Chad Burton: The good thing about this is that, especially if you’re doing short-term loans, there’s a website called nationalfamilymortgage.com. I have not used them yet, but I’ve heard of people that did, and they talk about AFR rates. When you’re giving an intra-family loan, especially when it’s tied to a mortgage, you have to use certain rates that the IRS publishes called the applicable federal rates. For example, if you’re doing a loan to somebody for more than nine years, the current monthly rate in June of 2020 was 1.01%. July of 2020, it looks like it’s going to be 1.17%.
Chad Burton: You can actually give a mortgage to somebody at a really low rate because current mortgages right now on a 30-year are around what? 3, 3.25% or so, somewhere around there. Don’t quote me. I’m not a mortgage broker. You have to actually charge some interest to make it a actual loan. Now, there’s all sorts of things you can do if you’re dealing with estate taxes on forgiveness and gifting monthly payments and stuff like that. That’s for a different segment.
Chad Burton: In this situation, I want to explain what this family needs to truly do so they don’t screw up the son’s tax deductibility of the interest on the mortgage and cause some sort of a gift tax return situation and at least qualify for a decent rate. I already talked about what’s called delayed financing. It’s different from a home equity line of credit or a cash-out refinance. It’s when the bank understands that you used your own money to purchase the property and then you’re paying yourself back.
Chad Burton: In this case, he’s not paying himself back. He’s paying his parents back so the delayed financing doesn’t technically work. By the way, so you know, in a delayed financing, the loan limits are lower and oftentimes the rates are a little bit higher. If you’re a person that’s going to pay all cash for something and then turn around and refinance it with delayed financing to pay yourself back, whether it’s your bank account or whether it’s your brokerage account.
Chad Burton: I already talked about the collateralized loan, which a lot of our clients do when they’re trying to get short-term money for real estate. In this situation, when he does this loan to pay back mom and dad, it needs to be a refinance so it still qualifies for tax deductibility. Essentially, mom and dad need to be the bank. It needs to be the bank of mom and dad. You need a company like National Family Mortgage, Nolo, LegalZoom, somebody to actually create this promissory note, so that when the son goes to the … And these are the steps they’re going to have to take in this situation.
Chad Burton: This intra-family mortgage has to be created. The note needs to be signed and somehow tied to this new property, right? Let an attorney or one of these specialty firms do this for you. Then the son goes and puts the all-cash offer on the house. They buy the house. They move in. They sell their other home. They first pay off the mortgage on that home. They give the remaining cash to mom and dad. Mom and dad now have a note that has been paid down, so when the son goes to the new bank, and says, “I need to refinance my existing loan with the bank of mom and dad,” mom and dad can actually give a payoff quote to the bank that’s doing the mortgage.
Chad Burton: They do an actual normal, in this case, 30-year fixed mortgage with the bank and they pay off mom and dad. It’s a refinance of acquisition debt so it’s still fully tax deductible. Nobody has to file a gift tax return, and the loan should be tax deductible. Again, nationalfamilymortgage.com. There’s a couple of good websites out there. When you’re in these situations, you need to know the difference between a home equity line of credit, a cash-out refinance, a delayed finance option.
Chad Burton: All of the different things that are out there that allow you to do these things. Let me tell you what some of the other things that people are doing these days. What I’ve seen older people do that they want to use money out of their home to live, to pay expenses, but they don’t want to do a reverse mortgage because it’s expensive. They don’t want to sell it because of capital gains taxes. The kids are wealthy.
Chad Burton: The kids can do the reverse mortgage and help out the parents and actually have that note tied to the home so that there’s no questions when somebody passes away and they have to settle the estate. There’s different things about helping people out. Here’s what people have done. A wealthy couple that’s dealing with estate taxes that’s going to pay estate taxes when they pass away, they can be the bank of mom and dad. Create the mortgage.
Chad Burton: The kid still pays them back, but if they want to forgive on an annual basis a certain amount of the loan, they can do that. It spreads the issue out over time. It helps the family that’s doing the gifting maintain some control. A lot of wealthy people are looking at it, especially with the ability to do this at really, really low interest rates. You can leverage some gifting, I guess you could say, by getting the real estate now, but you’re gifting it to them essentially over 30 years at really low interest rates.
Chad Burton: Talk to your estate planner about it. If you’re going to do these intra-family loans, create the note, either a real estate attorney or one of these specialty sites, LegalZoom, Nolo, nationalfamilymortgage.com. Make sure that they do it for you so there’s no mistakes on anybody’s end so that people can still deduct the mortgage. You know what you’re dealing with and make sure you know what rates you’re going to pay and make sure that the kid can actually pay it back and that you don’t get tied to something you can’t afford for your retirement.
Chad Burton: All right. We’re going to take a quick break. We’ll be right back. We’re going to talk with a specialist at BlackRock iShares about macro-economic issues. Where are the bargains out there? If you want to email me, it’s firstname.lastname@example.org.
Announcer: Now back to a New Focus on Wealth on AM 1220 KDOW.
Chad Burton: Welcome back into the show. I’m your host, Chad Burton, certified financial planner. Joining me now, I’m excited, I’ve got Tom Logan. He’s a chartered financial analyst. That’s CFA. He’s an investment strategist on BlackRock’s iShares U.S investment strategy team. Of course, with fed action and BlackRock has been in the news a lot. Tom is responsible for global macro research and single-country analysis at iShares. He’s also spent time as a credit research analyst as well with Western Asset Management covering financials and high yield energy. Also, worked in fixed income at JPMorgan.
Chad Burton: Tom, you got an MA in economics. You got a BA and a BS in economics and finance. You live and breathe these markets on a daily basis. Let’s just start, if you could explain to me in layman terms for our listeners, what does macro strategist mean and how do you spend your day researching different areas of the markets, the economies or different themes?
Tom Logan: Yeah. Well, thanks Chad for having me. When we say a macro strategist, we mean big picture. I’m not looking at a single stocks. Instead, what I’m looking at are, what are the global trends that are really shaping, not just asset classes, but different countries and different parts within certain asset classes? For example, looking at different parts of the credit market or different parts of the equity market.
Tom Logan: I think what it really means is that I have some economic view and I want to express that economic view in the portfolio, such as a view on growth, a view on interest rates, or a view on inflation. Often, there’s a number of different expressions or instruments you can buy or sell to express that view. Macro strategy is really trying to think about what are the big picture trends in the world? How these affect the economy, and how do I want to position for them in a portfolio?
Chad Burton: It’s really the drivers of asset allocation, because you can say, “Okay. Here’s the U.S versus international small cap, mid cap, large cap real estate,” whatever it may be. You leave the stock picking up to the fund managers or the indexes in the case of iShares. You look for opportunities that look cheap or situations that look expensive. Is that fair to say?
Tom Logan: Yeah. It is. One of the reasons that I tend to spend my time focusing on the macro is if you build a truly well diversified portfolio, almost by definition, you’ve diversified away any of the idiosyncrasies of any one business. Often you can summarize a portfolio of any number of positions across any number of markets into just a handful of these macro factors as we call them. Growth, credit, liquidity, et cetera. That’s what I really spend my time on because as you just illustrated, that’s really what drives the asset allocation decisions, which is something that we spend a lot of time on my team thinking about.
Chad Burton: Yeah. I follow the ETF portfolios that BlackRock using iShares and a couple of other ETFs, well, they’re all iShares ETFs, exchange traded funds. I especially look at the 60/40 type of portfolio, which is something that a lot of retirees go for as they go into retirement. Obviously the U.S. has bounced back a lot off the March lows, but I recently noticed a very slight decrease in U.S. equities that went to international but within international, there was a little bit of a decrease in emerging markets.
Chad Burton: A little bit of that money that came out of the U.S. plus a little bit of that money that came out of emerging markets went into international developed markets. Can you speak to that a little bit on what you guys are seeing there?
Tom Logan: Yeah. Typically, when we say international develop, we typically just mean developed Europe and Japan. Now, anytime you see a portfolio manager make these changes, you should just be mindful of the fact it may just be good housekeeping, just rebalancing. I think good discipline to instill in any portfolio for any investor type is just to have a long-term asset allocation and when your portfolio deviates from it perhaps due to different returns in the market that you rebalanced back to your target.
Tom Logan: Now, with this particular asset allocation change, I suspect what the team is doing is wanting to get some type of what we call typical exposure towards stronger growth, which you can find better in Europe and Japanese equities, as opposed to U.S. equities. U.S. equities tend to have a very strong, what we call, quality component to them. They tend to be actually less sensitive to the GDP cycle or the growth cycle compared to say their Japanese or European counterparts.
Tom Logan: This is true, both due to different composition of the different sectors. About half of the S&P 500 is technology and healthcare. Then in contrast, Europe and Japan tend to have a larger representation in their public markets by financials, industrial, materials, consumer discretionary. Those economies tend to be more plugged into global trade. If you’re a portfolio manager expecting there’s going to be a recovery after these shelter-in-place orders have been lifted, for a given dollar invested, you can actually find more or better exposure for that type of economic upside in some of these international and developed markets.
Tom Logan: Typically, you could have found the same pattern in emerging markets. Historically, emerging markets had really been the place you wanted to be for any type of growth upswing, which has become increasingly the consensus here in market. However, emerging markets are really being, I think, troubled by a couple of factors that are a little bit unique. First and foremost, has been reverse of this globalization that over the past several decades had really been a key tailwind to emerging markets.
Tom Logan: Increasingly, the U.S.-China tension is really constraining the typical operating space that emerging markets did occupy, which was global trade. With China decelerating and even saying possibly a second wave coming out of Beijing, there’s a number of I think risks specific to emerging markets that do not affect this international developed or IEFA space to the same degree.
Chad Burton: Got it. That makes sense. You know, a lot of the IEFA space was trading almost at recessionary levels going into 2020, just because everybody’s talking about Brexit, the slow growth, all these other issues. They sell down even farther. I guess it’s just, okay, these things are cheap and if the global economy does a little bit better than expected then you’re expecting a little better balance there.
Tom Logan: Yeah. I think some of the policy support you’ve seen out of Europe have been in contrast to what had become pretty hardened expectations. In particular, the German-Franco proposal, as well as the EU Commission’s proposal. These are both big fiscal steps forward for an area that historically had not had the type of fiscal solidarity that it needed during crises. When the French and German governments initially put forward their proposal and then the EU commission follows again, that was a big reversal in market expectations.
Tom Logan: I think when you find those reversals in expectations, coupled with cheap valuation, that’s typically the combination of catalyst you’re looking for. If there’s good value and something’s changed, that should hopefully allow that value or that evaluation to rerate higher in the market.
Chad Burton: That’s interesting. I mean, everybody has their home country bias and we hear about the CARES Act, PPP, all these different stimulus packages that are being put forth in our country, but a lot of people don’t really hear about these other things that you’re talking about now, so that makes sense. Another big issue that people are talking about a lot of is real estate investment trusts, REITs. How are various REITs going to do in light of this whole new work from home world that we live in? Do you get much in the area of looking at real estate in general?
Tom Logan: A little bit. Yes. I think more so lately. The real estate investment trust, the REITs market, was especially hard hit during the March selloff for a couple of reasons. The business model for REITs effectively is to borrow at the short term and leverage up and buy mortgage-producing assets. This is basically a maturity transformation that banks also undertake. Now, these REITs business models are highly sensitive to what we call funding liquidity. That is how easy is it for companies to borrow.
Tom Logan: This funding market effectively seized up in early March and then the secondary mortgage market also seized up. It really led to fire sale condition where selling begets selling. Now, there were really fundamental reasons behind this, but the whole REITs complex because various sub sectors, industrial, self-storage, healthcare, industrials, like family, all of these were just taken to the woodshed. That’s indicative not of a specific fundamental or idiosyncratic driver.
Tom Logan: That’s indicative of broader macro factors. That has been a space that has been on my radar as possibly thrown out with the bathwater, so to speak. When you look at it, there are some pockets that actually are firming up and the incoming data is much better than I think people expected. In particular, if you look at industrial. There actually really hasn’t been that much of a change here from what management committees were telling investors prior to the COVID-19.
Tom Logan: May rent collections, that’s just one example, has actually been exceptionally high. In particular, most of these REITs on the industrial side are able to offer pretty clear guidance all things considered. Even some of the other areas that have been especially hard hit like senior housing, and it’s tragic, all things considered, but simply to be clinical, even here, the sequential declines have actually moderated. With the removal of some of these admission bans, they’re actually seeing an uptick in some of the occupancy rates.
Chad Burton: Yes.
Tom Logan: I think overall as the fed has stepped in it’s really providing a liquidity support for the whole REITs complex. Then in particular, the sub-markets of REITs, which were especially hard hit by COVID are actually faring better than many people had expected coming into this.
Chad Burton: Yeah. I wonder how many of the smaller retailers that are leasing spaces and small businesses and things like that currently using some PPP loans to get through. I think the next couple of quarters will give us more information on those areas. Some of the other REITs, let’s say cell phone towers, there’s even REITs for that, right? It’s very interesting on how this is all playing out. Everything sold off.
Chad Burton: Then all the stuff that people realize. Okay. There will be more people aging. There will be more multifamily. There will be more housing needs. People are going to move and what new houses somewhere else and stay at home and work. A lot of that’s changing.
Tom Logan: It is. It is. That’s what we try and think a lot about is, what are the trends that were already in place before COVID-19 that’ll be reversed? What are the trends that’ll be accelerated? I think in many parts of the market you can find a lot of very supportive trends that appear to be accelerating at what feels like light speed. Certainly, in other parts like retail, which had been challenged it’s probably going to stay challenged. Other parts of industrials, which has been a huge beneficiary of any delivery [crosstalk 00:30:32]
Chad Burton: Hey Tom, we’ve got to cut you off there for this hard break, but I’m going to bring you back. We’re going to talk a little bit about small caps, interest rates and the credit markets. We’ll take a quick break. We’ll be right back.
Announcer: This is New Focus on Wealth on AM 1220 KDOW.
Chad Burton: Welcome back into the show. I’m your host, Chad Burton, certified financial planner. If you want to find out more about me and my team of certified financial planner practitioners, just go to chadburton.com or newfocusfinancial.com. I’ve still got Tom Logan on the line. He’s an investment strategists on BlackRock iShares invest U.S. investment strategy team. He’s a macro research and single-country analyst.
Chad Burton: He looks at the big picture, not drilling down to individual stocks per se, but more on what’s going on all over the world and then within different asset classes to try to find value, overall value in different asset classes. Then leaves it up to the fund managers or indexes to pick the actual individual stocks from there. Now, we were talking about so far U.S. versus international emerging market. We’ve talked a little bit on real estate investment trusts.
Chad Burton: Let’s talk interest rates, because if you had asked me a year ago, two years ago, five years ago, six years ago, I would never have thought rates would have gotten this low. We went all the way down to subs, six tenths of 1% on the 10-year treasury and gosh, where are we at today? Somewhere. It was 0.9. It’s bouncing all over the place, but people have to retire and typically people have some fixed income or some bonds in their portfolio.
Chad Burton: What do you expect for the long-term when it comes to U.S. interest rates on government bonds and basic corporate debt? Are we lower for longer? Is that where we’re at now?
Tom Logan: I think it is. Even before the fed actions in recent months, there has been an interesting development in recent decades, which is there is a shortage of debt in the world. This catches most people by surprise and almost taking them aback. When I say there’s not enough debt in the world, what I mean by that is there’s not enough high quality AAA sovereign U.S. dollar denominated assets, given the demands, the global demand for that type of debt.
Tom Logan: This has been a fundamental wedge between the demand, which has always far outstripped the available plot. This is something that’s actually deeply rooted just in the international monetary system. It’s called the Triffin dilemma for anybody interested in some homework. What it effectively means is that there is a persistent, excess demand for U.S. government debt. When I say there’s an excess demand for the debt, what that means is that it’s pushing prices up and yields down.
Tom Logan: I don’t have the expectation on either a cyclical nor on a longer term structural view that we’re going to see U.S. interest rates rise materially from here, because there’s simply more demand than there is the ability for our U.S. national treasury to issue that debt to meet that global demand. This is a-
Chad Burton: Okay. Okay. Where’s this demand coming from? I know we’ve got the Federal Reserve in the market now, obviously. That’s why BlackRock’s in the news so much. They were even going as far as buying ETFs, exchange traded funds, which are essentially a fund of different bonds inside the ETF. There’s demand there. It seems like China’s demand for U.S. treasuries over the years has dropped, is that correct to say?
Tom Logan: It’s plateaued. Yes.
Chad Burton: Okay. It’s kind of plateaued. Is it because we have so many people that are retiring in the U.S.? I mean, where’s this demand coming from, or is it simply a lack of enough of issuance of bonds?
Tom Logan: There’s certainly a lot of issuance. It tells you the issue isn’t, no pun intended, isn’t on that part of the equation. What it does come from effectively is non-economic sources of demand. When you think about other central banks around the world, especially in any emerging market countries, their central banks have a foreign exchange reserves to guard against certain capital outflows as we saw in Asia in 1997.
Tom Logan: Now, these FX reserves are held in U.S. dollars, which they’re not just going to sit on hundreds of billions or trillions of dollars. They recycle that money back into U.S. debt markets. This is why China owns our debt in the first place. It’s not out of any sense of, it’s a good investment. They’re almost straddled to as a function of their FX reserves. If you think about anybody doing business over 95% of global trade is invoiced in U.S. dollars, whether or not you’re actually trading with an American.
Tom Logan: A Brazilian and South African, they will trade in U.S. dollars. The U.S. dollars is more overseas than there are in the U.S. gets pushed back into our capital market. The final point just to really contextualize it. We talk a lot about the fast growth in the emerging markets. It’s true. They have been growing faster than the U.S. which means the U.S. share of world GDP has been declining. At the same time, these emerging market countries do not have well-developed financial systems, if they’re even open to the international investment community, as in the case of China.
Tom Logan: There’s been a persistent growth in the demand side of the equation globally, but yet the U.S. is the sole provider, the sole issuer of AAA rated debt is dollar dominated, we just can’t supply enough of it given the growth in demand. Even with China plateauing there are a number of other demand sources, some of which originate simply from falling rates itself, which is true of any of the pension community that is trying to hedge their liability. Lower rates, higher liability.
Tom Logan: They got to buy more duration. They got to buy more bonds. This is a very reinforcing feedback loop here but this is why we’re not expecting interest rates to rise materially from here.
Chad Burton: Wow. Okay. We’ve got about 90 seconds left. Where do we go then for fixed income? Because as we open the market today, the 10-year treasury for the U.S. 10-year Treasury bond is at 0.741%. It was well over 4% prior to the great recession in 2007. I mean, what do we have to do? Expect a much lower rate on one end of our bond investing and then go much more aggressive on the other end? Where are you seeing bargains in the credit markets around the world?
Tom Logan: Well, I do think there are places that you can pick up some good additional yield over treasuries without compromising and taking on too much risk. One area in particular is municipals. If you look at just the general or generic national municipal bond index, it’s yielding about 1.45%. Now, if you factor in just assume a 40% tax rate, the tax equivalent yield on that is now 2.55%. That’s basically what you’re getting on triple-B rated corporate debt. It’s better than what you’re getting on the overall corporate investment grade debt. [crosstalk 00:37:45]
Chad Burton: Wait, we got 30 seconds left though. How scared are you on some of these municipalities to be able to survive COVID and the lack of sales tax and things like that?
Tom Logan: It’s important but if the equity market is rallying this much, putting us flat year to date that’s sending you a signal that the reopening is real, that the economy is bouncing back and with that the tax revenue of economic activity. I think more importantly, if the fed’s willing to backstop non-governmental corporate actors who are already indebted to begin with, they should feel very comfortable backstopping federal and state municipalities.
Chad Burton: All right. Tom, we’ve got to cut it off right there. We’ve been speaking with Tom Logan, investment strategist with iShares. If you want to find me, you can find me chadburton.com, Facebook, LinkedIn iTunes for the podcast. It’s all there. Chadburton.com. Have a great day everyone.