FIRST SHELBOURNE LLC
COMMACK, NEW YORK 11725
MEMORANDUM FOR FIRST SHELBOURNE CLIENTS
DATE: JANUARY 13, 2024
FROM: CHRISTOPHER WARGAS - PRESIDENT
SUBJECT: 2023 PRESIDENTS' LETTER
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If 2023 has taught investors anything, it's that the brain is not the most important organ when investing, but instead, the stomach. Toward the end of October, rates on 30-year fixed-rate mortgages hovered around 8%, which shocked many who were used to living in a 3.5% mortgage world. As rates soared, equities and bonds careened lower. But with the S&P 500 closing strong in 2023, it shows why this firm takes a long-term buy-and-hold approach to both bonds and equities. In last year's letter, I wrote that sticking to shorter-duration treasuries and agency bonds would be more suitable for investors than long-dated bonds. Clients have been served well by this approach. Not only did your accounts avoid stomach-churning drops, but the portfolios have generated adequate income for those in retirement.
A heavy weighting in equities is ideal for younger individuals not nearing retirement. For those in retirement, gambling with an unknown sequence of returns risk while taking required minimum distributions is not ideal. History demonstrates that we should avoid this at all costs. First Shelbourne focuses heavily on the bond market, and the goal is not to generate market-beating returns but the best risk-adjusted returns. I've seen too many older individuals destroy their portfolios due to riding a wave of optimism, only to liquidate their portfolios on significant downturns, negating years of positive returns.
Wealth preservation and the conservative investment of capital is this firms mission. Remember, diamonds are only lumps of coal that stuck to their jobs. As the great medieval English philosopher Roger Bacon stated, "More people should learn to tell their dollars where to go instead of asking them where they went."
Let me now talk about some bonds I have bought for clients and demonstrate why the bond market still offers us many opportunities. I'll turn my attention to FHLB bonds.
The Federal Home Loan Bank System (FHLB) is a system of 11 regional banks that fund member financial institutions, such as banks, savings and loans, and credit unions. The FHLBs were created by the Federal Home Loan Bank Act of 1932 in response to the Great Depression. The goal of the FHLB system was to provide a stable funding source for member institutions to continue lending to homeowners and businesses. The FHLBs issue bonds to raise funds, called consolidated obligations (COs).
We recently purchased some of these bonds with a yield to maturity of 6.09%. This particular bond is due to mature in 2028 (5 years) and has been compared to 5-year treasury bonds, which, at the time of purchase, were yielding 4.09% (as most checking accounts are yielding 0.10%). The FHLB bond gives us a much larger yield, almost two percentage points higher. However, it is essential to note that the FHLB bond is callable, which means that if interest rates drop, the bonds can be called in. We would have to reinvest your principal in a lower-rate environment, like a homeowner refinancing their mortgage (the difference here is lower rates don't help us like they do a homeowner). Since treasuries are not callable, but the FHLB bond is, we want to ensure we are compensated for the potential reinvestment risk. We adequately compensate by earning 2% more on the FHLB bond over a treasury. Banks make money using this model to borrow short-term, then lend long-term by taking your deposits and loaning them out as 30-year mortgages. The bank keeps the spread, called the net interest margin. Now you know why banks have the most beautiful buildings in city centers.
Millions of investors today have their funds parked in stable funds within their 401ks, getting paid inadequate interest. For example, the New York State Deferred Compensation Plan Stable Income Fund releases an updated annual audit. As of Septemeber 30, 2023, it showed a crediting rate of 2.73%. Yet, on this same date, a 1-year treasury paid about 5.4%, almost a three percentage point difference. Many may not want to use the services of an investment advisor due to not wanting to pay an annual fee, yet they are paying much higher indirect fees through lost interest. Although it's no fault of the plan because it must keep readily available liquidity for withdrawals, those holding the stable fund are financing this liquidity.
Let's look at another bond I purchased for some accounts in 2023, a Federal Home Loan Mortgage Step bond that matures in August 2025.
Federal home loan mortgage bonds, or MBS, are bonds backed by a pool of mortgages. They are issued by government-sponsored enterprises (GSEs), such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). The bond purchased is a part of the Freddie Mac STACR REMIC Trust, a structured agency credit risk (STACR) bond. STACR bonds are a new type of mortgage-backed security that offers investors exposure to the credit risk of single-family mortgages without the credit risk of Freddie Mac. Although the bond is callable, we received a 6.753% yield-to-maturity and a 6.115% yield-to-worst. On another note, this is a step bond with a specific increased rate schedule each year. For example, when purchased, the coupon was fixed at 4%, and in August of last year, it got "stepped up" to 5%. By February 2025, it will be at 8% after numerous "steps." Notwithstanding the bond getting called, all coupons combined give us our yield-to-maturity of 6.753%.
Let me now turn my attention to stocks. Although many clients favor their portfolios to hold bonds and CDs, others still should have equity exposure. Most of the year was quiet, with minimal purchases, until early November, when various REITs (real estate investment trusts) were purchased. During this time, REITs had suffered significant declines due to rising interest rates, and decent values presented themselves. The added sweetener with many of these REITs is that they paid over 5% dividends at purchase. Real estate is an excellent wealth generator, with REITs giving superior diversification. Instead of taking on single-property risk, REITs own globally diversified portfolios of properties in various industries and countries.
2024 has just begun, and many U.S. companies with high returns on invested capital are trading at more opportunistic valuations than the top holdings of the S&P 500. Although holding the S&P 500 over many decades should ensure adequate returns, today's S&P 500 has a severe concentration problem. Over the last 35 years, the average weight of the top 10 stocks in the S&P 500 index has been 20%. During the dot-com bubble, the combined weight of the top 10 stocks peaked at 25%. At present, the figure stands at 32%. The index concentration phenomenon may persist due to the top seven companies having superior margins while highly profitable. For client portfolios, I prefer indexes that don't have extreme concentration while still holding some of the best-managed companies in the world.
It's worth noting that this concentration has been supercharged by the low-interest rates of the past decade. In a recent memo by Howard Marks, he compares the effect of low-interest rates to the moving walkway at the airport. If you walk while on it, you move ahead faster than you would on solid ground. But you mustn't attribute this rapid pace to your physical fitness and overlook the contribution from the walkway.
I believe fixed-income investments are an excellent addition to retirement portfolios today. Whether interest rates level off, go higher, or lower is irrelevant if we lock in adequate rates for bondholders. 2024 should be another exciting year, and your portfolios will always be managed with wealth preservation as this firm's top priority.
Respectfully,
/s/ Christopher Wargas
President, First Shelbourne