Bonds are behaving badly. This year, the bond market has lost about 2.5%, after factoring in interest payments received and the downward shift in market value. For most investors, a loss is unusual in this typically steady part of their portfolio. Why is this happening?

To begin, visualize a teeter-totter. Like a teeter-totter, when interest rates drop, bond prices rise. This downward movement in interest rates has been the general trend since way back in Ronald Reagan’s first term. But, like a teeter-totter, it also works in reverse. When rates rise, bond prices fall.

Lately, interest rates are rising. I’m not talking short-term rates, though. Those are controlled by the Federal Reserve. Like a steady drumbeat, the Fed has raised rates three times this year, just as they did last year. But, short term rates really don’t directly affect bond prices much. I’m talking about long term rates. That’s where today’s losses in bonds come into play.

At the start of the year, the 10-year US Treasury rate was just under 2.5%. Today, this closely-watched “benchmark” rate is almost 3.2%. This has caused the teeter-totter to swing; rates up, prices down. An upward shift of almost 1% in long term rates is quite big. For those who are familiar with teeter-totters, it’s never fun when your partner jumps off!

With longer-term interest rates having reached a decades-long low not too long ago, the fear of rising rates has been palpable. Yet, it has largely been all bark and no bite. Lately, that fear has been validated.

With this, there are two burning questions. Why have rates risen? And, what should we expect now?

The typical explanation of why long-term rates rise is inflation. This makes sense. After all, when you lend money, you’d like to first keep up with inflation and also make some “real” money to boot.

When you look at investors’ inflation expectations, though, not a lot has changed since the start of the year. Future inflation expectations have held steady at around 2%. No, interest rates have risen because bond investors now demand more of a “real” return on their money. This often happens when the economy looks strong.

If the economy keeps wind in its sails, it’s not inconceivable to expect longer term rates to keep rising, perhaps up another 0.5% or so. If that happens, bonds face some more headwinds. However, I believe the bulk of the pain in bonds is likely over.

If, on the other hand, the economy’s sugar high from the recent tax cuts and deficit spending wears off, the teeter-totter just might swing back in bond investors’ favor again.

With the balance of risk about even, in my view, my generalized advice is to shift your bond portfolio into some shorter-term bonds. This analogous to scooting your bum a little closer to the center of that teeter-totter. If your partner keeps jumping off, the swings won’t be quite as jarring!

Jason P. Tank, CFA is the owner of Front Street Wealth Management, a fee-only wealth advisory firm located in Traverse City. Comments welcomed by phone at (231) 947-3775, by email at Jason@FrontStreet.com or online at www.FrontStreet.com

At our upcoming Money Series at Traverse Area District Library, I will be speaking about a topic that I now believe is bordering on an obsession; the new tax law.

Perhaps that’s due to its important changes that affect charitable giving. Perhaps it’s due to how it affects families with younger children. Perhaps it’s due to the new law’s effect on business owners. Perhaps still, it may be due to how it has affected the stock market and the federal budget deficits for as far as the eye can see. The fact is, it’s a pretty big deal, worthy of a small professional obsession.

On the evening of November 14th, the Money Series will provide a sweeping overview of what’s changed in the world of taxes for individuals and couples. And, I’ll give proper focus to the wildly impactful and still-misunderstood small business deduction.

According to the Tax Foundation, about 90% of all tax filers will benefit by claiming what’s known as the “standard deduction.” This means most taxpayers will no longer have to gather piles of paperwork to hand to their tax preparer. No more property tax statements. No more investment fee statements. And, no more verification of the deductibility of charitable donations. Instead, the vast majority of people will rely entirely on the new, much higher standard deduction. It’s a big simplification for many.

However, as a result, many people will need to change their charitable habits in order to gain a tax benefit for their generosity. If you don’t, Uncle Sam will cease to be your “partner in giving.” After all, when the federal and state government reimburse you by lowering your tax bill after you donate money, it’s as if they picked up part of the tab.

My presentation will also provide a layman’s perspective on the very important small business tax deduction. Ironically, it’s the opposite of tax simplification. As a result, I expect it will occupy a good amount of time. If you know of anybody who owns a business, they need to know how Congress handed them a big bone and how to use it to their advantage.

I also suspect the Q&A segment will delve into the mind-boggling projections on the federal budget deficit. While I sense that today’s financial markets don’t foresee an issue with our profligate spending as a nation and, in the end, the US has an infinite printing press, Ernest Hemingway’s quote may someday carry the ring of truth, “How did you go bankrupt? Two ways. Gradually and then suddenly!”

Before the upcoming Nov 14th Money Series, there’s also a chance to catch attorney Diane Huff’s talk, “What the Heck is a Trust, Anyway”, to be held on Wed., Nov. 7 at 10:30am at the Senior Center. The Money Series is a program of the Front Street Foundation, a non-profit committed to providing open-access to financial education, for all. To register, go to MoneySeries.org or call (231) 714-6459.

Planning for the possibility of mental decline is not something any of us likes to consider. The fact is, however, it’s critically important. And, if it’s your own decline that requires such a plan, don’t you think you should be the one who develops it?

This reminds me of something I thought about in my early 20s. Back then, I watched Bill Clinton blow up his personal life – and almost his presidency – by having an affair with an intern. At that time, I remember noting how men in their 40s must be unavoidably prone to colossal mid-life crises.

I felt so certain of this that I once remarked to my wife that all of us really should designate another person – call it your “life proxy” – who would have ultimate veto power of all of your major life decisions during that dangerous life stage.

So, you want to quit being an attorney and become a musician? Call in your life proxy to decide! Really? You want to get a divorce and marry your long-lost college girlfriend? Proxy to the rescue!

While I haven’t followed the advice of my younger self, I still think naming a life proxy was a sound idea. The mid-40s is certainly a funny age. Heck, I ran for the school board and I’m quite certain my life proxy, if I had named one, would have likely vetoed my decision!

Yet, even if you missed your opportunity to hand over the keys to your life proxy in your mid-40s, you still have another chance to be proactive during your retirement years.

I have had a recent experience with a wonderful client and her caring children. Her mental faculties have slipped over the years and the decline has sadly accelerated over the past few months. She knew she never wanted to be in this state. Yet, now that she’s there, she predictably and sadly cannot recognize the depth of her decline. For her, and for many others, the time to plan was well before she crossed that blurry threshold of self-recognition.

Fortunately, official recognition of just how vulnerable seniors are to financial fraud has begun to take hold. For example, at the time of opening a new account, brokerage firms have now begun to ask for what’s called a “trusted contact.” A trusted contact is someone who you want notified if the suspicion of financial exploitation or self-harm arises.

As an investment advisor serving a generally older clientele, I am a proponent of this idea. In fact, my firm is going to soon begin to gather our clients’ trusted contacts.

Clearly, designating a trusted contact is a far cry from naming your all-powerful life proxy to make all of the big decisions in your life, but it’s a very good place to start your plan as you advance in your retirement years.

Speaking of life planning, attend our next Money Series presentation by attorney Diane Huff entitled, “What the Heck is a Trust, Anyway”, to be held on Wed., October 17 at 6:30pm in the McGuire Rm. of the Traverse Area District Library. The Money Series is a program of the Front Street Foundation, a non-profit committed to providing open-access to financial education, for all. To register, go to MoneySeries.org or call (231) 714-6459.

After eight months, the IRS finally clarified how the new small business deduction works for LLCs and S-Corporations. Given its complexity, it’s no great surprise it took 184 pages to explain.

Here’s why it’s so important to understand.

If you happen to have lots of kids or pay high property taxes or pay big state income taxes or took out a mortgage that funded something other than home improvements, you’ve likely lost a lot of tax deductions and exemptions. When all is said and done, the new law effectively subjects more of your income to taxation.

However, if you are fortunate enough to own your own business, Congress found a way to make it up to you. You may now qualify for the very large 20% small business income deduction under Section 199A.

Here’s how it works. But, remember, it only applies to pass-through businesses; LLCs or S-Corps. C-Corps got their own tax break, so don’t feel bad for them!

Section 199A’s very first eligibility test is based on your taxable income. If your taxable income is less than $315,000 as a married person (or $157,500, if filing single), you’ll get the tax break.

Importantly, below these income levels, you don’t need to have any employees to qualify for the deduction. And, despite what you may have read, this tax break applies to “service” businesses too. Below these income thresholds, it’s not just for “non-service” businesses. The IRS’ recent guidance made it clear that many service business owners will qualify for the 20% small business tax deduction.

Now, if you make more than $315,000 (or, again, more than half that level, if you’re single), the tax break fades away fast. To be clearer, it fades away fast for service businesses only.

Service businesses are defined as fields that look like paper-pushing, such as investment advisors, accountants, attorneys or catch-all “consultants”, as well as businesses providing health services, like physicians.

For these service businesses, as you make more than the taxable income limit, the deduction begins to decline. Once you reach $415,000, it totally disappears.

Interestingly, no matter how much the business owner makes, this big tax break is never gone for “non-service” businesses. Bizarrely, it also sticks around for certain carved-out paper-pushers; engineers, architects or real estate agents!

For “non-service” business owners, there’s a two-pronged test to determine the level of the small business deduction you’ll get. The tax deduction you’ll get is the smaller of two distinct calculations.

The first calculation is equal to 20% of your business income. The second calculation is the larger of (a) 50% of your employees’ total wages or (b) a combination of 25% of employee wages plus a factor of how much money you invested in your business.

Only Congress, in its infinite wisdom, would think all of this represents tax code simplification. They deserve stacks of love letters from CPAs across the country thanking them for their continued job security!

Speaking of the new tax rules, we’ll be discussing the possible benefits of Donor-Advised Funds at this season’s kick-off Money Series presentation on Wed., Sep. 26 at 3:30pm at the Traverse City Senior Center. Front Street Foundation is a local non-profit whose mission is to provide open-access to financial education, for all. To register, visit www.MoneySeries.org or call (231) 714-6459.

Q: I’ve heard a lot about index fund investing. The funny thing is, I don’t really even know what an index fund is! Can you explain the difference between index funds and regular mutual funds?

It’s always a smart plan to do some learning before committing money! That advice applies to index fund investing too, despite its massive popularity. Since the start of this current bull market, low-cost index fund investing has become much more than just an investment philosophy. It’s almost become an investment religion.

To begin, index funds are types of mutual funds, just like apples and oranges are types of fruit. However, unlike a mutual fund managed by people doing financial research, an index fund’s only goal is to mimic the market.

The index could be designed to track the many hundreds of separate stocks that make up the S&P 500 or it could be made to track the performance of a short list of speculative marijuana companies. In the end, an index fund is nothing more than a low-cost, take-what-the-market-gives-you investment, for better or for worse. You just pick the index to track and the result is essentially written in the stars.

And, since the bull market began almost a decade ago, taking what the market gave you has been a fine result. My consistent advice, however, is for you to periodically assess your risk capacity and to rebalance your portfolio as necessary. There’s always another turn in the cycle.

Q: With interest rates going up, I’ve read that bonds won’t be the place to have my money. What do interest rates rising have to do with how badly or how well bonds will perform?

It always surprises me that investors feel they understand stocks much better than they do bonds. I suppose, like most things, it’s just a matter of familiarity and exposure.

For the record, though, bonds are much simpler than stocks. With stocks, you are a part-owner of a business and you only get what’s leftover after paying everybody else. On the other hand, with bonds, you are simply a lender of money and all that matters is whether or not your interest is paid on time and your principal is paid in full upon maturity.

Now, to visualize the effect that interest rates have on bonds, imagine a teeter-totter. On one side sits a man with a t-shirt labeled “Interest Rates.” On the other side is a woman wearing a shirt that says “Price.” When interest rates go up, the price of bonds swing down.

As it is with teeter-tottering, to lessen the risk of a jarring crash in bond prices if interest rates suddenly rise, the proactive move is to inch your bottom toward the middle! The closer you sit to the center of the teeter-totter – that is, you choose shorter-term bonds over longer-term bonds – the less you’ll experience the up and down swings in your bond portfolio as interest rates rise and fall.

Jason P. Tank, CFA is the owner of Front Street Wealth Management, a fee-only wealth advisory firm located in Traverse City. He encourages questions and comments about future columns. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com