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Wide Ranging Perspectives and Views for Managing Retirement Assets.

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LayLine Asset Management Inc

Harry J. Campbell III, CMT

5/20/25

US Credit Rating Downgrade

            The rating being considered here are those that apply to the credit quality of the debt issued by a company or a government.  Last Friday the third, of three primary, rating companies downgraded US Treasury debt from Aaa (triple A) to Aa1 (double a 1), a one notch drop in the credit rating.  This is normally (there’s that word I should not use) a bond geek event, but since this is the debt of the US that’s been downgraded, more folks are paying attention.  Moody’s follows the other two firms of consequence, S&P (Standard and Poors) and Fitch in downgrading the relative safety, for investors, of owning US debt, Treasury Bonds.  Of note, S&P lowered their rating on US Treasury debt back in 2011 and Fitch lowered theirs in 2023, both a single notch drop in the rating. 

            The ratings companies (sometimes referred to as ratings agencies) fundamentally analyze the debt, commonly bonds, issued by an entity, whether it be a company or government, and assign a risk adjusted rating on the debt.  Ratings range from AAA or Aaa for the best rating, down to BBB or Baa for the lowest rating, for what’s referred to as investment grade debt.  Below BBB or Baa is so called speculative debt, or junk bonds, with ratings that range from BB or Ba down to D.  All three ratings firms use letters of the alphabet to designate the rating, then use numbers, 1-2-3, + or –, to further differentiate the credit quality.  A bond with a A1 rating is higher quality than a bond with an A3 rating.  Ratings are used by bond investors to compare the relative value, price and income, of one bond to another.  For example if two firms both have an A rating for bonds with similar terms, but one has a larger coupon (pays more interest), most investors would prefer owning the one with the higher coupon, as they earn more income for the same level of risk, as indicated by the rating on the debt. 

For companies, the higher the Rating on their publicly traded debt, the lower the coupon rate (interest rate) needs to be to attract investors.  A AAA bond will have a lower coupon then a lower rated A bond, resulting in a lower interest expense for the company.  This is why companies work very hard to maintain or improve their credit rating.  Take for example, Dell and Apple.  Dell has a Baa2 Moody’s credit rating while Apple has a Aaa rating.  Looking at a bond from Dell that matures in 5 years, it pays investors ~4.904% YTM (yield to maturity) interest on that bond.  An Apple bond maturing in 5 years pays ~3.983% YTM.  Basically the lower the rating on the debt the more interest a firm has to pay to entice investors to buy their bonds.

            Back to the US credit downgrade issue.  Moody’s lowered the rating for US debt from Aaa to one notch lower at Aa1.  For perspective, this means that Apple’s debt, with a Aaa rating, is rated higher than US issued debt, suggesting that Apple’s debt is less risky than US issued debt.  Looking at today’s yields, an Apple bond maturing in 5 years pays ~3.983% YTM, while a 5 year Treasury bond pays ~4.067% YTM.  For a 5yr bond, that is a big spread in rates.  In other words, the US has to pay a higher rate, more interest, on its debt then Apple currently does.  To put in another way, Moody’s considers Apple a less risky borrower than the US Treasury.  The actual default risk of not getting the principal back when the bond matures for either bond is extremely low, but a lower rating does increase the interest expense for US debt.

            That same thought process applies to Treasury bond investors (central banks, pension and insurance companies and so on).  As they consider how much US debt to buy or hold, the higher perceive risk due to the lower rating requires a higher interest rate to compensate for the perceived higher risk associated with the lower ratings now attached to US debt.  The US level of debt was one issue mentioned for the downgrade and higher interest costs associated with the downgrade will only make the US debt situation more tenuous.     

Harry

LayLine Asset Management Inc

Harry J. Campbell III, CMT

4/15/25

Effective Income Tax Rates

            I thought it would be appropriate on tax day to examine what we actually pay as a percentage of our income in Federal taxes, referred to as an effective tax rate.  With so many variabilities to the tax code, for this discussion only the standard deduction, filing status, and published tax bracket rates will be looked at.  This discussion is also only meant to provide some understanding of what the effective tax rates are, and not to provide a thorough understanding of the effective tax rate.  Please contact an accountant for your specific circumstances. Income brackets, tax bracket rates, and standard deduction are for 2025.

            Starting with the income and tax bracket rates.  It’s important to recognize that a particular tax rate only applies to the income in that tax bracket. I.e., the 12% tax bracket rate only applies to income between $23,851 to $96,950.  Here are the first three tax brackets for a married filer for 2025 and the taxes on the maximum income of that income bracket.

Income Bracket                       Tax Bracket Rate        Taxes on Maximum Bracket Income

$0 to $23,850                                      10%                                           $2,385 ($23,850*.10)

$23,851 to $96,950                             12%                                           $8,772 ($96,950*.12)

$96,951 to $206,700                           22%                                         $24,145 ($206,700*.22)

So, before considering the standard deduction, on an income of $206,700, the taxes due would be $35,302.  This results in an effective tax rate of 17.1% ($35,302/$206,700) and not the 22% tax bracket rate associated with that income bracket.  In this example the effective tax rate is about 22% lower than the listed tax bracket rate.

Next let’s consider the effect of the standard deduction on the effective tax rate.  The standard deduction in 2025 for single filers is $15,000 and for those filing as married it is $30,000.  For all intents and purposes this means that married filers don’t pay federal income taxes on the first $30,000 of income even though the federal tax bracket rate on an income of $30,000 for married filers is 10% - 12%. 

On an income of $206,700 used in the above example, taking the standard deduction for married filers of $30,000 would leave a taxable income of $176,700 ($206,700 - $30,000).  The taxes due would drop from $35,302 to $28,703, resulting in an effective tax rate of 13.9% ($28,703/$206,700), about 37% lower than the 22% associated tax bracket rate.  To actually have a 22% effective tax based solely on the tax bracket rate, before standard deduction, you would need to have federally taxable income of over $500,000.  The associated tax bracket rate on incomes over 501,051 is 35% making an effective tax rate of about 22% on that level of income quite a relief.

As we approach the expiration of the current tax rates this fall and debate new tax rates, it’s good to understand that the effective tax rate that is paid is what really counts, literally, rather than the much higher tax bracket rate often quoted.

Harry

LayLine Asset Management Inc

Harry J. Campbell III, CMT

3/18/25

Tariff Update

            I first wrote about tariffs on 9/17/19 as the prior Trump administration put new tariffs in place.  Keep in mind, and not to be political about it, the Biden administration continued with the tariffs and in some cases increased tariffs.  I’m not going to kid you, the concept of tariffs are so extremely complicated and so highly varied that the term tariff itself lacks the specificity required to discuss the topic.  Here are a couple of examples to make the point.

1.     Some tariffs are limited by quotas.  Canada does have a significant tariff on dairy products imported from the US.  However, the tariff only kicks in when the quantity of imported products reaches a particular level above the quota set.  If the total amount of imports remain below that quota level, there are no tariffs imposed.  This use of tariffs looks like it is intended to protect a country from having another country dump huge quantities of products, at very low costs, into the country with the intent of damaging that countries economy.  However, without knowing about the level of quotas and the quantities actually being imported, one would likely come to the wrong conclusion about the absolute dollar amount of the tariff being imposed on imports.

2.     The EU (European Union) imposes a 10% tariff on all cars imported from any country.  The US imposes a 2.5% tariff on all cars imported into the US from any country.  The tariff is paid (generally speaking as there appears to be many extenuating circumstances) by the importer and the revenues are collected by the government.  In this case, the tariff increases the cost of an imported car considerably more in the EU than here in the US.  This type of tariff appears to be a way for the government to add revenue to its coffers and or to provide incentives to move production facilities to the country (think Toyota or BMW with factories in the US).  Cars produced in the US are not subject to 2.5% tariff.  The catch is that some countries make it very difficult to build such facilities in that country, making it difficult for an exporter to get around a tariff.

3.     Some tariffs are used as a negotiating tactic, as we have seen recently in the US.  Just the threat of a tariff can influence a country to change its economic behavior regarding the use of tariffs.  The difficulty is knowing when it is a threat or the specific intention to impose a tariff.  This tariff situation can lead to an escalation of tariffs leading to a full blown trade war, where no one benefits.     

There are so many what if this, what if that, regarding tariffs that I wrestled with even making an attempt to bring some clarity on the subject.  The best I can do is to instill an understanding that quick explanations by anyone regarding specific tariffs, are deceptive at best.   

Tariffs

(Originally published 9/17/19, with some updates and clarifications)

I was recently asked about tariffs.  I realized that that most consumers have had little exposure to tariffs (they are always around) unless you have studied economic history or were around in 1930 when Smoot Hartley Trade legislative was blamed for exasperating the Great Depression.  I will try to provide a brief (by definition incomplete) explanation of the theory of how tariffs work their way through the system.  I used the word theory, as there is little consensus about tariffs except that ultimately, it would be nice if we could conduct global business without them.

While there are many purposes for tariffs, the basic purpose of a tariff is for a country to use economy pressures to alter the behavior of another country, whether it be economic or other behavior.  Regardless of the purpose, here is a rough approximation of the financial mechanics when a country places tariffs on a widget (economic term for a product) bought and imported from another country. 

Country A puts a 15% tariff on a widget being imported from Company 1, from Country B.  If the widget cost Company 1 $1.00 before the tariff, it will cost $1.15 after.   If Company 1 sells the widget with a 50% gross profit margin for $2 before the tariff, they will need to sell it for $2.30 after the tariff to maintain the same gross profit margin.  Since Country A collects the tariff (tariffs go to the government), the tariff resembles a tax on the Company 1.  The net result of the tariff is that Country A has taken 15% out of a sector of the economy (whatever sector is targeted) as a tax.  Unless the tariff is circulated back into that sector of the economy, that sector of the economy is in effect, impaired by the tariff. 

Who ultimately pays for the tariff will depend on how Company 1 handles the cost increase from the tariff.  They can absorb the full amount of the tariff; selling the widget for the same $2.00, earning 15% less, or $.85 rather than $1.00.  But that’s a 15% decline in gross profit.  If Company 1 has a net profit margin of 8% on the widget, that widget is now unprofitable.  Company 1 can pass along the increase, or portion of, to the end consumer by increasing the price.  This is where an economic principal of substitution comes into play.  Consumers have many choices and they may be able to get the widget from Company 2 (substitute), who imports from Country C, that does not have tariffs placed the widgets they export and therefore can sell it for less.  Company 1 has to decide what to absorb, what to pass along, and whether there are other sourcing options for widgets without tariffs.  You can get a feeling for the difficulties tariffs place on the companies effected.

Some tariff costs will be passed along to the consumer and some will be absorbed by the company. To the degree that the increase gets passed to the consumer, the consumer pays.  Whatever is absorbed, is a cost to the company.  Regardless, the government imposing the tariff collects the revenues from the tariff.  There is no clear answer as to the implications for the economy as each tariff is unique.  The math would indicate that the immediate economic costs are borne by the economy of country implementing the tariffs unless the government recycles the tariff revenue collected back into the economy.  It would seem that tariffs are in the short term counterproductive to the economy unless the tariffs result in the desired change in economic behavior that produces sufficient positive economic returns to justify the tariff in the first place.  As the Bard wrote in Hamlet, “ay, there’s the rub”.

Harry

LayLine Asset Management Inc

Harry J. Campbell III, CMT

2/18/25

 Income Investments: Fixed or Variable Income

            There are many types of investments that qualify as an income investment, but for this conversation, we will limit it to Fixed Income (Bonds) and Variable Income (Money Markets Funds).  The primary goal for income investments is to generate income over time.  One of the more common income investment are bonds, commonly referred to as Fixed Income.  Individual Bonds are often referred to as “Fixed Income” b/c (assuming no defaults) they pay the owner a “Fixed” amount of income that will not change during the time the bond is owned.  If a bond pays 5%, one bond ($1000) will provide the owner of that bond $50/year for the life (until it matures) of the bond, hence the term Fixed Income.  When the bond matures the owner gets the $1000 paid back.

            The good thing about Fixed Income is that the owner of the bond knows exactly how much income they will receive from that bond.  The downside is that over time, given the effects of inflation, that income will buy less each year, creating a loss of purchasing power.  If inflation is running 3%, the $50 in income will only purchase $48.50 worth of goods and services the next year.  Over time the value of the income is eroded each year.  This is why it is so important to owners of Fixed Income that inflation stays under control, and that’s the Federal Reserve’s (FED) job.  This also means that Fixed Income, when purchased, needs to represent a good estimation of the future level of interest rates and inflation.  For example, in 2021 the best interest rate that a 10 year Treasury was paying was 1.76%.  Today, a 10 year Treasury is paying 4.54%.  From an investing standpoint, if an investor thinks interest rates will rise in the near future they would need to reconsider the purchase of a Fixed Income investment.  The same applies to inflation, if an investor thinks inflation will rise, perhaps a fixed income investment is not the most prudent investment.  On the other hand, if an investor thinks interest rates will fall and or inflation will not rise, then Fixed Income might be appropriate.

            An option to a Fixed Income investment is an investment that has a variable interest rate.  There are many varieties of variable income rate investments such as Bond Funds, both mutual funds and EFT (exchange traded funds), dividend stocks and funds, to mention a couple.  However, staying with Money Market funds, the interest that is paid on a Money Market Fund varies, moving up and down over time, hence it is not a Fixed Income investment.  The advantage is if interest rates go up, the Rate paid in the Money Market Fund will likely rise (not a guarantee).  Money Market Funds often trend in the same direction as the FED Funds Rate, set by the FED.  If the FED pushes the FED Funds Rate up, we would expect the interest rate on a Money Market Fund to also rise. It also works the other way, if the FED Funds Rate is pushed lower the interest rate on a Money Market Fund will likely trend in that direction.  I use the term trend as the relationship between FED Funds rate and the interest rate paid on Money Market Funds is not always directly correlated.

As discussed above, both Fixed Income investments and Variable Income investments have their downside and upside.  In a falling interest rate environment, Fixed Income has an advantage, while in a rising rate environment a Money Market Fund as some advantages.  If it were only that simple, it is not.  There are many other variables, too many for this discussion, that need to be considered when investing for income.  The important take away is a basic understand of the difference between Fixed Income and Variable Income investments like Money Market Funds. 

Harry

CMT: Chartered Market Technician

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