RISK REWARD RATIOS NOW FAVOR INVESTING IN TRUST DEEDS
MORE THAN AT ANY TIME DURING THE LAST TEN YEARS

By Richard Temme

December 10, 1997

Those of you who have known me for many years know that just over 21 years ago I gave up my seat on the Pacific Coast Stock Exchange. Dealing on the floor of the stock exchange was fun and interesting. However, I missed the interaction with clients. Trust deed investments appealed more to my conservative nature. After all, the Dow Jones was at 950. Where could it go from there????

 As trustee for a large pension plan, I periodically try to shed my obvious bias and try to recall some of the years of training and experience in stocks and bonds to look at a broad range of investments from a neutral position. The following comments reflect some of those current thought processes:

THE BOND MARKET AND INTEREST RATES

Why are so many investors slow to recognize low inflation and stable interest rates are very likely here to stay? One historical fact that long term debt investors will never forget is, in 1979 and 1980, double digit inflation practically destroyed the bond market. It did not exactly encourage investments in longer term trust deeds either. Considering that experience, inflation remains the deadly enemy of debt investors. Many investors, remembering the adage "once bitten, always wary" are still reluctant to trust the subdued level of current inflation rates. Actually, the disinflation of the last few years is likely to continue, albeit, not in a straight progression. Some economic pundits are actually whispering the word deflation as a possibility.

Do not panic if the Federal Reserve Bank, in reaction to its inflation concerns, raises short term interest rates soon. It would, at least partially, be in response to the current high level of employment. Whether the economy continues to slow on its own or later slows as a result of interest rate increases, mandated by the Federal Reserve Bank, the resulting economic slowdown could ultimately cause even lower interest rates than we are currently experiencing.

It is important to remember, former Federal Reserve Chiefs, Frank Burns and Paul Volcker had the luxury of erring on the side of inflation. The federal debt structure has since grown to such massive proportions that the rules have changed for federal reserve chiefs as well as presidents.

When was the last time we saw a Democratic president proposing to cut entitlement programs? Mr. Clinton knows he CANNOT RISK INFLATION. Alan Greenspan, as current head of the Federal Reserve, does not enjoy the same margin for error available to him as his predecessors did. He is keenly aware that we cannot take a chance on allowing inflation to run again.

Perhaps some of the best proof available that we finally have a government commitment to low inflation rates is the fact the U.S. government is now selling inflation indexed U.S. bonds. Even more interesting is that investors, knowing the government now has no choice but to maintain low inflation rates, have not been overly enthusiastic about buying the inflation indexed bonds.

Our country's debt is now held by so many international sources that any hint of irresponsibility on the inflation front would likely cause a massive exodus from dollar denominated debt instruments, a scary thought. As a result, unlike his predecessors, Mr. Greenspan, in managing the economy, must give approximate equal weight to the possibility of erring on the side of recession. That raises the specter, if Mr. Greenspan overdoes it on the side of recession, we could see some deflation and lower rates of interest than we have seen in 20 years or more.

 Higher grade bond or bond fund investments would be even more worthwhile in a recession scenario. Conversely, high yield, lower grade bonds or bond funds, because they are usually issued by more highly leveraged and/or less stable companies, would present a higher than normal risk during a recession. It is very important in a declining interest rate environment to be sure bonds have long call dates to protect against refunding.

 TRUST DEEDS VS. BONDS

I submit to you that if trust deed investments are available with the quality and in the quantity you desire, they will likely present a more favorable risk reward ratio than bonds or bond funds. Individuals in the maximum tax bracket will see a closer comparison to trust deed investments when considering municipal bonds as opposed to corporate bonds; however, we think not as close as many would believe. Ratings on many higher yielding municipal bonds are not that high. Poorly rated municipal bonds may not be as safe as many conservative first deeds of trust.

High grade long term bonds, both corporate and municipal bonds, pay a relatively moderate but very dependable return. If that is what you want, they can be a good investment, especially with low inflation expectations on the horizon. Remember, municipal bonds only make sense if you are in or near the maximum tax bracket.

Most long term corporate or municipal bonds have a call date. That means in usually five to seven years, if interest rates go down, the issuer can pay off the investor by refinancing in the lower interest rate environment. On the other hand, in the very unlikely event rates should rise significantly, the investor is stuck with a sub par return for 30 years or, alternately, must sell at a discount. Most trust deed investments offer a significant advantage over long term bonds when weighing this possibility. This is partially due to the fact that, unlike bonds, many trust deed loans are paid off for reasons having nothing to do with interest rate variations, such as selling the property, divorce, health reasons, etc.

Additionally, unlike most bonds, many longer term deeds of trust are fully amortized, returning much of the principal early.

The biggest advantage of trust deed investments over bonds is that the higher yield generally offered by trust deed investments is not necessarily due to higher risk. The higher yield offered by Trust Deed investments, particularly well secured first trust deeds, is primarily due to receiving a retail rate of return on the invested funds. Bonds, CD's or insurance annuities represent a wholesale investment of your funds.

 THE STOCK MARKET

It was Bernard Baruch who said " Making money is easy. You just observe the future and act before it happens." Earlier this year Warren Buffett made this statement in reference to the stock market, "There is substantial risk, at this time, of over payment." Rich Temme was recently caught thinking "I don't know what is going on; however, it sure seems like a lot of our investors are taking money out of the stock market and investing in notes secured by deeds of trust."

Many of our clients who also invest in the stock market tell me they believe the Dow Jones could hit the 9,000 or even 10,000 mark during the next few years. On the other hand, many of those clients are also concerned about high price/earnings ratios that suggest, like Warren Buffett, that the market is over priced at this time. Many of these investors feel the risk of a decline in the Dow is starting to look almost as large as the potential rewards on the upside. Many, but not all of them, tell me it is time to get out or at least lighten up on stock market holdings.

 To our many investors who, when the Dow broke 4,000, 6,000 and 8,000, said in effect "I told you so," my hat is off to all of you for having the foresight to get into the market in 1988 and 1990. What do we do with our money now?

REAL ESTATE INVESTMENTS

Real estate investments present the biggest challenge in weighing risk reward ratios vs other investments. Today, big tax write offs and anticipated rapid appreciation are no longer the significant factors they were more than a decade ago. It is a given with most investors that real estate values in California have seen a bottom and will rise over the foreseeable future. This conjecture generally assumes significant inflation is not imminent and any deflation will be relatively mild. I believe it also assumes that the compressed state of Southern California real estate values will be more resistant to deflationary pressures, if such pressures appear, than other commodities. The most difficult problem, from an investor's perspective, is in determining which property types and areas will rise the fastest, what will be the rate of increase and how much leverage in the form of financing makes sense for a specific investment?

Homes and condos will likely remain a good buy for living purposes. This is especially so if the new federal tax law can be used to your advantage.

Industrial property, commercial property and apartment houses have demonstrated varying degrees of appreciation over the last year or two. Those property types and areas with the lowest current vacancy factor will likely see the best appreciation near term.

CONCLUSION

The pension plan, for which I am trustee, is, at this time, invested in a geographically diversified trust deed portfolio and also in commercial properties managed by a non-affiliated property manager. Additional amounts are invested in no load investment grade bond funds and money market accounts. I wish we held some industrial property.

We are currently afraid of the stock market. The possible economic slowdown, described in the bond section of this letter, would likely reduce earnings or at least reduce the growth rate of earnings for many companies. When coupling this with current high price earnings ratios of most stocks, I do not want the responsibilty of being in the stock market if/or when this occurs, particularly if the Fed errs on the side of recession. Of course, my feelings were similar, with only moderately less conviction, when the Dow hit 4,000.!!!!!!!

The purpose in sharing this review is to demonstrate why I believe investments in notes secured by deeds of trust, at this time, are likely to enjoy a clear advantage in any risk benefit analysis compared to most other investments. Yes, income tax considerations may have to be made. Yes, corporate bond funds are more liquid than trust deed investments. Yes, some leveraged real estate investments may bring a better return, particularly in the short term while we are still experiencing a bounce back effect. Yes, there are stocks, somewhere, that will outperform the yield on trust deeds. However, such stocks are becoming more difficult to find.

Overall, the time is right to again think about collecting a retail rate of interest on your funds. This is, of course, accomplished through trust deed investments, even if only lower yielding and more conservative first trust deeds are considered.

 260.105.30

Real Estate Broker CA Dept. of Real Estate

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