This is the second piece in Seeking Alpha's Positioning for 2013 series. This year we have taken a slightly different approach, asking experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.
The Financial Lexicon (See Seeking Alpha's policy on anonymous authors) has a decade’s worth of experience in the world of finance, the last seven years of which have been spent as a proprietary trader and investor. Before becoming a full-time trader and investor, The Financial Lexicon worked for one of the largest investment management companies in the world. Additionally, The Financial Lexicon is the author of the recently published book, The 5 Fundamentals of Building a Retirement Portfolio, and writes for LearnBonds.com and OilPrice.com.
Seeking Alpha's Jonathan Liss recently spoke with The Financial Lexicon to find out how his views on a range of bond asset classes were shaping up as 2012 turns into 2013 - with an eye on actionable fixed income asset allocation advice.
Jonathan Liss (JL): Great to have you join us this year. How would you describe your investing style/philosophy?
The Financial Lexicon (FL): In a word, adaptive. At this time, I am favoring income and principal protection over growth. I am also favoring longer-term positions versus having a portfolio 100% dedicated to shorter-term positions. In the past, however, the exact opposite was true of my portfolio. I am open to investing in all sorts of assets; I am willing to carefully consider stocks, bonds, options, commodities, currencies, and anything else that has what I consider an attractive risk-reward profile.
Moreover, I am a very patient investor. When making an investment with a longer-term time horizon, I prefer to average into the position. Averaging into a position could mean anywhere from two orders to more than ten orders, depending on the size of the position I am building and my confidence regarding the prices at which I am buying/selling. If, however, I am trading (short-term time horizon), I usually buy all at once.
I am a big believer in the fact that every investor’s situation is unique; what is suitable for one person’s portfolio may not be suitable for another’s. That is part of the reason I like to write about such a wide variety of topics.
JL: What's your definition of ‘trading’. Are you referring to acting on technical signals, or are you more of an ‘event-driven’ trader?
FL: I always have my eye out for shorter-term opportunities that I think can make me double-digit returns in a matter of days or weeks. These can be centered around an event, although that doesn’t have to be the case. By “event”, I am not just referring to product launches or other major expected announcements. I am also referring to things such as quarterly conference calls and options expiration days. Regarding options expiration days, I think many investors would be surprised by how often short- or longer-term trends and momentum in stocks change on or immediately after options expiration days. I have seen this occur so many times over the years.
Apple’s (AAPL) stock provides a recent example of this. Apple’s first major bottom of 2012 occurred on May 18 (options expiration day). That ended the roughly 19% sell-off that began in April, taking the stock from $644 to $522.18. It then rallied strongly into September, reaching its all-time high of $705.07 on September’s options expiration day before immediately reversing course. The stock then fell non-stop into November, bottoming on November’s options expiration day before rallying more than 17% in just a couple of weeks. Entering trading positions around options expiration days can provide great opportunities for capturing short-term gains or even building a longer-term position.
Technical indicators are definitely something I use when setting risk parameters and when determining entry and exit points. I generally stick to more basic technical analysis, looking at things such as support/resistance levels, moving averages, and trend lines. From time to time, I venture into more esoteric technical indicators. But I only use those on occasion and never as the primary factor in making a trading decision.
JL: Broadly speaking, what are the risks/catalysts you see on the horizon for the U.S. bond space heading into 2013?
FL: I think investors in individual bonds should hold their positions through 2013 with only three exceptions: First, they find another asset into which they can roll their funds that generates a similar amount of income and is trading at extremely attractive levels. Second, they believe an issuer will default. And third, it appears that confidence in fiat currencies is truly collapsing (not just talked about in the press), in which case investors should sell all fixed income holdings and purchase gold and out-of-the-money call options on the S&P 500. If those three scenarios don’t materialize, then hold onto your bonds.
I suspect Treasuries will have a seasonal sell-off at some point in 2013, taking the long end of the curve up a solid 50 to 100 basis points. That should drag corporate bond yields up along with it, although I assume spreads to Treasuries would narrow during that seasonal bump up in yields, thereby offsetting some of the rise in yields for corporate bonds.
Regarding municipal bonds, I think it is quite hard to make a prediction until I know whether negotiations on the Fiscal Cliff and debt ceiling will include any type of cap on the tax exemption munis enjoy.
I should also note that whenever the next bear market in stocks arrives, I think Treasuries will make new lows in yield. If that bear market in stocks arrives in 2013, then it will be a very good year for intermediate- to long-term Treasuries.
In terms of catalysts, the three biggest to my mind are the debt ceiling (difficult to predict how Treasuries would react), troubles resurfacing in Europe (positive for U.S. Treasuries, neutral-to-negative for investment grade corporates as spread widening offsets gains from benchmark yields declining, negative for high-yield corporates), and a bear market in stocks (positive for Treasuries, neutral for double-A-and-higher-rated corporate bonds, negative for mid-grade corporates and high-yield corporates).
JL: Where would you suggest retirees turn for income in this low-rate environment? How have potential changes to the tax code affected your assessment of interest-paying investments?
FL: The question of where retirees should turn for income was a major theme in my newly published book, The 5 Fundamentals of Building a Retirement Portfolio. I certainly think dividend-paying equities should play a role in a retirement portfolio (I own many myself) but also think that investors should not completely forgo bonds, even in the current interest-rate environment.
Over the past few years, fixed income investors should have been focused on extending duration in high-quality bonds and moving the shorter-duration segment of the portfolio to lower-rated bonds. The risk of U.S. bond markets experiencing what Japan has experienced with its bond markets was far too great to ignore. And yet many have chosen to ignore it. We are likely still in the early stages of the Japanese bond market experience. We are not necessarily doomed to a multi-decade experience of ultra-low interest rates. But to avoid it will require politicians to restructure entitlement programs and genuinely get control of the deficit (no accounting tricks). It will also require a major improvement in the labor market, not just from a total jobs created perspective, but also from a full-time, well-paying jobs perspective. Without all of that occurring, the Fed will continue its unconventional monetary policy, doing whatever it takes to keep rates down.
The new 6.50% unemployment guidepost the Fed recently announced will be something bond markets are likely to misinterpret at some point in the future, giving fixed income investors a great opportunity to buy. This is because the Fed is unlikely to raise rates if the unemployment rate falls to 6.50% as a result of the combination of temporary, low-paying jobs, and people dropping out of the labor force. Additionally, the Fed has shown a willingness to ignore inflation driven by commodity futures, calling it “transitory.” This is something I suspect will happen again in the future. When combining “transitory” inflation with a 6.50% unemployment rate led by a declining participation rate and temporary jobs (not a recipe for strong wage growth), I suspect that a series of rate hikes is a low probability event even if the unemployment rate heads to 6.50% in the coming years. The bond market will disagree for a period of time if the unemployment someday nears 6.50%, and that will be an opportunity to buy bonds.
Furthermore, as the stock market and the economy become dependent on ultra-low interest rates, it will be harder to take the punch bowl away without causing a major bear market in stocks as well as a recession. This catch-22 the Fed is in puts the odds in favor of a Japanese bond-market-like experience in the U.S.
I know there are investors who will say that if inflation gets out of control, the Fed will have no choice but to raise rates. I would respond by saying that inflation stemming from highly leveraged commodities futures markets (too much money chasing too few financial assets) rather than wage growth (too much money chasing too few goods) is much easier to control without having to raise interest rates. In a world of government intervention in financial markets, it should surprise no one to see done whatever is necessary to keep a lid on commodities futures. It is simply a matter of will.
Regarding yields, I fully expect seasonal rallies in interest rates (quite common), which, at the longer end of the Treasury curve could top 100 basis points. But I think the odds are greater that benchmark Treasuries do not break above their highs from this most recent equity-market cycle (4.01% for the 10-year Treasury and 5.06% for the 30-year), let alone the highs of the previous cycle (5.32% for the 10-year Treasury and 5.60% for the 30-year). What I mean by equity-market cycle is the time period between when a bear market in equities ends and the next bear market begins. Therefore, if you were carefully buying over the past few years, I don’t think you have a lot of risk to your original investment. Instead, the risk is to your current profits, which represent future interest that will be paid to you that you could choose to take as a capital gain now.
From an opportunity cost perspective alone, I think those investors who failed to purchase the longer-duration, high-quality bonds at much higher yields over the past few years are likely to never make up the difference before those bonds mature. Remember that when you give up an opportunity to purchase higher-yielding bonds and instead sit in cash or in much lower-yielding bonds, you will need interest rates to go above the levels you passed up in order to make up the difference in yield. And the longer it takes interest rates to do that, the higher you will need them to go in order to make up the difference prior to the higher-yielding bond’s maturity (the bond you passed up).
Fixed income investors who did not adjust their portfolios in the way I just described will, in my opinion, have to make very difficult choices over the next few years as their intermediate-term bonds come due. The opportunity cost of moving into longer-term bonds will have changed, and investors will simultaneously have to grapple with incredibly low-yielding short-term bonds.
There will be opportunities to purchase corporate bonds when spreads widen at various times over the coming years (more to say on this in a bit). I think investors should definitely take advantage of those opportunities. Remember that even though benchmark Treasury yields are likely to remain very low for a very long time, there are frequently opportunities in other parts of the bond market. If you find a bond that in your opinion is in good credit standing and has an adequate yield, buy it. If that means purchasing a bond with a longer duration than you have historically purchased, then purchase the bond with the longer duration. But do so while also making sure you’ve adequately planned for any liquidity events you may encounter. Also, don’t let mark-to-market movements in the price of the bond scare you out of a security that will mature at par and that helps you achieve your retirement income goals. In addition, don’t forget that just as equity investors average into positions on pullbacks, so too can bond investors.
Putting a small percentage of your portfolio into longer duration bonds in order to help you achieve your income goals and protect you from the possibility that the U.S. bond market lives through what Japan’s has lived through seems acceptable.
Thus far, I have answered this question with individual bonds in mind. But I know that more everyday investors put their money into bond funds than into individual bonds. In my aforementioned book, I have a lot more to say about bond funds versus individual bonds. But for the purposes of this question, I will touch on three things:
First, if a bond fund can provide for your portfolio some advantage that you find worthwhile and that you cannot replicate with individual bonds, then I think an allocation to a fund can be appropriate. In my portfolio, I have a small allocation to iShares iBoxx $ High Yield Corporate Bond ETF (HYG). It provides me exposure to a certain segment of the high-yield corporate bond market in which I don’t have a lot of individual bond exposure (below double-B). I am also considering purchasing AdvisorShares Peritus High Yield ETF (HYLD) the next time the high-yield bond market experiences a decent size sell-off.
A fund like iShares Barclays 20+ Year Treasury Bond ETF (TLT), however, is one that I find little value in purchasing. If you want to purchase long-term U.S. Treasuries, just purchase the individual bonds themselves. You can do so for commissions of $0 at several brokers. Additionally, the spreads are narrow, and the market is incredibly liquid. In my opinion, TLT is better suited for hedging strategies rather than as a core position in long-term Treasuries. Additionally, TLT is not a bad way to express a short position in the S&P 500 (SPY).
Second, in this low-interest-rate environment, an environment in which it is already difficult enough to find adequate yields, how much of your yield are you willing to give up to a fund manager (in the form of fund expenses)?
Third, if you do purchase a fund, it is essential that you are aware of the potential consequences to your principal should bond yields head higher. Remember that individual bonds mature at par, whereas bond funds generally maintain constant durations and have no maturity dates (there are exceptions).
I would also like to briefly address the question concerning taxes. If taxes go up, then I will demand a higher risk premium from potential new investments. I have structured my portfolio in a way that I can be very patient and wait for the higher risk premiums to materialize. After-tax returns are an important consideration when investing. While investors in the late 1990s may not have cared as much about their tax rates (given the enormous returns being realized on stocks), in a world of low economic growth, slowing corporate earnings growth, and a dependency on ultra-easy monetary policy to prop up asset prices, higher taxes may make certain investments unsuitable, despite those investments today just making the cut.
This is in no way a political statement. I am thinking about the effects of taxes purely from an investment perspective. Politicians will do whatever they will do. My job, as an investor navigating today’s politically-aware markets, is to figure out the best course of action based on the policies Washington puts in place. Those investing decisions will be made from a dollars and cents perspective, not from a political perspective.
JL: In his 2012 letter to shareholders, Warren Buffett referred to U.S. Treasuries as currently offering ‘return-free risk'. Let’s talk risk/reward assessments as they relate to the yield curve. Where is the sweet spot currently located? (i.e. the spot offering the best yield relative to interest rate risk)
FL: If we are just talking about capturing the yield-to-maturity, then I don’t think there is a sweet spot on the Treasury curve today. If, however, an investor wants to try to ride the yield curve, then the sweet spot is, in my opinion, somewhere in the seven to ten year range.
I know others will favor the five to seven year range, but I think we’ll be lucky to see the Fed raise rates within the next three to five years. And yes, I would consider it lucky. The fixed income investor in me hopes the Fed does raise rates. In fact, I think there is a good chance the Fed doesn’t even stop QE over the next three to five years, let alone raise rates. Therefore, if you buy the seven to ten year part of the Treasury curve on a 2013 seasonal pullback in price (rise in yield), I think you have a good shot at being able to pick up a few percentage points in capital gains on top of the coupon as you ride the yield curve over the next couple of years. This is especially true because I think the next bear market in equities will occur at some point over the next five years and will likely take the 10-year Treasury to 1%.
JL: Same question but for corporates (both investment grade and high yield). What sorts of durations are ideal from a yield vs. risk standpoint?
FL: The world of corporate bonds is very different from the world of Treasuries. At any given time, you can find very attractive individual bonds, even if the broader market is not trading at attractive spreads/yields. That makes this question much more difficult to answer than the Treasury question.
As I mentioned earlier, each investor’s situation is unique. I am comfortable with an allocation to longer-duration bonds that I am sure would make others cringe. But given the very real risk that yields on highly-rated bonds stay low for many years to come (with only seasonal upticks or an occasional broader-market spread widening), I think investors should remain open to allocating funds to individual bonds with greater than 10 years to maturity. This is especially true if you can find investment grade credit with yields of 5% or more. And you will be able to find plenty of those in the corporate bond market if you actively look for them over the next couple of years.
Regarding high-yield corporate bonds, there generally are not a lot of longer-term bonds offered (beyond 10 years to maturity), so investors are almost forced to keep short-to-intermediate durations in their high-yield bond exposure.
If you are an investor who is more comfortable in shorter-duration bonds, then you will likely collect less income and perhaps even feel forced to build a bigger position than you otherwise would in dividend-paying equities or non-investment grade bonds. I’ve met plenty of investors who fit that mold. Just as moving into longer-duration investment-grade bonds has certain risks, so too does allocating funds to shorter-duration high-yield bonds and/or equities out of a desperate need for income. Whichever route you choose, be sure you understand the risks and are able to deal with the consequences of those risks turning into reality.
JL: That being the case, would you consider maturity-date corporate bond funds? They have the benefit of offering diversification while allowing investors to hold to maturity – and they are easy to build bond ladders with.
FL: I have looked at defined-maturity corporate bond funds such as Guggenheim’s BulletShares but have yet to purchase any. Regarding the investment grade funds, I don’t see anything those funds can provide me that I can’t/won’t do for myself by buying individual investment grade corporate bonds. In the investment grade bond space, I am still not convinced it is worth giving up yield to a fund manager (in the form of fund expenses).
I am more attracted to the high-yield BulletShares funds and like the idea of building a ladder with those. For many investors, that could be a relatively simple way to create a hold-to-maturity portfolio. If you do go that route, remember that right now, the furthest-dated high-yield BulletShares fund is in the five to six year time frame. Investors who like to extend their high-yield exposure to maturities of greater than six years will need to look elsewhere.
JL: Which fixed income asset classes do you feel currently offer the best yields relative to risk?
FL: At this time, the answer is “None.” It has been a couple of months since I purchased an individual bond. My last fixed income ETF purchase was HYG on June 1, 2012. I search for opportunities almost every day, and at this time, I am not finding anything that excites me enough to buy. It is why my most recent articles about bonds have focused on bonds to add to a watch list rather than bonds to consider purchasing now.
With that said, I do think the opportunity to purchase high-yield corporate bonds and probably BBB-rated corporate bonds at much more attractive yields will present itself in 2013.
JL: Do you have any significant allocation to foreign bonds? How about emerging market sovereign debt?
FL: As I build my fixed income portfolio, I don’t pay a lot of attention to whether I am long domestic or foreign bonds. Instead, I focus on buying good credits at attractive yields. I do own some U.S. dollar-denominated bonds of foreign companies. A couple of examples of foreign companies whose bonds I own are Vale S.A. (VALE) and AngloGold Ashanti (AU).
In today’s global economy, there are plenty of U.S. companies that will benefit from strong growth overseas. Therefore, buying certain U.S. corporate bonds can get you a decent amount of exposure to overseas growth. I don’t think investors should focus too heavily on making sure they have a certain allocation to foreign bonds. Instead, the focus should be on finding the good credits at attractive yields. If that search takes you to foreign companies, then so be it.
Regarding emerging market sovereign debt, I am not interested in holding any such debt. If that does interest you, one ETF you can look at is the iShares Emerging Markets High Yield Bond ETF (EMHY). This fund has both sovereign and corporate bond exposure.
JL: Are there segments of the bond market you feel investors should be avoiding entirely right now?
Let’s start with Treasuries. I view them as a “Hold” with a contingent sell attached. Earlier, I mentioned a couple of reasons to sell bonds in 2013. Those reasons describe the contingent sell I would attach to a “Hold” rating on U.S. Treasuries.
Additionally, I think most single-A-rated-and-higher corporate bonds are currently a “Don’t Buy.” The yields simply do not justify buying many of them. You can even get FDIC insured CDs at higher rates than some high-quality corporates.
I would also, in general, stay away from European issuers (corporates and sovereigns) at this time. They’ve rallied nicely in recent months. But none of Europe’s long-term challenges have been resolved, and I am confident European bonds will once again sell off in 2013.
As I keep building the list of segments to avoid, I am beginning to wonder if the better question is where I think investors should put their fixed income money right now. There are likely opportunities on an individual bond basis that certain investors will find attractive at today’s prices. I think it is definitely worth spending the time looking for those. Remember that even if market-wide spreads and yields are not attractive, spreads can and do widen on specific issues. This provides investors opportunities to step in and buy individual bonds here and there. As I come across such opportunities, I plan to write about them in my articles.
Over the next year or two, I do think there will be broader-market opportunities in the U.S. corporate bond market. In my opinion, the odds are quite high that high-yield spreads move back above 700 basis points at some point in 2013 (currently at 531 basis points). Above 700 basis points is where I think ETF and mutual fund investors can average into broader-market positions with confidence that their principal will be reasonably protected over the longer-term. And the higher spreads go beyond 700 basis points, the more aggressively you buy. If, on the other hand, you believe a self-sustaining economic recovery is on the horizon, then you will want to start buying at today’s levels. This is because under a self-sustaining economic recovery in the United States, the broader-market high-yield spread will likely work its way back down to under 300 basis points, offsetting a decent amount of the rise in benchmark Treasury yields that would likely accompany such a recovery. That, however, is not my base-case scenario for 2013.
I also think there will be an opportunity to pick up some U.S. dollar denominated European corporates (individual bonds) in 2013. But I would stay away from the sovereigns and the European municipalities, even if spreads widen and yields rise.
JL: There were lots of (unfounded) fears surrounding Muni bonds heading into 2012. Now they have become exceedingly popular as they offer tax-free yields in a rising tax-rate environment (although there has been increasing noise about munis possibly giving up some of their tax advantages). What is your assessment of the Muni market heading into 2013?
FL: As I mentioned earlier regarding munis, I think it is quite hard to make a prediction until I know whether negotiations on the Fiscal Cliff and debt ceiling will include any type of cap on the tax exemption munis enjoy. Beyond that, I can say that while I understand the attractiveness of U.S. munis from a tax perspective, I think the market, as a whole, doesn’t have a ton of value beyond simply riding the yield curve and hoping for spread improvement from current levels. This is similar to my current feelings on corporate bonds.
JL: Finally, what advice would you offer a ‘do-it-yourself’ fixed income investor as we approach the New Year?
FL: Let me mention several things:
- Be patient. Avoid doing a lot of buying at today’s levels. And when spreads widen, don’t be afraid to buy in larger quantities than you typically would.
- Don’t expect spreads to narrow to pre-2008 levels without the economy reaching self-sustaining momentum mode. And don’t expect the economy to reach that mode in 2013.
- It would be wrong to assume that a downgrade of the U.S. credit rating is bad for Treasuries. In 2011, bond professionals across the board were wrong about what losing the AAA rating would mean for Treasuries. I have more to say about why a downgrade might actually be bullish for Treasuries in Chapter 6 of my aforementioned book.
- At some point over the coming years, I expect the market’s confidence in the Fed’s ability to prop up equity markets to significantly wane. When that happens, equities will take a major leg down. That next bear market will, in my opinion, give investors who currently own Treasuries an amazing opportunity to sell some or all of the position, lock in profits at capital gains rates (rather than realizing those profits over the coming years as interest taxed at ordinary income tax rates), and roll some or all of the funds into equities. Whenever that time comes, don’t be afraid to act.
- If you see corporate and/or muni spreads widen in 2013, and you have bonds maturing at any point over the next year or two, consider closing them out early and rolling the funds into other bonds at the time when spreads have widened. In other words, don’t wait until your bonds mature and hope that spreads/yields will be adequate at that time. If the market is offering you the opportunity to roll into attractively priced bonds in 2013, take advantage of that opportunity by selling your soon-to-mature bonds early.
- Last, don’t be afraid to buy bonds trading over par. In a world of ultra-low interest rates, you are likely to find many attractive bonds trading above par. But when purchasing bonds trading above their face values, be sure to carefully consider the call features of the bond. You don’t want to purchase a bond over par only to see it called at a lower price shortly thereafter.
Disclosure: I am long HYG. I am long AngloGold Ashanti (AU) and Vale S.A. (VALE) bonds. I am also long numerous other individual corporate bonds (investment and non-investment grade). I am long Treasuries. I am long gold. I am long numerous individual stocks (none mentioned in this article) that pay dividends.
To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.