This is the fourth 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.
Larry Swedroe is principal and director of research for both Buckingham Asset Management, LLC, a Registered Investment Advisor firm in St. Louis, Mo, and BAM Alliance, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. BAM Advisor Services currently has 135 participating firms. Buckingham currently has $4.5 Billion in assets under management, while the BAM network of advisors has an additional $13.5 Billion in AUM. He is the author of a dozen books including The Only Guide to a Winning Bond Strategy You’ll Ever Need and most recently, Think, Act, and Invest Like Warren Buffett: The Winning Strategy to Help You Achieve Your Financial and Life Goals.
Seeking Alpha's Jonathan Liss recently spoke with Larry to gain insight into his understanding of the fixed income landscape - and how he allocates to fixed income as part of an overall strategy to decrease portfolio risk and smooth out returns.
Jonathan Liss (JL): How would you describe your investing style/philosophy?
Larry Swedroe (LS): First, none of the investment advice we give is based on our opinions. It’s all based on what we refer to as the “science of investing,” or what might be called evidence-based investing. For both stocks and bonds we adopt what is referred to as a passive approach, accepting market returns in the asset classes we seek exposure to. That doesn’t necessarily mean index funds. But, it does mean that the funds are passively managed, no fundamental or technical analysis going on, with the exception of incorporating momentum into some of the strategies (positive, long only momentum) because the research shows that including momentum screens adds value. What that means is that when a stock enters the defined buy range of a fund, but it has negative momentum, the fund will not buy it until the negative momentum has ended.
For equities we currently use the structured portfolios of DFA and Bridgeway, but we are also working with other fund families that use “science” in their approach (such as Vericiymetry and AQR) to see if their funds fit into our strategies. We also use the index funds of Vanguard on occasion, especially for clients who don’t want to have all of their assets with one fund family.
On the bond side, with the exception of smaller accounts where we use the passively managed funds from DFA and Vanguard, and also TIAA-CREF’s traditional annuity product, we build individual bond portfolios using a passive approach. To balance the risks of inflation and reinvestment risk we typically build ladders of about 10 years and simply stay the course. We don’t make any bets on the direction of interest rates because the evidence suggests that’s a loser’s game.
In terms of quality, we take as little credit risk as possible because the evidence demonstrates that of all the risk premiums, credit risk is the least rewarded. So for taxable bonds, when building individual tailored portfolios we buy TIPS, government agencies, FDIC-insured CDs, and taxable municipals. For bonds that are free of federal income tax (municipal bonds), we limit our holdings to AAA/AA-rated bonds, even avoiding bonds with those ratings if they are not general obligation or essential services revenue bonds. And we have always only considered the bond’s underlying rating. We will consider A-rated bonds if the maturity is less than 3 years.
The reasons for the strict credit restrictions include:
- The research shows that credit risk has not been well rewarded except at the very short end of the curve;
- credit risk doesn’t mix well with equity risk (the risks tend to show up at the worst of times, just when you need your bonds to offset the losses in your equity holdings);
- you can diversify the risks of equity more effectively;
- the returns to stocks are earned in a more tax efficient manner;
- if you limit your holdings to the safest credits you don’t need to pay a fund manager to gain the benefits of diversification.
For those interested, my book, The The Only Guide to a Winning Bond Strategy You’ll Ever Need provides a lot more detail on all of these issues.
JL: In light of the abysmal performance of the ratings agencies in the lead-up to the 2008 financial crisis, how confident do you remain in the agencies’ ability to properly identify levels of risk in the bond space? Or is that irrelevant since everyone is forced to rely on the same ratings, imperfect as they may be?
LS: That’s a great question. And it’s not irrelevant. The ratings agencies certainly did a very poor job in the asset backed area. And that resulted from their conflict of interest with the issuers. The problem was that the more the issuers were able to get rated as investment grade, the more they brought to market and the more fees the ratings agencies collected. Clearly this was a problem and it's why the buyers should pay for the ratings, not the issuers.
Having said that, there aren’t the same problems with the types of bonds we recommend buying. Local governments don’t issue more debt because they get higher ratings. And we avoid all asset backed products including mortgages because of the unknown maturity risk (I don’t know why investors would be willing to give up control over the maturity risk in return for a relatively small premium), and also because the risks of calls doesn’t mix well with the risks of equities, as 2008 demonstrated.
One last point. When most investors/advisors see a bond that is trading at a higher yield than the market’s requiring from similarly rated issues, they tend to want to jump on that, thinking they have a bargain. Instead, we would avoid buying that bond because we believe the market is better at pricing risks than the rating agencies as ratings changes typically lag reality.
JL: I already know how you're going to respond to this question but for the benefit of our readers I'll ask it anyway. As we approach 2013, are you bullish or bearish on bonds as an asset class?
LS: While I might have my own personal views, I’ve learned that there are no clear crystal balls. And the evidence demonstrates that trying to time bond markets is a loser’s game. Just consider this evidence. In a study by John Bogle, he found that the best predictor of bond fund returns was expense ratios. The lowest expense funds produce the highest returns. And the latest S&P Active vs. Passive Scorecard found that over the prior five years 80 percent of long-term government bond funds underperformed their benchmark index, 84 percent of long-term investment grade bond funds underperformed, 96 percent of short-term investment grade bond funds underperformed, 92 percent of high-yield funds underperformed, 91 percent of national municipal bond funds underperformed, and 100 percent of California and New York municipal bond funds underperformed. I don’t know why anyone would buck those odds.
Here’s another example. When investors think of great bond managers, the first name that might come to mind is PIMCO’s Bill Gross, who has been dubbed “The Bond King.” In March 2011 Gross announced that PIMCO had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Federal Reserve ended its quantitative easing program. The yield on the 10-year Treasury was about 3.5 percent.
Those investors that listened to experts like Gross have paid a steep price. They not only missed out on the ensuing bond rally, as rates fell sharply, but they also missed the chance to earn the term premium that existed (longer-term rates were higher than short-term rates).
It’s been four full years since the federal funds rate hit 0.1 percent, and many experts were convinced that the combination of easy fiscal and easy monetary policy would surely lead to rising inflation and higher rates. And they were all wrong. Not only did rates not rise, they fell sharply, by about 2 percent for 10-year Treasuries. And Gross eventually apologized for his now infamous forecast.
The historical evidence is very clear: Just as there are no good stock market forecasters, there are no good bond market forecasters. Thus, the winning strategy is to have a disciplined approach, one that balances the risks of rising yields (and falling bond prices) and falling yields (leading to reinvestment risk).
JL: Where have you been having retirees turn for income in this record low rate environment? How have potential changes to the tax code affected your assessment of interest-paying investments?
LS: Whenever interest rates remain at very low levels for extended periods investors begin to make the mistake of stretching for yield. This is especially true of those who make the mistake of managing their assets on a cash flow basis — meaning they live off of only dividends and interest, never touching principal.
For a variety of reasons we believe that the correct strategy is to take a total return approach. Thus, the rate environment has no impact on our strategies, with the exception that we will give some consideration to the slope of the yield curve. The reason is that the evidence demonstrates that term risk has been best rewarded when the yield curve is steep (like it has been for the last several years). Thus, when the curve is steep, even if rates are low, we will consider extending our bond ladder out by a few years. On the other hand, when the curve is flat, we will consider shortening up by a few years. But, this is all on the margin. Again, we will not make major bets because the evidence shows that’s a loser’s game.
What we won’t do is stretch for yield. For all the reasons I gave earlier, we won’t consider the typical suspects as substitutes for safe fixed income: high-yield bonds, preferred stocks, MLPs, REITs (though we do recommend considering including REITs as part of the equity allocation), or high-dividend stocks.
And here’s a warning to those who have done so. The prolonged period of low rates has led to a dramatic increase in the flow of funds into higher-yielding assets such as high-dividend stocks, REITs, and MLPs. And the recent performance of these investments has been quite good.
As the popularity of these investment “fads” increases, in the short-term it can become a self-fulfilling prophecy (which is how bubbles occur). However, investors who know their history know that such trends ultimately become self-defeating, and most often end badly. The reason is that investors chasing the latest fad cause valuations to rise. And the evidence is clear that the best predictor of future returns is a valuation metric such as the P/E ratio. REITs for example are now trading at a P/E of about 40. The Alerian MLP Index has a P/E of about 24. Those kinds of valuations have generally turned out very badly for investors. Just think about 1999 and the P/E of the S&P, let alone of the NASDAQ. And the high-dividend strategies now have much higher valuations than similar value strategies, with much higher P/Es and P/Bs.
As to potential changes in the tax code, we don’t know what the new tax regime will look like. However, because it certainly seems quite possible, if not likely, that ordinary income tax rates are going up for higher bracket investors, we are making one small adjustment to our advice. When buying bonds in taxable accounts we do a breakeven analysis comparing the after-tax yield on tax-exempt municipals and taxables. Given the risks of rising tax rates, if the after-tax yield on a taxable bond only has a small marginal advantage over a tax-exempt municipal we might recommend the tax-exempt bond. The differences in credit risk would also be considered in the decision.
JL: In his 2012 letter to shareholders, Warren Buffett referred to U.S. Treasuries as currently offering investors "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)
LS: First, everything is relative. I don’t think that there are really any good choices right now for fixed income. Certainly nothing stands out the way TIPS were a screaming buy and we were pounding on the table trying to convince investors to load up on them when yields on long-term TIPS were around, and even well above, 4 percent, as they were in 2008 and in 2009.
Lately we have been buying lots of CDs, which if you stay within the FDIC limits you have the same credit risk (none) as you do with Treasuries but with quite a bit higher yields. We’ve even been buying them in taxable accounts for many investors, at least at the shorter end of the curve (too many investors just automatically assume that municipals will be better in taxable accounts).
As to maturity, as I said earlier, we generally stick with ladders of about 10 years, sometimes a bit longer and sometimes a bit shorter, depending on the client’s ability to take term risk, as well as the slope of the yield curve. As a general rule of thumb for taxable accounts, we’re willing to consider adding a year of maturity if we pick up an extra 20 basis points in yield. For municipals it might be an extra 16 basis points per year. For TIPS it would be a lot less because you don’t have the inflation risk. For example, the current 7-year nominal Treasury yield is about 1 percent, and the 10-year is about 1.6 percent. So we would go to 10 years because we are earning an additional 20 basis points per year.
JL: As someone who tries to produce ‘market returns’ by including as many global asset classes in portfolios as possible, what does that look like with a bond portfolio?
LS: With equities we build globally diversified portfolios gaining exposure to domestic, developed, and emerging markets with roughly a market cap weighting strategy, with a small home country bias (because international investing is a bit more expensive and a bit less tax efficient). Thus, we typically recommend 40-50 percent international exposure. Then we diversify across risk factors of size and value. And we typically have a heavy value and size tilt. The higher expected returns to size and value allows us to hold lower equity allocations than we would if we owned a market-like portfolio (and still have the same expected return). That has dramatically cut the tail risk for investors who have adopted that strategy. Just last year, the New York Times wrote an article on this calling it the 'Larry Portfolio'. The approach is explained in the Appendix of my book The Only Guide You’ll Ever Need for the Right Financial Plan.
On the bond side we take a very different approach. Our buying menu is very limited. That’s because we view the main role of fixed income to be to dampen the risk of the overall portfolio to an acceptable level and we can take all the risk we need to on the equity side — where we can do it more tax efficiently and diversify the risks more effectively. And we don’t need to pay bond managers because by sticking with the safest bonds we don’t need the diversification benefits provided by a fund. So we save our clients management fees.
Another benefit of separate account management is that we are able to tax manage the portfolios at the individual security level as well as to tailor them to our client’s state specific and tax specific situation. That’s a real benefit. For example a major disadvantage of owning a national bond fund is that you own bonds from the high tax states like NY and California, whose yields are depressed by the demand from their residents for tax free income. Why would a California resident want to own New York bonds? We often buy bonds from states other than where our clients reside because we can earn higher after-tax returns even if we have to pay the state income tax.
JL: How do you determine asset class mixes?
LS: One of the mistakes investors, and even many professional advisors, make is to consider an asset’s risk and return in isolation. The only right way to evaluate whether an asset belongs in a portfolio is to consider how an asset’s addition impacts the risk and return of the entire portfolio. And we carefully consider not only the long-term data, but also look to see when the risks show up. The table below provides an example of why we won’t include the typical list of high-yield assets:
The evidence demonstrates that the risks of high-yield strategies show up at exactly the wrong time, when your equities are getting hit hard. They clearly have equity-like risks and the average low correlations people use to justify their inclusion in portfolios become very high correlations at exactly the wrong time. In other words, high yield investments contain equity risks in disguise. They are not substitutes for safe bond investments.
JL: Are you allocating to TIPS in this environment despite their negative yields?
LS: As explained in The Only Guide to a Winning Bond Strategy You’ll Ever Need, we discuss with clients two alternative strategies for TIPS. One is a ‘buy and hold’ strategy, keeping a fixed allocation between TIPS and relatively short to intermediate nominal bonds. For TIPS we would use a laddered type approach, similar to what we do with nominal bonds. The one difference is that we would consider going much longer with TIPS because you don’t have the risk of unexpected inflation that you have with nominal bonds. That allows you to earn the term premium without taking that risk.
The other approach we consider is a shifting maturity approach. When TIPS yields are high in absolute terms (relative to historical averages), we would increase our allocation to TIPS and reduce it to nominal bonds. And we would also consider extending maturities. When TIPS yields fall to below their historical averages the reverse would be true. The advantage of this strategy is that when TIPS yields rise to high levels, as they did in 2009, you can lock in those high real yields for a very long time (as much as 30 years) without taking inflation risk, and doing so might allow you to actually lower your equity allocation at the same time because your need to take risk has been reduced by the high yields you have locked in.
We think that there are merits to either strategy. You should choose the one you’re more comfortable with and stick with it, and avoid confusing strategy with outcome — since all crystal balls are cloudy your strategy must be right or wrong before you know the outcome.
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. What is your assessment of the Muni market heading into 2013?
LS: When Meredith Whitney and Nouriel Roubini put out their famous warnings, we thought they were vastly overstating the risks. I explained why in my blog posts. The reason was that we believed that local governments would be forced to take actions to address their problems, cutting spending and raising revenues. Unlike the federal government, all states except one are required to balance their budgets. And just as we expected, in almost all cases budget gaps have been closed by layoffs of public employees, greatly reduced services, renegotiation of contracts with union members regarding wages and especially benefits, and increased taxes and fees. These actions have gotten results. And while there have been a few defaults, if you adhered to the buying parameters we require you would not have experienced any. Nor do we think you’re likely to, though it’s certainly not impossible.
The bottom line is that from a credit standpoint, with the exceptions of California and particularly Illinois, the municipal bond market is in much better shape than it was entering 2012.
JL: Do you ever consider closed-end funds for clients in the muni space? Or does the active nature of these funds make them non-starters in your book, even if trading at significant discounts to NAV?
LS: We don't track the closed end funds for variety of reasons. First, they are actively managed and we avoid them because we want to maintain control of the credit risks and maturity risks of our portfolio. When you use active managers you cede control. And in my opinion that is never a good idea.
Second, many of them use leverage, which is a no-no in our book. They need to do that, or take on credit risk, to try and recover their high expense ratios.
Third, by doing so we would lose the benefits of a separate account management including ability to manage the individual securities from a tax perspective and also the ability to tailor the use of different investments (taxable or tax exempt) depending on the yield curve, and their tax situation
While there may be opportunities to try and capture a large discount we just don't think the risks/costs are worth it.
JL: Finally, what advice would you offer a ‘do-it-yourself’ fixed income investor as we approach the new year?
LS: Follow the advice in my bond book. Keep it simple. Don’t try and stretch for yield or maturity. Stick with the safest fixed income investments. Ignore all economic and market forecasts because they have no value. And use a total return approach to your portfolio.
Disclosure: Larry Swedroe's fixed income exposure is through DFA Short Term Extended Quality Fund (DFEQX) as well as via individual AAA/AA municipal bonds that are General Obligation and Essential Service Revenue bonds. He doesn't own any Treasuries directly.
To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.