The low interest rate environment we face has made fixed income the most challenging asset class to manage. As a portfolio manager, I am faced with a dilemma. I can invest in high-quality fixed income and receive little to no income or dramatically increase risk to achieve some income. In summary, there is no return being offered for safe fixed-income investments and the risk required to achieve a small amount of return is too great to be taken. So what am I doing with fixed income?
Sticking with Short-Term U.S. and International Treasuries
History has shown that no asset class provides better protection against a declining stock market than Treasuries. I typically use DFA Funds or the iShares Barclays 1-3 Year Treasury Bond Fund (SHY), SPDR Barclays Capital Short Term Intl ETF (BWZ) and WisdomTree Emerging Markets Local Debt Fund (ELD). Treasury prices have historically gone up as stock prices have gone down. This has not only provided investors with a form of insurance against a stock market decline, but also the treasury yield has provided investors with income.
Today, we face the reality that Treasuries provide little to no income, yet they still provide invaluable insurance against a decline in the stock market. I am maintaining my positions in short-term Treasuries.
Avoiding U.S. Investment Grade and High Yield Bonds
I am holding a small allocation of short-term corporate bonds, floating rate loans, and short-term high yield bonds. I often use mutual funds for my allocations but similar ETFs include: Vanguard Short Term Corporate Bond ETF (VCSH), SPDR Barclays Investment Grade Floating Rate ETF (FLRN), and PIMCO 0-5 Year High Yield Corp Bond Index ETF (HYS). Doing this reduces the risk that interest rates rise and accepts some credit risk.
Capital that once went into the above mentioned investments is now being shifted to alternative investment strategies and equities. For the equity allocations I am using WisdomTree Total Dividend Fund (DTD), WisdomTree DEFA (DWM), and WisdomTree Emerging Markets Equity Income Fund (DEM).
Avoiding the Hunt for Yield
Bubbles begin and end when investors take increasing amounts of risk in an effort to seek a declining amount of return. The returns on short-term Treasuries have almost disappeared, but the risks remain the same. Most importantly, they provide invaluable portfolio insurance. This is in stark contrast to the decline in yields on medium- to long-term bonds and corporate bonds. In these assets, the effect of a shift in interest rates or slow down in the economy could cause a drastic reduction in price and this level of risk does not justify the low return potential.
Investors would be well served to hold onto their Treasuries to maintain their portfolio insurance and give up on the "Hunt for Yield."
Disclaimer: This article does not provide investment advice. It does provide the reader with content meant only as a broad overview for discussion & educational purposes.