Practical Thoughts on Asset Allocation

When I think about asset allocation, I typically begin with my model that chooses between BBB corporate bonds and common stocks. The model still favors corporate bonds. After that, I look at the bond market, and ask myself where I think risks have more than adequate compensation. I look at the following factors:

• Duration (Average Maturity is similar, sort of) — do we get fair compensation for lending long?
• Convexity — does the bond benefit or get hurt by interest rate volatility?
• Credit — are we getting decent compensation for credit risk?
• Structure — Structured notes always trade cheap to rating, but how cheap?
• Collateral/Sectors — Are there any collateral classes or sectors that are trading cheap to their fundamentals?
• Illiquidity — are illiquid issues trading stupidly cheap?
• Taxes — How are munis trading relative to tax rates and creditworthiness?
• Inflation — is the CPI expected to accelerate?
• Foreign currency — if nothing looks good on the above (or few things look good), perhaps it is time to buy non-dollar denominated notes. My view is buy foreign currencies when nothing else looks good, because foreigners will do the same.

At present, I am not crazy about corporate credit relative to other bonds. I would move up in quality.

We are getting decent compensation for duration risks, so I would buy some amount of long Treasuries. I would also hold some cash, running a barbell.

On convexity, I would be market weight in conforming mortgages. If I had an edge in analyzing non-conforming mortgages, I would buy highly rated tranches of seasoned deals (2005 and before).

I would do a lot of analysis, and buy seasoned CMBS (2005 and before) — there are real risks, but the seniors should not get killed.

Munis offer promise for taxable accounts — the difficulty is doing the credit analysis on long bonds.

On inflation — I am not a fan of TIPS right now. I would rather buy foreign bonds. The actions of foreign nations lend themselves to dollar depreciation.

So, where would I go with a portfolio that has an intermediate horizon, say, 5-10 years out?

• 30% global equities — half US, half foreign (emphasize value, but not financials)
• 15% long Treasuries
• 15% residential mortgages — seniors, conforming
• 10% CMBS seniors
• 15% cash
• 15% foreign bonds

Yeah, I know this seems conservative, but I am not a believer in the current rally in stocks or corporate debt. This is a time to preserve capital, not hunt for yield.

Comments

[Roger Knights:]

What, no out-of-the-money calls on SRS?!

(Just kidding.)

Jul 12 10:52 AM

[Graham and ...:]

"Conservative" is the way to go right now. Return OF capital more critical than return ON capital (Will Rogers).

Jul 12 01:17 PM

[Old Trader:]

Dave,

I'm in agreement with the general tenor of your article; being conservative at this juncture, but I do have a question regarding the 15% you've got allocated towards foreign bonds.

Are you speaking of foreign corporates (high grade, of course), or are you thinking sovereign debt? Or perhaps some of both? Given the premise of staying conservation, I'll guess you're not suggesting emerging market debt, or am I reading things wrong?

Jul 13 05:49 PM

[Living4Divi...:]

David - you said "This is a time to preserve capital, not hunt for yield." - Actually that portfolio sounds like it will have a good yield.

Jul 13 06:15 PM

[Mark54:]

Bravo... seasoned CMBS is the star here. I personally would break out CMBS into <1yr avg life and >1yr avg life and go a little heavier in this class. Say 5% <1yr and 10% >1yr. Money market bonds can be had +800 to +1000. Of course loan extentions may stretch out the cashflows slightly but mmkt CMBS is an excellent place for 18 month liquidity.

Jul 14 09:21 AM