How might an investor position the fixed income portion of his / her portfolio given the rapid rise in long interest rates?
This article will outline how I'm instituting practical, actionable strategies to manage the bond segment of my investment portfolio. Readers will note that I am no securities trader: my investment horizon runs years, not months. Therefore, my premises and strategies revolve around the "long view."
Two Key Premises
The strategies outlined below are built upon two long-term, underlying premises. The accuracy of these premises are likely to define the success of the subsequent strategies:
- Interest rates are going up; the long end of the yield curve first
- I am bullish on the U.S. economy; its long-term prognosis remains positive
The first premise is has been brewing for some time, but I believe the trigger event has come: a dramatic change in intermediate to long rates precipitated by anticipated Fed policy changes. However, the intent of this first premise is not an attempt to predict near-term interest rate change. It is a long-term assumption that rates will now trend up over time. I don't know precisely when or how quickly, but I submit go-forward interest rates will demonstrate an upward bias.
Simply stated, the second premise means that I am bullish on America. Similar to my interest rate forecast, I profess no ability to predict exactly where the GDP is heading over the next several quarters. It's really not fundamental to my premise, either. What I believe is important is that over the long haul, the United States economy will retain its global, dominant role. Our economy's long-term growth trajectory will be up, not down.
Five Subsequent Strategies
Having delineated two long-term premises, I determined several aligned strategies, or patterns of action, are appropriate to manage my portfolio:
- Cut fixed income allocation
- Reduce general domestic bond fund exposure
- Emphasize select, individual bonds
- Diversify amongst various fixed income investment categories
- Hedge a little
Let's examine these strategies one-by-one.
Cut fixed income allocation
For many years, I've maintained a 30 percent fixed income portfolio allocation target. No more. Over the past year, I have been scaling back my exposure to the fixed income markets. I've now settled upon a new allocation target of 20 percent.
For most of my thirty-plus year investment experience, I've been a beneficiary of generally declining interest rates. Declining interest rates are good for fixed income investments, particularly the longer maturities. As rates decline, the underlying securities become more valuable. Unfortunately, I believe that recent events have signaled the end of the line. I contend that today's low rates are not sustainable for the long-term. Here's a 1983-2013 graph illustrating a thirty-year journey:
Many investment benchmarks tend to "revert to the mean," thereby showing a propensity for finding their way back to historic averages. In the case of interest rates, this is a little tricky. Here's some long-term perspective:
From 1900 through 1959, interest rates ranged from a low of just below 2.0% in 1941 to a high of 5.1% in 1921 - a range of only a bit more than 3.1%; the average rate was 3.3%.
Since 1960, the range has run from this year's all-time low of 1.6% to the September 1981 high of 15.3% - a delta of nearly 14%; the average rate during this period has been 6.6%.
A chart with more historic detail can be found here.
Putting it all together, my view is until the ten-year note approaches four or five percent, I see a greater probability for interest rates to trend higher than lower. I contend we've seen the generational lows. Therefore, I want less exposure to interest-sensitive bonds than my previous allocation target has been for much of the past three decades.
Minimize general domestic bond fund exposure
A boogie man is hiding in the closet: the construction and past performance of most general domestic bond mutual funds. For years, generally trending lower rates have translated into positive returns for bond fund investors; a one-two combo of income and capital appreciation. I submit the tables have turned. Today, I believe most general domestic bond funds will provide neither capital preservation nor good income. If interest rates rise, then bond funds' Net Asset Value (NAV) will fall. Funds with longer average duration will get hit harder than shorter maturity funds.
For three decades, when rates increased, fund prices decreased, but it was always temporary. Rates eventually headed lower again. I am no longer convinced that cycle will continue. If it did, we would need to see ten-year treasuries declines to yield about one percent. I find that scenario unlikely.
Here's the practical application of the foregoing: the reason I seek a fixed income component to my portfolio is to offset the inherent risk and instability of equities. I want bonds for income and safety; a "ballast" for my overall investment portfolio. When purchasing fixed income securities, I know that as long as the issuer is solvent, I should fully expect a return of all principal and whatever interest is due. If rates rise, I am aware it may cost me opportunity loss, but at least my principal is safe.
Unfortunately, as a bond mutual fund investor, I receive no such assurance. As rates rise, NAVs fall. There is no guarantee an investor will ever get his / her principal returned in full, even with no creditor default. This is because, unlike individual debt instruments, open-ended bond funds have no stated maturity date. To make matters worse, current interest rates are at an historic low. In a climate of even modestly rising interest rates, bond fund investors will find that income is highly unlikely to compensate for the loss of capital. Fund manager fees and redemptions simply compound the issue. It's the worst of all worlds: low income combined with no guarantee for the full return of principal; even if all issuers are solvent.
The only general domestic bond fund I own is the Pimco Total Return ETF (BOND). Of that, All that remains is a small, core position. The ETF is run by Bill Gross, arguably the best in the business.
Emphasize select individual bonds
The bonds I own are select, individual bonds issued by highly-rated corporations or municipal governments. Corporate issuers are higher level investment grade, and munis are rated "A" or better. The maximum remaining duration is 10 years. A large chunk of my fixed income portfolio was created during the fiscal crisis: "A" rated or better issuers found their securities trading on the secondary market for 60 or 70 cents on the dollar. Since that time, I have added a few new municipal offerings that came to market yielding at least three percent.
Currently, I'm effectively out of the federal government bond markets. I plan to buy no additional treasury offerings: rates are just too low.
Note to readers: My portfolio includes a reasonable proportion of U.S. treasury I-Bonds. These are fantastic securities for individual bond holders. Unfortunately, I believe the current I-Bond rates are now so low as to make them a near liability: almost certain negative real returns after inflation. However, at the right time, these investments will become attractive again.
Diversify Amongst Different Classes of Fixed Income
I firmly believe that investment diversification is about the only free lunch in town. Fixed income is no exception. Here's how I have diversified my fixed income segment:
High Yield Bonds: The high yield, or "junk" bond space offers several important differences versus general corporate or government securities. Foremost, the price of these offerings are driven more by credit risk and less by interest rate risk. Therefore, high yield bonds generally perform well when the issuer default rates are low. The default rate is most likely to be lowest during periods of economic growth. Indeed, my second general premise is aligned with a continued investment in these instruments.
When is it time to get out?
I utilize the following indicator: determine the spread between the U.S. treasury ten-year note (constant maturities) and the Moody's seasoned Baa corporates. When the spread falls below two percent, it's time to reduce exposure. Daily selected interest rates may be found on the Federal Reserve Board web site found here. The current differential is 2.62 percent.
Therefore, rock on, high yield.
I go the fund route when investing in the high yield bond category. I have neither the time or expertise to create a diversified junk bond portfolio. Personally, I like the Pimco High Yield Bond Fund (PHIYX), but there are a number of other decent funds and ETFs out there.
Convertible Bonds: Convertibles are hybrid securities that combine the investment characteristics of bonds and common stocks. Typically, these investments are structured so that bonds may be converted into stock upon certain triggers or events.
Similar to my approach to high yield bonds, I prefer to let a professional fund manager handle these securities for me. My clear choice is the Vanguard Convertible Securities Fund (VCVSX), sporting a low 0.52% expense ratio.
When is the time to downsize convertible bond investments?
My indicator for these investments is the yield spread between the convertible bond(s) and the Moody's AAA seasoned corporates. In this case, when the spread is greater than two percent, it's time to head for the exits.
Currently, the VCVSX fund yields 2.30 percent. AAA corporates are at 4.52 percent. The 2.22 percent spread is above my target, so I've been taking profits in this category. I always scale in or out of any investment: never all-in or all-out.
TIPS (Treasury Inflation Protected Securities): I find little to excite me about this niche of the market today. Nonetheless, I continue to hold a placeholder stub position. This is another bond category whereas I prefer to invest via a fund or ETF manager.
Foreign Bonds: Importantly, I highlight the universe of international fixed income securities. While the U.S. is has a ZIRP (zero interest rate policy) with little room to reduce rates further, other places around the globe are facing a far different set of economic or monetary circumstances, thereby allowing such bonds a place in my portfolio.
Once again, I believe this bond category is best left for the professionals. My choice is the Templeton Global Bond Fund (TGBAX), a year-in and year-out top performer, currently yielding 5.65 percent.
Hedge a Little
Since my view is that interest rates are set to rise, at some magnitude and over some extended period of time, I have decided it's acceptable for me to sacrifice an element of future "potential" fixed investment capital appreciation (which I believe is quite low) in consideration for a little capital protection hedging.
For this purpose, I have taken a starter position in the ProShares Short 20+ Year Treasury ETF (TBF).
Investors should read the prospectus thoroughly and understand what and how this fund is attempting to do. Yahoo Finance offers a short explanation how this fund operates:
The investment seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the Barclays U.S. 20+ Year Treasury Bond Index. The fund invests in derivatives that ProShare Advisors believes, in combination, should have similar daily return characteristics as the inverse (-1x) of the daily return of the index.
I have highlighted parts of the above that I believe require particular attention.
In my case, I have accepted the risks and ETF fees (0.95%) in consideration for the potential to at least partially hedge short to medium-term upward rate volatility. I do not view the TBF as a long-term investment, and I plan to watch its performance versus expectations carefully. My objective is for TBF units to appreciate if rates continue to rise, thereby hedging some of my Pimco domestic bond fund, which will likely decrease in value. On the other hand, this ETF will fall inversely if rates drop back; but the BOND should appreciate.
The year-to-date ProShares Short Treasury ETF inverse relationship with the Pimco BOND ETF has been demonstrable. A 2.5:1 ratio would have offered a full hedge. However, please note that prior to the May interest rate spike, the returns on both ETFs bobbed up and down nearly on par.
Pimco Total Return ETF v. ProShares Short 20+ Year Treasury ETF
Courtesy of google/finance.com
My ownership thesis for this investment vehicle includes purchasing only a ratio of the TBF as a function of my investment in the BOND ETF. Here's why. The ProShares fund:
- pays zero income
- is managed completely unlike the Pimco Total Return ETF; indeed, Total Return may itself use hedges in an attempt to mitigate interest rate risk
- has a history of being considerably more volatile than Total Return
- may provide some buffer during times of more steeply rising rates, but is less likely to be an efficient investment during times of flat rates
I currently target a 3:1 BOND v. TBF ratio. I reserve the right to change my mind.
Summary and Conclusion
I believe we have seen the bottom of some thirty years of declining interest rates. While I make no prediction as to the prospective path or duration of prospective interest rate increases, I nonetheless premise the probability of rates now trending higher is considerably greater than revisiting and sustaining the 1Q 2013 historic lows.
I envision we have passed a fulcrum or tipping point, so to speak.
Therefore, I have and will continue to take steps to proactively manage the fixed income portion of my portfolio accordingly. This includes reducing exposure to debt instruments; avoiding general domestic bond funds; stressing ownership of select, high-grade, individual corporate and municipal bonds; diversifying fixed income holdings across several categories; and instituting limited and carefully managed hedging activities. I halted the purchase of any additional U.S. treasury securities several years ago.
Disclaimer: This article contains premises and strategies that the author has determined are appropriate for himself. These assumptions and actions are not intended for any other individual or collective investors. Please do your own due diligence and only purchase securities that fit your own investment premises, style and risk profile. Good luck with all your 2013 investments.