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, Buckingham (110 clicks)
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Summary

  • Investors who need better returns than high-quality bonds will provide should adjust their portfolio’s equity allocation, not stretch for yield.
  • Credit risk in lower-rated bonds is mostly equity risk in disguise.
  • Building an individual bond portfolio allows investors to avoid mutual fund fees while tailoring credit and term risk to their specific situation.

The Federal Reserve's zero-interest rate policy is now well into its fifth year, probably far longer than most - if not all - investors were expecting. This persistence of low interest rates has pushed many investors to stretch for greater yield from their bond investments. One way to achieve higher yield is to take on more credit risk through the purchase of lower-rated bonds. Many argue that higher-yielding bonds also provide some diversification benefits. While this is true, the low average correlation between lower-rated bonds and stocks has a nasty tendency to dramatically increase at exactly the wrong time, such as when equity risk shows up. As my colleague Jared Kizer and I discuss in our book, The Only Guide to Alternative Investments You'll Ever Need, this should come as no surprise because high-yield bonds are basically hybrid securities. Some of the risk in high-yield bonds is unique, but much of it can be explained by certain types of risk in common with equities and Treasury bonds. In other words, credit risk is mostly equity risk in disguise. If investors were unaware of this, 2008 should have provided ample instruction.

Because of this nasty tendency, we advise investing only in the highest investment-grade bonds, limiting purchases to AAA/AA bonds. For investors who need a higher return than such high-quality bonds provide - and who also have the ability and willingness to accept greater risk - we believe the superior strategy is to increase either a portfolio's equity allocation accordingly or increase its exposure to small and value stocks while holding the equity allocation unchanged to access the higher expected returns of these asset classes.

Before looking at the historical evidence, it's important to note that one advantage of limiting your portfolio's holdings to only the highest investment-grade bonds is that you won't need the broad diversification benefits provided by mutual funds and that are required when taking on more idiosyncratic risk. The need to minimize idiosyncratic risk is why we advise using mutual funds for equities but can build individual bond portfolios. Building an individual bond portfolio allows investors to avoid mutual fund fees while tailoring credit and term risk to their specific situation. There are also significant benefits for taxable accounts. They include:

  • The ability to harvest losses at the individual security level.
  • The ability to tailor a portfolio to take advantage of an investor's place of residence, avoiding bonds from high-tax states such as New York and California, where bonds typically carry low yields.
  • The ability to tailor a portfolio to specific individual tax rates and yield curves. For example, at times the highest yields can be for taxable bonds or CDs at the shorter end of the curve, but for municipals on the longer end.

Consider the following two examples, each covering the same 20-year period from 1994-2013. The first example compares returns from a typical 60 percent equity and 40 percent bond portfolio using A-rated municipal bonds to returns from a portfolio that limits its bond holdings to AA-rated municipals. To compensate for lower yields on AA-rated bonds versus A-rated bonds, we'll shift our allocation to 62 percent equity and 38 percent bonds. In both cases, we'll use the Barclays Aggregate indices for our bonds; equity allocations are split two-thirds to the S&P 500 index and one-third to the MSCI EAFE index.

1994-2013

60/40 With A Rated Munis

62/38 With AA Rated Munis

Average Monthly Return

8.2

8.2

Compound Return

7.4

7.4

Volatility

12.3

12.2

2008 Performance

-25.9

-24.4

As you can see, the two portfolios had identical compound returns (7.4 percent) and experienced virtually the same volatility (12.3 percent versus 12.2 percent). However, the portfolio with A-rated bonds experienced the period's worst-case loss (-25.9 percent versus -24.4 percent), which occurred in 2008. Not only was there no benefit in terms of improved returns, but the portfolio with AA-rated bonds experienced a more significant worst-case loss despite its higher equity allocation. The size of a portfolio's worst-case loss is particularly important for investors in the withdrawal stage of their investment life cycle because assets that are withdrawn permanently from the portfolio cannot benefit from future recoveries.

The second example uses the same analysis, but now compares a portfolio holding even higher-yielding BBB-rated municipal bonds to our portfolio with AA-rated municipals, again with its equity allocation shifted higher to account for lower yields. Remember that the lower a bond's credit rating, the higher its correlation with equities - it's essentially equity risk in disguise. We then compare returns from the typical 60 percent equity and 40 percent bond portfolio using BBB-rated municipal bonds with equities allocated two-thirds to the S&P 500 index and one third to the MSCI EAFE index to returns from a portfolio with 66 percent equities and 34 percent bonds using AA-rated municipal bonds. Equities in both cases are split the same way.

1994-2013

60/40 With BBB Rated Munis

66/34 With AA Rated Munis

Average Monthly Return

8.3

8.4

Compound Return

7.3

7.6

Volatility

13.6

12.9

2008 Performance

-32.0

-26.0

Here we see that the portfolio with the higher equity allocation and the higher-quality bonds not only produced higher returns (7.6 percent versus 7.3 percent), but also experienced less volatility (a standard deviation of 12.9 percent versus 13.6 percent) and a significantly smaller worst-case loss (-26 percent versus -32 percent) in 2008.

The bottom line is that investors shouldn't be tempted to stretch for yield. It's simply not the most efficient way to take on incremental risk, even if you have the need, ability and willingness to take that risk.

Later this week, we'll examine the impact of taking credit risk with taxable bonds.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Do Lower Investment-Grade Municipal Bonds Add Value?