Why a Diversified Fixed Income Portfolio Is Crucial

Includes: AGZ, LQD, PFF, PSK
by: Bernard Thomas

The FOMC meets this week and the result of the meeting will be... nothing. Oh sure, maybe we will see marginally more positive language in its statement, but the Fed is likely to leave policy unchanged. The Fed’s refusal to acknowledge the strength of the economic recovery has many market participants perplexed.

If one is perplexed it is because one does not understand what troubles the Fed. Mr. Bernanke and his merry band are concerned that employment is not recovering quickly enough. Not only that, but the FOMC does not see a segment in the economy which is poised to create large numbers of good paying jobs. Unlike many economists and strategists, the Fed is looking beyond models which indicate that jobs “always” recover and that hiring is just around the corner.

Recent data indicates consumers are dipping into savings to fuel their resurgent spending habits. This is not because they have found religion and reformed from their debt-laden ways. It is because they lack both disposable income and access to credit. If jobs are not created somewhere in the economy to keep the drive going, consumer spending could wane once savings are depleted.

Alright, we all know my opinion of jobs and inflation. I believe they are both likely to grind higher (as they have been). However, one should be prepared if the economy and inflation catch tailwinds. As with any task, one needs the correct tools. The problem is that investors do not always know what tool to use.

Some investors are like do-it-yourself home repairers in that instead of assembly all of the appropriate tools to complete a task they try to accomplish their task by using an all-in-one multi-tool. This is what some investors are doing with their portfolios at the current time. Instead of constructing a diverse fixed income portfolio featuring a variety of vehicles with staggered or laddered maturities, they purchase the latest and greatest adjustable-rate or floating-rate note.

Investors and some financial advisers have been sold a bill of goods that floating-rate securities protect one’s portfolio against rising “interest rates” or rising inflation and will always trade at or near par. This is not the case. Look at it from the issuer’s (borrower’s) perspective. If their cost of financing is going to rise just because some rate rises, why issue a floater when rates are low.

The answer lies in debt schedules. Borrowers, be it the corporations, municipalities, etc. need to spread their maturities out over the course of time. What they try to do is to issue long-term debt with coupons which float off of short-term benchmarks. This explains why there has been a plethora of long-maturity (but callable) bonds with coupons which float off of short-term benchmarks, such as three-month LIBOR. However, when it becomes more likely that short-term rates will rise due to possible Fed policy shifts (all U.S. dollar short-term rates are influenced by the Fed Funds rate) bond issuers will offer fewer adjustable-rate vehicles and offer more fixed-rate securities.

Another possibility is that they will issue bonds which float off of the 5-year treasury because the middle portion of the yield curve tends to be the least volatile or they will simply offer spreads over benchmarks so tight that the underlying benchmark has to sky-rocket for investors to be rewarded. Of course, most of these bonds have call features. This enables issuers to leave the bond outstanding when the bond is providing a cheap source of financing, but permits issuers to call in the bond when it is to their advantage.

Instead of searching for the magic tool which allegedly performs all tasks well, it is better to construct a laddered and diverse fixed income portfolio, if rates rise, the short-term bonds will mature and permit reinvestment at a higher rate. Also, a rising rate environment usually means an improving economy. This can cause the credit spreads on corporate bonds to narrow which can help offset higher treasury yields.

A laddered and diversified portfolio also protects against low or lower interest rates by locking in a portion of one’s capital at comparatively-high rates for an extended period of time. A portfolio is like a tool box, it should be stocked with a variety of tools which come in handy in a variety of situations.

A portfolio might consist of CDs on the short end of the curve, callable government agency bonds in the 4-7 year areas (step-ups work nicely) and corporate bonds (especially those issued by banks, finance companies and insurance companies) in the 7-10 year area of the curve. If yield needs to be juiced further one may consider non-cumulative traditional preferreds with coupons over 8.00% as their short duration helps to lower volatility while providing high income. Of course these are only suggestions.

The Wall Street Journal Credit Markets column puts forth yet another theory on why the yield curve is steep at the present time. The Journal opines that it is because the U.S. could lose its AAA credit rating. It is much more likely that the curve is this steep because the Fed has promised to keep the Fed Funds rate near 000% for an extended period of time and that the fear of deflation is dissipating. If fears that the U.S. is close to losing its AAA credit rating (or that inflation was poised to explode), the yield of the 10-year note would not be inside 3.50%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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