How To Minimize Fixed Income Portfolio Risks

|
Includes: AGG, TIP, TLT
by: Roger Nusbaum

A reader left the following questions;

At this point in the cycle, when everyone is hammering that bonds are expensive, if one's stock/bond allocation is tilted too highly towards stocks due to the recent uptrend, how should new money be allocated? Is holding cash appropriate?

The first thing to note is that this was an anonymous comment so obviously there is no way an RIA can give specific advice to an anonymous commenter on a website.

As for holding cash: If someone can afford it then I do believe in some sort of cash cushion as an emergency fund. Some would tell you this should be the priority over having an investment portfolio, some would suggest an emergency cash fund should be the secondary priority to an investment portfolio. I don't have one answer here which is why I say if you can afford it.

The other aspect to cash is holding some cash tactically in an investment portfolio which I think is fine and we often do have some cash in the portfolio. With where interest rates are, cash that is in an emergency fund will not grow, which is obviously a tradeoff for the peace of mind that someone might get from having a sum of money for the unexpected. Cash waiting to be deployed in an investment portfolio will also not grow which is a tradeoff for the ability to be opportunistic.

As far as bonds being expensive that is generically the case but not universally true and investors need to decide what it is they are trying to do with the bond portion of the portfolio. Longer term treasuries have been dangerously expensive for a while but have continued to climb in price. Why can't the ten year U.S. treasury yield go down to 1.5%? Japan's did. If it does go to 1.5% then some people will have had a very good trade. There is obviously some percentage of the time where buying at the all time high (or close to it) works out to be a great trade.

Great trades are not the primary objective for how we manage fixed income portfolios for clients. The very low interest rates that exist in most segments of the bond market creates interest rate risk. As a general rule for each 100 basis point increase in the interest rate the price of a ten year bond will drop about 8%. The price drop for a longer dated bond under the same circumstance will drop even further in price. With an individual bond you will get your principal back (assumes no default) but waiting for eight or nine years while collecting below market interest is not ideal. Of course bond funds have no par value to revert back to. If/when interest rates normalize (think 5-6% for high quality ten year paper) there will be some bond funds (both indexed ETFs and actively managed funds) that will get decimated. A couple of Sundays ago I mentioned TLT dropping 6% when the ten year yield went up just a few basis points.

As disclosed in previous blog posts our path has been to minimize exposure to what appears to be the most obvious risk facing the bond market which is interest rate risk. We have a large portion of our fixed income exposure in short dated, investment grade corporates (individual issues). If rates skyrocket starting today the price of these short term issues will not tank because of how close they are to maturity. We might be collecting below market interest (that is if rates do go up a lot) for 18-24 months as opposed to eight or nine years as mentioned above.

We also have a large portion in individual foreign sovereign debt that is also short dated. In some cases the yield is pretty close to normal like Australia and in other cases the idea is owning very fiscally sound economies like with Norway. We also use an emerging market debt ETF to round out our foreign exposure.

We take a little bit of interest rate risk with a couple of funds (one CEF and one traditional mutual fund). The yields are pretty good but they are funds so there would be no par value for them to return to. Another good source of yield are individual preferred stocks. We own one from a bank and one from a REIT. Again the yields are good; high fives, low sixes. I am not a fan of the preferred stock ETFs, all the ones I've ever looked at are heavy in financial companies that I want no part of.

The last segment we have exposure to is inflation protected. The percentage allocated depends on the age of the client. Someone who is 50 will generally have more exposure here than someone who is 70. I think ETFs can be used in this space. We own the iShares TIP ETF (NYSEARCA:TIP) and while it is not up as much as TLT since we bought TIP it has done well with very little relative volatility.

For a couple of the segments above, as noted, I prefer individual issues but that may not be ideal for individual investors managing their own portfolios but there are ETF solutions that I think can work. For corporate bonds I would look to the BulletShares product line from Guggenheim and I think iShares is on to something with the recently launched corporate sector ETFs.

You need to look under the hood of anything but with the BulletShares you have to know how they work. The 2016 fund, symbol BSCG, isn't really a 2016 fund. There are issues in there that start maturing in February of that year and the proceeds will be held as cash until the fund terminates. I didn't take a complete inventory but at some point in the middle of the year the fund might be 50% cash. Maybe it is better to think of the 2016 fund as more of a 2015 fund but either way I think they can be very useful for individual investors who have taken the time to look under the hood.

There is also utility with the foreign bond ETFs too. iShares and SPDR have some funds here but PIMCO and WisdomTree seem to be doing more interesting things here. The broader funds tend to be heavy in Japan and Europe which are not great places to be. Our emerging market bond fund is the PowerShares fund with symbol PCY -- obviously we think that is good fund to hold.

This was a long post but hopefully creates some understanding of spreading things across many different segments of the bond market as a way to reduce certain types of risks. Risk can't be eliminated of course but the potential impact can be minimized somewhat. The other observation is that I am not a fan of broad based funds as a first choice for accounts large enough for it to make economic sense to have many exposures. A $100,000 account for a younger person with a 25% allocation bonds probably can't take on eight different fixed income positions so something like the iShares Aggregate (NYSEARCA:AGG) does make sense.

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