It is a question investors avoid and a scenario people dread, but investors must ask themselves about the durability of their portfolio. While no investor knows precisely when the next collapse will come or what will cause it to occur, the simplest strategy for achieving alpha (risk adjusted returns over the market) is to focus on reducing the downside risk. I follow this technique within my own portfolio and my holdings are skewed toward the defensive side. In this article I'm going to ask the questions and provide the answers to building a portfolio that can withstand downturns.
Types of Investments
Start with a few broad types of investments:
I like to see the preferred shares as their own class because they share some characteristics with both bonds and traditional (common) equity. However, they also offer some very unique characteristics that can assist in building a stronger portfolio.
The first part of this series focused on finding the right allocations for domestic equity.
The second part of this series focused on finding the right allocations for international equity.
This is part 3 and it will cover both bonds and preferred shares.
The above suggestions on international equity could also be taken to apply to international bonds. The major focus here will be related to domestic bond investment.
Limited Capital Gains
Capital gains were a major source of returns for bond investors over the last 15 years. If an investor was buying long duration bonds, the capital gain on their position would be huge. The rates on bonds denominated in USDs (United States Dollars) are already fairly low. As of early April the 10 year treasury had a yield of 1.73%. This is substantially higher than international bonds in German or Japan where the 10 year yield runs around 0%. In some cases the yield on the 10 year in those markets is negative.
Due to the low rates on bonds, huge capital gains would be very unlikely since it would require rates to follow Germany and Japan into negative territory. However, the capital loss may also be limited as I don't believe long term rates can soar domestically while being at negative levels internationally.
For a fairly defensive bond allocation, there are a few investments I like. The Vanguard Total Bond Market ETF (NYSEARCA:BND) is a great option for high quality. I'm using the Schwab U.S. Aggregate Bond ETF (NYSEARCA:SCHZ) in my portfolio. The ETF's allocations are very reasonable. For investors wanting to take on longer durations to get a better yield, I see the additional yield on high quality corporate debt to be very attractive. My suggested ETF there is the Vanguard Long-Term Corporate Bond Index ETF (NASDAQ:VCLT). Investors in VCLT should be especially wary of the bid-ask spread though. The spread has a tendency to widen during market sell offs events such as the one investors witnessed this winter. I wanted to get some VCLT while the market was weak, but I wasn't willing to cross a bid-ask spread that expanded to more than 1%.
Investors may be too quick to look at the bonds of a business and ask about the value of the assets that could be used to satisfy those bonds. While that is one part of the analysis, it is also very important to look at the operations of the company. If a company is defaulting on their bonds, it is unlikely to be a result of making too much money. Defaults will come from companies that are failing to make money. If they were unable to turn a profit with those assets, it is an indication that surviving competitors may want to bid much lower prices on the assets.
I never want to buy bonds on the premise that the bankruptcy courts would take care of me. I want investments to be based on a reasonable yield given the risk and an expectation that the company will survive, earn profits, and be able to return my cash.
The preferred shares come last because they incorporate several of the things that were just discussed. The most important one should be the fundamentals. If the underlying company has a weak business model, the preferred shares are not safe either. There are some opportunities where a mediocre business can offer a great investment in preferred shares, such as Gladstone Commercial Corporation (NASDAQ:GOOD). I own some of the O series of their preferred shares. I was able to buy them at only a hair over the accrued dividend and accrual since then would already cover the premium I paid if they were suddenly called.
Watch out for Leverage
Investors buying into the preferred shares should be very careful in assessing what levels of leverage they are willing to tolerate. They will want to look at the debt to equity ratio, but the ratio can be misleading. Using book value for debt is fine and book value for a mortgage REIT is a reasonable value, but for most holdings investors will want to consider what percent of the total enterprise value (market value of all stock plus debts) is coming from each category. A small percent coming from common equity should be a red flag.
Watch out for Debt Timing
All else equal, a company that fails to diversify the due dates on their debt has done a poor job of protecting shareholders. Management of a company should strive to never need capital. Such a situation gives the company a much weaker bargaining position and can force them to pay much higher costs to get the loans. In a worst case scenario, they might even default if lending standards were suddenly tightened. For the preferred shareholder, the expected annual return is not exceptionally high. Taking a few hits to the portfolio from this kind of event could severely damage returns.
By the same token, if the company has access to lines of credit (they'll discuss this in their 10-K filings), it is a positive sign. Access to cash on demand from multiple lending parties means management should have a better negotiating position.
Check Common Price Movements
This is nowhere near doing proper due diligence, but it can be a very quick step to get an idea for the prospects of the company. If common shares are in a massive slide, perhaps down over 30% in the last year, investors should ensure that they understand precisely what is threatening the common shares before they buy into the preferred shares. The common stock can be a bit of a canary in the coal mine in this regard since it will usually get hammered much harder and first.
I have a couple other points to make that are not directly tied to any of these asset classes. The first is to avoid high cost producers in all areas. The high cost producers are significantly more likely to be taken out during a depression. In a prolonged bull market these producers may do exceptionally well because they are usually going to be cheaper to buy, but investors have to weigh the additional risk.
The next suggestion is to hold some cash. The cash takes care of two challenges. The first is that it helps the portfolio value remain steady and the second is that it gives investors the opportunity to buy when the market dips. In my experience, having cash on hand can help an investor keep a more balanced view of the market because they want their holdings to perform well but they also want to find new opportunities for investing.
The last one is that investors should avoid personal leverage when possible. Personal leverage is things like carrying an excessively large mortgage or car loans. Unless the investor has a plan where they believe it is materially possible for them to discharge the debt for less than the carrying balance, they are likely to be paying more in interest than they can expect to earn high quality debt. There are certainly some exceptions to this rule, but it is a reasonable starting point.
Disclosure: I am/we are long GOODO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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