Newsletter Fall 2010
         

In This Issue

        
Fixed Income Risk in your Portfolio

Focus on the things within your control.
The Lure of Individual Bonds
Taking Stock of Stock

                                                              Mark Sladkus

        

 

 

 

 

 

 
 

         

 

 Fixed Income Risk in your Portfolio

With interest rates near historical lows, some investors may be anxious about a possible interest rate increase and its potential impact on their fixed income investments.  Bond prices have an inverse relationship to interest rates.  Rising interest rates typically cause bond holdings to lose value.  To help mitigate this risk, our clients’ bond portfolios have a relatively short maturity.  The price sensitivity is less for shorter-term bonds as will be demonstrated below.  Treasury Inflation Protected Securities (TIPS) are also often used to protect against the potential for inflation.  TIPS can have a longer maturity since their principal payment is indexed to the rate of inflation. 

Rate movements in either direction affect aggregate portfolio returns.  This is true in any market environment, regardless of the current rate level. The larger question is how to manage the risk of changing interest rates. As you read the financial headlines, proclaiming the inevitability of higher interest rates, and evaluate your current fixed income exposure, it may be helpful to consider the following principles about fixed income investing.

Interest rate movements are unpredictable.

Academic research offers strong evidence that the bond market, like the equity market, is efficient, and that bond prices and interest rates are not predictable over the short term.1 This uncertainty is reflected in the often-contradictory interest rate forecasts offered by economists, analysts, and other market watchers.2

Even when the experts share similar views on the direction of the economy and credit markets, reality often proves them wrong. Last year’s Wall Street Journal forecasting survey offers a recent example.3 Among fifty economic forecasters surveyed in 2009, forty-three expected the ten-year US Treasury note yield to move higher over the next year, with an average estimate of a 4.13% yield. Only two respondents predicted rates to fall below 3.00%. In reality, the ten-year Treasury yield slumped to 2.51% on September 30, 2010, and rates on thirty-year mortgages fell to their lowest level since Fannie Mae began tracking them in 1971.  Clearly, the 50 forecasters predicted poorly.

Today’s bond prices already reflect expectations for tomorrow’s business conditions and inflation, and these expectations can change quickly in response to new information. Accurately predicting this new information on a consistent basis is not possible. Investors who accept market efficiency should not be surprised when the credit markets foil the experts. If prices were easy to forecast, you should find a host of fixed income managers with market-beating returns. But most of them underperform their respective benchmarks over longer time periods.4

Since no one has a reliable method for determining whether interest rates will rise or fall in the near future, investors should avoid making fixed income decisions based on a forecast, media coverage, or their own hunches.

Pursuing higher expected returns requires more risk taking.

The strong link between risk and return appears in all properly functioning capital markets. When investing in stocks, bonds, or other assets, investors must accept more risk to pursue a higher potential return.

In the fixed income markets, earning a return above short-term government instruments is usually a function of assuming more term and credit risk. Term risk refers to a bond’s maturity, and credit risk refers to the creditworthiness or default potential of the borrower. Bonds with longer maturities and/or lower credit quality are usually considered riskier and have offered higher yields to compensate investors for higher risk.

On the term side, investors who commit their capital for longer periods of time are exposed to the amplified effects of changing interest rates. As stated above, bond prices and interest rates move in the opposite direction. The longer the bond’s maturity, the greater the price adjustment for a given interest rate change.  The price of a long-term bond is more exposed to rate changes than a short-term instrument, and usually (but not always) offers a higher yield to compensate investors for the extra risk.  See table, below. 

Table: Bond Price Change for an Immediate 100 bp (1%) Increase in Interest Rates

On the credit risk side, the U.S. Treasury is considered the strongest borrower in the market, so it has a lower cost of capital relative to other issuers. The weaker a corporate borrower’s financial condition, the more it must pay in yield to attract investors. Investors seeking higher returns on the credit spectrum must bear a higher risk of default.5

 

Investment strategy should drive fixed income decisions.

Investors may hold fixed income securities for a variety of reasons—for example, to reduce portfolio volatility, generate income, maintain liquidity, pursue higher returns, or meet a future funding obligation. Each objective may involve a different portfolio approach, or a combination of strategies to manage the various tradeoffs.

Regardless of your approach, an investor should know the difference between controlling risk and avoiding it. You cannot eliminate risk, but you can manage your exposure by diversifying across maturities, industries, credits, countries, and currencies to reduce the impact of rates, inflation, currency fluctuations, and other risks. Your decision to take more or less term and default risk may depend on the current shape of the yield curve and the level of credit premiums.

Many factors influence the direction of interest rates and performance in the bond markets, and these are too complex for anyone to reliably predict. Rather than placing your faith in the “experts” or reacting to economic news, manage your fixed income component from a portfolio perspective. Your strategy should reflect your overall investment goals, risk tolerance, and other personal financial considerations. This is the proper approach to configure your fixed income exposure in managing your portfolio in an uncertain interest rate environment.

Endnotes

1 Eugene F. Fama, “The Information in the Term Structure,” Journal of Financial Economics 13, no. 4 (December 1984): 509-528. Also: Robert R. Bliss and Eugene F. Fama, “The Information in Long-Maturity Forward Rates,” American Economic Review 77, no. 4 (September 1987): 680-692.

2 Mark Gongloff, “Two Treasury Forecasts: a Grand Canyon-Size Gap,” Wall Street Journal, April 10, 2010.

3 Wall Street Journal Forecasting Survey, www.wsj.com, accessed July 7, 2010.

4 Christopher R. Blake, Edwin J. Elton, and Martin J. Gruber, “The Performance of Bond Mutual Funds,” Journal of Business 66, no. 3 (July 1993): 371-403. Also see Standard & Poor’s Indices Versus Active (SPIVA) Scorecard for the US, Canada, Australia, and Europe (http://www.standardandpoors.com/indices/spiva/en/us).

5 The yield curve plots the current relationship between rates and maturity, and the credit spread plots the risk-return relationship across the range of credit qualities. The curves offer a current snapshot of how markets are pricing term and credit exposure.

 

 The Lure of Individual Bonds

 

Some investors seek out, or more likely are sold, individual municipal and corporate bonds.  Buying these bonds, rather than a bond mutual fund, may seem like an opportune way to customize and or optimize fixed income exposure.  Bond brokers will sometimes claim that their research team can unlock undiscovered gems for their retail investors.  Caveat Emptor.

There are at least four reasons why buying individual corporate or municipal bonds may be unfavorable in comparison to buying bond institutional mutual funds.

Lack of diversification:  Just as with equities, diversification reduces risk.  Investment theory and common sense argue that investors are not compensated for idiosyncratic (unsystematic) risk.  Investors who were unfortunate enough to own BP were reminded of this recently. In early 2010, investors who purchased the BP bond expiring 4 years later were fairly certain that they would be getting their principal back on this investment grade, cash rich company.  Yet by June of 2010 those same investors had lost 15% of their investment. (Source: Morningstar: Bond Market Insights, June 17, 2010).  Mutual funds, by contrast often own thousands of bonds effectively eliminating the credit risk of an individual issuer.

Lack of economies of scale:  When it comes to bonds, size matters.  The biggest trading cost is transaction size, as there are significant economies of scale when it comes to purchasing corporate or municipal bonds.  As trade size increases, prices decrease.  An article in the Journal of Finance (1) estimated large trades cost only 4 basis points where as small trades can cost 75 basis points.  The graph below illustrates the significant discounts afforded by very large purchasers of corporate bonds e.g. mutual funds.  With bonds yielding so little, investors purchasing individual bonds risk losing most of their income to transaction costs.

Lack of liquidity: Many investors own bonds to reduce the volatility of their portfolio.  For these investors, bonds serve as the more conservative portion of a portfolio.  Unlike stocks, where millions of shares can be transacted daily, bonds trade infrequently.  Municipals in particular can trade very infrequently.  It is not uncommon for a specific municipal bond to not trade for months or even years. If you need to sell an individual bond, you could sacrifice a large portion of the bond’s value.  A high quality Municipal can easily have a bid/ask spread of 5 - 7%.  (The spread is the difference in what you would pay to purchase a bond vs. what a dealer would pay you if you needed to sell the bond.) In contrast, a bond mutual fund allows you to redeem at the fund’s net asset value should you need to sell. 

Lack of transparency in pricing:  Unlike stocks, corporate and municipal bonds primarily trade over the counter, between two dealers.  There is no exchange to check the current price. With so little trading it can be difficult to judge whether the price that you are quoted is fair.  This helps to explain why bonds can be very lucrative to the brokers who sell them.  The lack of transparency, even for high quality bonds, means it is very difficult to know if you are getting a fair price.  And the frictional costs of trading (bid/ask spread) are very high for all but the largest trades.  In contrast, mutual fund prices are transparent.  As mentioned above, you can buy or sell daily at the fund’s net asset value.

Many investors, even those with very large fixed income assets, are better served by investing in an institutional mutual fund. 

(1) Edwards, Amy K., Lawrence E. Harris, and Michael S. Piwowar. 2007. Corporate bond market transaction costs and transparency. The Journal of Finance 62(3):1422.

Taking Stock of Stock

In the first six months of 2010, we witnessed multiple events that led many to question whether the global economy was on a path to recovery.  These events included the rising levels of the national debt of Greece, Ireland, Portugal and Spain, (and its implications for the banks that own the debt); the volcanic eruption in Iceland; the Gulf oil spill; and political tensions emanating from North Korea and Iran. 

Many investors acted on their fears by reducing their exposure to risky assets.  As is often the case, acting on emotions is a poor way to allocate assets.  In the third quarter, the markets had excellent performance.  For example the S&P 500 was up 11.29% and developed markets, as measured by MSCI EAFE, was up 16.48% for the quarter.  Once again staying disciplined – changing your asset allocation only when needs or circumstances change – is likely to be the most rewarding strategy.

In a recent article(1) in the Sunday New York Times, titled Taking Stock, the venerable financial journalist, Roger Lowenstein, draws comparisons to today’s mood and that of the late 1970’s.  During the 70’s investors had lost so much confidence in our financial system that they pulled money out of equity mutual funds for 8 years.

  “Investors in the ’70s were stunned by an alarming rise in volatility. The comfortable, ordered system of international exchange, in place since the Bretton Woods accord at the end of World War II, had come apart, leading to violent fluctuations in currency values. Grain shortages sent food prices soaring, and memorably, OPEC put the squeeze on oil. The cumulative effect was a loss of faith in money itself. (Doomsayers urged redeploying assets into metals, oils — anything other than paper.) Inflation, a virulent form of instability, terrified investors, who duly stayed on the sidelines.”  

 

The lack of confidence in our political and financial system seems all too familiar.  As with the 1970’s, the depth and breadth of the problems that we face can seem overwhelming.  High unemployment, huge budget and trade deficits, a housing collapse, and a profound distrust of our political system are but some examples of such problems.  Despite all of these issues, it has historically been more profitable to buy on bad news and sell when things look rosy. 

For example, when the market reached its recent trough back in March of 2009 there was little good news to be found.  But those waiting for confirmation that economic conditions had improved before investing in equities missed the opportunity to participate in the subsequent rise in equities.  Conversely in late 1999, before the technology crash, little bad news was evident.  Many investors tended to increase their equity exposure, particularly to technology stocks, at exactly the wrong time.

In 1979 Business Week’s infamous cover story proclaimed “The Death of Equities.”  It is worth noting that from the following year through the next two decades (Jan 1980 –Dec 1999) the average return on US equities was 17.9%.  In Lowenstein’s recent article he continues:

  “In markets, of course, gloom is no more permanent than boundless optimism.  For the previous generation the turn arrived in 1982 – three years after “The Death of Equities."  It was fueled by corporate raiders, who could not resist seeming bargains on Wall Street and whose takeover bids sent share prices soaring.  There is no telling how long the present funk will last, but there are signs it could end in similar fashion.  Corporations in droves have been exploiting low interest rates by borrowing.  IBM raised $1.5 billion at a record-low interest rate of 1 percent.  It used a chunk of its haul to acquire a software vendor.  Borrow cheap and buy low.”   

We can’t predict the future.  This quarter’s performance (and the market’s performance year-to-date) reminds us that the disciplined investor is far more likely to be rewarded then is the investor who attempts to time the markets by exiting when the news is bad and buying when events seem more optimistic. 

(1) Lowenstein, Roger “Taking Stock.” New York Times 27 August 2010

   
     

 

 

     

 

 

 
 
 
 

 

 

Disclaimer: This newsletter is for information purposes only.  Past performance is no guarantee of future results.  While the information and data contained herein is believed to be reliable, we do not represent it as accurate.  Any opinions expressed herein are subject to change without notice.  Nothing contained herein should be considered a recommendation to buy or sell any security or fund. 

Red Lighthouse Investment Management, LLC is a fee-only registered investment advisory firm based in New York City. 

Red Lighthouse Investment Management - 212.799.3532 - www.redlighthouseinvestment.com

 

Copyright 2010 Red Lighthouse Investment Management, LLC