Wednesday, May 1, 2013

Rebalancing Portfolios In An Era of Low Interest Rates

Last Friday's Financial Times reported that Norway's oil fund - the world's largest investment pool - has reduced its bond holdings to their lowest level since the fund's inception in 1996.

According to the article, the fund held just 36.7% of its $726 billion in fixed income at the end of the first quarter.  Equity holdings, meanwhile, were 62.7% of the portfolio, which is close to a record high.

Here's a quote from the article:

Yngve Slyngstad, the fund's chief executive, told the Finanical Times there had been a significant change in rhetoric away from its previous comments that it was comfortable with a high level of equity holdings.

"Now it is that we are not so comfortable with the low returns in the bond portfolio.  It is not enthusiasm for the equity market but a lack of enthusiasm for the bond market," he said.

Many investors, including myself, share Mr. Slyngstad's feelings about stocks relative to bonds.

The S&P 500 is up nearly +13% for the first four months of 2013, but few are enjoying the ride, it seems.  Memories of the 2008 bear market remain fresh in most investors' minds, and the recent patch of soft economic data does little to inspire confidence.

Still, relative to bonds, stocks have not been as cheaply valued since 1980, so it is hard to make a convincing case to more into more fixed income investors.

The rebalancing act is particularly difficult if you are an individual investor who has to choose from either stock or bond mutual funds.

Last Sunday's New York Times reported on the current controversy surrounding allocations to bond mutual funds.

As regular readers of Random Glenings are aware, I am not a big fan of bond funds.  Unlike buying individual bonds - and at least have a set date in the future when investment capital is returned - bond funds are highly vulnerable to rising interest rates, since the interest rate sensitivity of bond funds tends to stay constant.

Authored by Paul Lim, the Times piece discussed another flaw in bond funds, focusing on those that are closely tied to the major bond indices.

John Bogle - a long-time advocate of stock index funds - is a foe of investing in bond mutual funds.  His concern is not just interest rate risk, but also the composition of the indices that the funds are managed to mirror.

Here's an excerpt:

Many people, particularly those who invest primarily in their 401(k) retirement plans, are likely to turn to a so-called total bond market index fund to diversify their fixed-income holdings. 

“There is a perception out that there that if I own one of these index funds, I own the total bond market,” said Kathy A. Jones, a fixed-income strategist with the Schwab Center for Financial Research. 

That’s not the case. Many bond funds mirror the Barclays U.S. Aggregate Bond index, which includes very little non-United States debt as well as relatively few high-yield or junk bonds. Around 75 percent of the index tracks government securities or other types of government-backed bonds. Less than 25 percent is in corporate bonds. 

“At the end of the day,” Ms. Jones said, “these funds may own a lot of different bonds, but you don’t get much issuer diversification, and you’re getting that at very low yields.” 

Because of this, says John C. Bogle, founder of the Vanguard Group, total bond indexes “are deeply flawed — and that’s coming from an indexer.”  He adds that individual investors should keep only about one-third of their bond stake in Treasuries and government debt, reflecting the market’s mix based on private investors such as pension and mutual funds.