More Thoughts on Bonds in a Balanced Portfolio

Warren Buffett was interviewed yesterday by Betsy Quick of CNBC.  As usual, he was asked about his views on stocks:

Acknowledging that milestones like Dow 15,000 can draw Main Street's attention to stocks, Buffett said people should pay more attention when indexes cross those milestones on the way down because that's when stocks are "cheaper" and more attractive to buy. 

While not as "cheap" as they were a few years ago, Buffett thinks stocks are now "reasonably priced" and not "ridiculously" high.

http://www.cnbc.com/id/100709849

However, when asked about bonds, the Oracle was direct and to the point:

Buffett said that bonds are a "terrible" investment right now because they are "priced artificially" high due to the Federal Reserve's massive asset buying program and could lose people a lot of money when inevitably interest rates start to rise. He doesn't know when that will happen and he doesn't know how much rates will rise, but he's certain they will be going up eventually. 

As I wrote yesterday, there have been generally three approaches that institutional investors with balanced portfolios have been taking with respect to bonds.

The first is to stay the course.  Managers are directed to try to outperform a benchmark such as the Barclays Government/Credit index even though there is a significant possibility of negative returns when interest rates rise.

The second approach is less conventional - invest bond holdings in short maturity, high quality issues, even though the yields are modestly lower than the alternatives.  The drawback here is mostly psychological: holding near-cash fixed income means that there is a risk of underperforming the usual benchmarks in the short term, particularly if interest rates move lower over the coming months.

The final idea is one that in my opinion makes little sense:  try to increase the yield on your bond holdings by ignoring credit risk and buying the highest yield bonds available.

However, I appear to be in a minority:  high yield debt is being gobbled up by the market, pushing yields to levels that once were considered only possible for investment grade issuers.

Ned Davis Research this morning wrote the following:


With yields on high yield debt falling to a record low of nearly 5.00% on Friday, pushing the average price above 107 for the first time, the term "high yield" has become somewhat of a misnomer.  In absolute space, 5.00% no longer qualifies as "high yield".  Not long ago, a 5.00% yield was the domain of investment grade debt.

Meanwhile, over in Europe, Portugal has issued its first bonds since it was bailed out two years. 

No one thinks that Portugal has suddenly solved all of its problems.  According to the Financial Times, the country's financing needs are covered only through the end of this year.  What will be the course of future policy in Portugal remains uncertain.

So why were investors lining up to buy Portuguese debt?

Here's what the FT wrote:

Portugal has issued its first new government bonds since requesting an international bailout two years ago, in an offer of 10-year debt that raised 3bn euro...

Investor demand was broadly spread across Europe and the U.S., according to bankers.  The yield was fixed at the midswaps market plus 400 basis points, offering a return of 5.6 percent.

http://www.ft.com/intl/cms/s/0/886d4624-b6f5-11e2-a249-00144feabdc0.html#axzz2ScBUiwjt

In some ways, the current rush for yield is reminiscent of the insatiable demand for technology stocks in the late 1990's.

Then, as now, there is a sense that somehow this will all end badly at some point.  However, with high yield bonds producing the best total returns in the fixed income world over the past couple of years, and the European Central Bank determined to do "whatever it takes" to keep the euro intact, advice of caution and restraint is being widely ignored.
 

Reconsidering Bonds in a Balanced Portfolio

With interest rates at historic lows, many investors are trying to figure out the best way to manage the bonds in their balanced portfolios.

There are generally a couple of reasons to include bonds in accounts. 

First, they provide some ballast if the equities markets turn south. Except for some kind of negative credit event, bonds will mature when due, regardless of what else is going on in the world, and investors will have their capital returned.

And, second, bonds usually offer a little income.

Unfortunately, with yields at such miniscule levels, the income return from bonds is paltry.  In the case of high quality bonds - such as U.S. Treasury obligations - today's yields are barely keeping up with inflation.

In recent meetings, I have encountered three different opinions on how best to manage a bond portfolio in today's environment.

The first is essentially to "stay the course".  In the case of institutional portfolios, this means to manage accounts against a widely-accepted benchmark such as the Barclay Government/Credit bond index.  This has been the strategy for most bond managers since the early 1980's.

The problem with this approach is that you can experience negative total returns for an extended period of time if interest rates move higher. 

The Barclays index, for example, has a duration of nearly 4 years. Roughly speaking, this means that if interest rates move 100 basis points higher than today's levels, the value of the bond portfolio will drop by -4%, or more than the income being generated by the bonds in the account.

The second approach is to move lower in credit quality.  This is approach that has adopted by a growing number of investors who are ignoring credit risk and simply buying the highest yields they can find.

Not only are assets like high yield bonds benefiting from this trend, but also some unusual issuers that in "normal" times would not have received much interest.

Two weeks ago the government of Rwanda - the same desperately poor country whose genocide was the subject of the award-winning Hotel Rwanda two decades ago - was able to issue bonds with a 6.875% coupon. 

Here's an excerpt from an article Reuters published last Friday:

Latest was Rwanda, still recovering from the 1994 genocide. Orders for the East African country's debut dollar bond last week reached $3.5 billion, more than 8 times the bond's issue size.

"In a market where you constantly get burnt trading fundamentals, traders are going to the other extreme, ignoring fundamentals and just looking for yield," said Manik Narain, emerging markets strategist at UBS.

"It's really reaching bubble-like proportions."

Single-B rated Rwanda issued dollar debt at a yield of 6.875 percent, paying not much more than euro zone member Slovenia, which issued 10-year debt on Thursday at 6 percent.

Rwanda's yield is below the 7 percent threshold which investment grade-rated Spain briefly breached last July, before the European Central Bank's OMT bond-buying plan helped to dampen yields.

http://www.reuters.com/article/2013/05/03/us-frontier-debt-idUSBRE94208O20130503

I am convinced that years from now investors will look back to crazed demand for yield with the same sense of bewilderment and wonder that we now view the dot com stock bubble of the late 1990's.

Sufficient to say that I am not a fan of low quality bonds here.

The third approach to bonds in a balanced portfolio is to reduce interest rate exposure and move higher in quality.  The idea here is that it seems pointless to take extreme interest rate or credit risk positions for just a few more basis points of return. 

Instead, by populating a bond portfolio with high quality issues maturing in 2 years or less investors are at least achieving one of the goals of including bonds in a balanced portfolio - capital stability.

Put another way, this may be one of those frustrating times when patience, and not greed, should be the watchword for investors.

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.

http://www.philippschmidli.com/?cat=48

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.

http://www.ft.com/intl/cms/s/0/3eb80a72-ae4a-11e2-8316-00144feabdc0.html#axzz2S2qjUZC7

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.   

http://www.nytimes.com/2013/04/28/your-money/the-stock-and-bond-mix-is-tough-to-rebalance.html?pagewanted=all&_r=0 

The Shortfall in Corporate Pension Plans

There is a story on Reuters this morning about the widening gap in corporate pension plans between what retirees are owed and the assets which are actually available to pay.

According to the story, pension consultant Towers Watson calculated that at the end of 2012 there was a shortfall of $295 billion in the top 100 corporate pension plans between assets and liabilities.  This represented a +17% increase in the funding gap from the end of 2011.

A large part of the problem stems from today's historically low interest rates.  Companies are required to calculate the present value of future benefits by using a discount rate based on corporate bond yields.  The lower the discount rate, the higher today's present value.

However, another huge part of the problem that corporate pension plans are facing is the fact that they have been steadily reducing their exposure to stocks in favor of bonds and alternative asset classes. 

Here's what the article notes:


Over the last few years many corporations have been gradually adjusting their portfolios to reduce investment risk relative to liabilities, shifting from public equities to fixed-income and alternative investments.

Since 2009, average allocations to equities have fallen 10 percentage points, while allocations to fixed-income investments have risen by eight percentage points. However, the shift away from equities slowed in 2012, according to the report.

"Of the 95 companies that reported target asset allocation strategies for 2012 and 2013, only three reduced their target equity allocations by 10 percent or more, versus 16 for 2011," Towers Watson's report said.

http://www.reuters.com/article/2013/04/23/us-pensions-funding-towerswatson-idUSBRE93M0OR20130423?feedType=RSS&feedName=businessNews

As I have written numerous times in the past, this makes no sense.  Due to the long-lived nature of their liabilities, pension funds should be using a very long time horizon in making their asset allocation decisions.  And the historical record is clear:  with very few exceptions, stocks have delivered returns far in excess of bonds, and most alternative assets as well.

Yet with their eyes firmly fixed in the rear view mirror, and the memories of the 2008-09 credit crunch still fresh, plan sponsors continue to add to assets that have virtually no chance of meeting actuarial assumptions  (bonds) away from the asset class that historically has delivered the needed returns (stocks).

Your Investment Time Horizon Is Longer Than You Think

Even though some mornings you might not feel it, you're actually a lot younger than you think.

Earlier this week, researchers at the Max Planck Institute for Demographic Research in Germany made the startling assertion that human longevity has improved so much over the past century that 72 is the new 30.

Originally reported in the Financial Times, here's an excerpt from an article on CNBC:

Researchers at the Max Planck Institute for Demographic Research in Rostock, Germany, said progress in lowering the odds of death at all ages has been so rapid since 1900 that life expectancy has risen faster than it did in the previous 200 millennia since modern man began to evolve from hominid species.

The pace of increase in life expectancy has left industrialized economies unprepared for the cost of providing retirement income to so many for so long.

The study, published in the Proceedings of the National Academy of Sciences of the United States, looked at Swedish and Japanese men – two countries with the longest life expectancy today. It concluded that their counterparts in 1800 would have had lifespans that were closer to those of the earliest hunter-gatherer humans than they would to adult men in both countries today.

Those primitive hunter gatherers, at age 30, had the same odds of dying as a modern Swedish or Japanese man would face at 72.

http://www.cnbc.com/id/100493887

Something to keep in mind, I guess, the next time I am thinking about asset allocation for a client!

Has "The Great Rotation" from Bonds to Stocks Begun?

According to Credit Suisse, more than $1.1 trillion has flowed into bond mutual funds since 2008, while equity funds have experienced $415 billion of outflows.  Even the low level of interest rates which has prevailed over the past several years has not changed the enthusiasm for bonds among retail investors.

There's been a lot of talk in the financial press about when we will start seeing a significant move from bonds to stocks, a.k.a. "The Great Rotation".

And they are not alone.  Credit Suisse also notes allocation to equities among US and UK insurance companies and pension plans are at 50 year lows.  Institutional investors have not only been adding to bond positions, but to investments in alternative asset classes such as hedge funds and private equity.

At some point, some analysts believe, bond investors will face the unhappy prospect that their investment positions are not even earning the rate of inflation, and begin to rotate back to stock positions.  When interest rates rise, the thinking goes, investors in bond mutual funds will find the value of their funds declining, and move back to stocks.

All of this, of course, is a very bullish long term forecast for stocks.

While we are starting to see some signs of a shift in asset allocation, it is too early to state that we have begun to see any significant changes, in my opinion.  But the press, at least, has begun to pick up on any signs of change.

Here, for example, is an excerpt from a Reuters article published this morning:


According to Lipper, net flows to U.S.-based equity funds in the first two weeks of 2013 was, at $11.3 billion, the biggest fortnightly inflow since April 2000. Including exchange traded equity funds (ETFs), the number tops $18 billion - well over twice the flow to equivalent bond funds.

What's more, fund-tracker EPFR said some $7 billion of inflows to emerging market equities alone in the first week of the year were the biggest on record and these have outstripped demand for emerging bond funds five weeks running.

http://www.reuters.com/article/2013/01/23/us-investment-rotation-idUSBRE90M07720130123

In a note published this morning, Merrill Lynch chief equity strategist Savita Subramanian wrote the following:

Despite relatively consistent net buying of US stocks by our pension fund clients since 2008, Small Cap Strategist Matt Trapp recently noted in his US Pension Analysis report that pension equity allocations have generally been decreasing over this period as flows into bonds have been much larger than equity inflows. If we begin to see a Great Rotation from bonds into stocks, pension funds may increase their equity allocations, suggesting inflows could begin to accelerate. As Matt notes, every 1ppt increase in equity allocations for private defined benefit pensions could yield additional equity inflows of $23bn. Given the longer time horizon of pensions vs. other institutional and hedge fund clients, pensions may also be better positioned to take advantage of the attractive valuations of US equities. 

Whether the recent trends are the start of a significant asset shift, or merely a blip in fund flows at the beginning of a new year, remains to be seen.

In my opinion, the real test will be when we get a market "correction".  If there is truly pent-up demand for equities, this will present investors an opportunity to buy at prices cheaper than today.