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.

Dow 15,000

I had a great visit with a client yesterday.  He and I have worked together for many years, and I generally feel that I learn something from him every time we get together.

Naturally, as the markets continue to move to record new highs, much of our discussion talked about the future prospects for stocks.

I have been generally bullish on stocks for the past three years.  In 2010 bullish sentiment was scarce, but I gradually began to feel that stocks had reached a major bottom, and were due for a significant rise.

I wrote a piece in September 2010 on Random Glenings (and I also used for my client quarterly letter) that was typical of my thinking at the time.

The title of the piece was "10 Reasons to be Bullish on Common Stocks", and here's an excerpt from what I said:

Perhaps, I thought, there were a number of reasons to be bullish on the stock market, despite the steady drumbeat of negative economic news and my own innate caution....

1. Fed policy remains very accomodative. As this week's Economist notes, recessions are almost always the result of tight monetary policy. Most of the talk in Washington is about more Fed stimulus, not tightening;

2. With exception of the dismal unemployment rate, much of the recent economic data is actually not all that bad. True, GDP growth is has been low relative to other recoveries, but at least it is moving in the right direction;

3. The highly partisan bickering in Washington greatly reduces the chances of a major fiscal policy mistake. Yes, taxes will probably go higher, but it now seems more likely that they will simply revert back to the 2001 levels, prior to the Bush tax cuts;

4. Transportation stocks have continued to move higher, which is typically a bullish signal for the economy and the stock market;

5. Corporate cash levels remain very high, and we have seen a significant pickup in M&A activity. With top line growth muted, it is now almost an announced strategy for many companies to "buy growth" through acquistions;

6. The appetite for corporate bonds has remained strong, with no signs of worries. Even the junk bond market has been robust, and yield spread levels are back to 2007 (i.e. pre-crisis) levels;

7. Sentiment on stocks is ridiculously bearish. Domestic US stock mutual funds have seen large outflows in favor of either bonds or emerging markets. If most managers are bearish, can't most of the "bad news" be already priced into the market?;

8. September is historically the poorest month for stock market returns, yet we have actually had a pretty good up move so far. The fourth quarter, meanwhile, is historically the best;

9. Referring to point 8: volume has been low, and concentrated in just a few stocks, so a number of analysts say that the rally this month means little. On the other hand, historically good moves in stocks rarely begin with explosive volume, so perhaps the current market action is actually positive;

10. For anyone with a time horizon of longer than a few months, it is hard to get excited about investing in either bank CD's or short maturity bonds, with yields of 1% or less.

Yesterday's market action, I thought, was actually pretty encouraging, since both bond and stock prices moved higher together. There's a lot of cash on the sidelines that needs to be invested.

http://randomglenings.blogspot.com/2010/09/10-reasons-to-be-bullish-on-common.html

My client agreed with me a few years ago, and his account has grown nicely. Yesterday he agreed with me on my generally positive outlook for stocks.

However, like the smart businessman he is, my client is always thinking about downside risk.  The day will surely come, he said, that we will need to reduce equity exposure, even if that time is not now. What factors would make me turn cautious?

As I look at the list above, most of the factors that made me more positive than most on stocks in 2010 remain in place.  There is less bearish sentiment today than was true in 2010, but I still get the sense (and survey data agrees) that many pension and endowment funds are underinvested in public equities relative to their benchmarks.

In other words, many advisors seem to be "talking the talk" when it comes to equity investments, but less are "walking the walk".

The one area that I am watching carefully, however, is the credit markets.

Nearly every serious market downturn in the course of my career has been preceded by either a significant upturn in interest rates or tight credit conditions, and I have no reason to doubt that the next significant correction will be caused at least by similar conditions.

However, the European Central Bank (ECB) just cut interest rates again yesterday, and signaled that they are open to a policy of negative interest rates if European economies continue to falter.

Japanese officials, of course, have unleashed a massive stimulus program ("Abenomics") attempting to revive their moribund economy.

And of course our own Federal Reserve is staying the course on their efforts to keep interest rates low.  Recent comments from Fed officials reflect a larger concern with low inflation rates, which implies that it is unlikely that we will see any tightening moves from the Fed any time soon.

The credit markets, in other words, are wide open for most qualified borrowers.

So perhaps the Dow at 15,000 is only an interim step to higher prices?

Meet One of the Few Analysts On Wall Street Bearish on Apple

According to FactSet, 80% of the 54 analysts who follow Apple rate the stock a "buy". 

While I don't have the data to prove it, I suspect that many of these analysts were equally enthusiastic about the tech icon when the stock was trading +40% higher than today's levels.

I don't mention all of this to be critical.  As I have written in several posts about Apple, this has been one of the hardest stocks to analyze in my career.

The company has all of the characteristics of a growth company - and trades at levels that make most value managers pay attention - yet the stock has disappointed since last fall.

Part of the problem for the analyst community, I think, is that many have been following Apple for years. They have witnessed first hand how the company has transformed the way the world lives.

Nearly 3 billion people globally, or about 45% of the world's population, are connected to broadband via a mobile device, and Apple has been the leader in this technology revolution. Personal computer sales are in a free fall due to the huge growth in tablet usage, led by Apple's introduction of the iPad a few years ago.  Steve Jobs has become an iconic figure even after his passing, and for good reason.

So what's wrong with the stock?

Glen Yeung at Citigroup has followed the semiconductor space for years, but only started following Apple last year.  Perhaps because he brings a fresh perspective to the stock, Glen has become one of the most vocal doubters on Apple. I had the chance to hear some of Glen's thoughts in person yesterday.

Glen is officially "neutral" on Apple, but my sense is that he would not be a buyer of the stock here. 

The problem Glen sees for Apple is that while its products are terrific, they are also very expensive relative to the alternatives. 

The iPhone 5 sells in the $600 to $700 range (unless you sign a two year contract with a telecom company). Samsung's Galaxy S3 is $100 cheaper with equal or better performance characteristics, according to Glen.

More ominously for both Apple and Samsung, Chinese cellphone manufacturer Xiaomi is offering smart phone named MII2 that is priced at half of the Apple iPhone.  For around $300, then, Chinese purchasers can get a device with essentially the same performance as Apple's.

Since Citi estimates that 84% of smartphone growth in 2013 will come from China and other emerging markets, Apple has some serious challenges in the fastest growing parts of the market.

Apple's iPad also faces pricing pressures from other manufacturers, primarily Samsung.  Moreover, Apple's iPad mini with its 7 inch screen is apparently seriously impacting sales of Apple's regular iPad,  Since the company makes more on its larger models, Apple in some ways is cannibalizing its own sales.  Glen does not expect this trend to reverse.

Citi's overall view on smartphones and tablets is that the innovation curve has reached its peak.  Sales of mobile devices will continue to grow, but the growth will come in lower-priced models which offer enough capacity to satisfy most consumers. 

Glen is not ringing the death knell for Apple, however. He thinks the real opportunity for company will be in software. When Apple introduced iTunes ten years ago, they revolutionized the music industry, and created a whole new source of demand for its products.  If they can develop new uses for its hardware, Apple could see a resumption in growth.

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