Focusing on interest rate risk and credit risk, we will describe how we utilize current rates, yields, and spreads to build a bond portfolio for you.
"Interest rates are to asset prices like gravity is to the apple. They power everything in the economic universe.".
--Warren Buffett
Many find it confusing that bonds could ever be down more than stocks given that bonds have long been ordained the “conservative” investment while stocks are said to be the object of shifty gamblers. As always, in all ways, it is important to know the granular details of a thing instead of just the shadow. What may appear to be certain usually is not, and a bond can have just as much volatility as a stock depending on the circumstances. It is important that we think about investing over a long period of time, and not just examine each year’s spoils. We need to think about risk in terms of permanent loss, not just in terms of fluctuations as the academics would have us do. Unfortunately, focusing on average annual returns and short-term volatility can fool us into missing the bigger picture, and consequentially not meeting our true goal, which is to have our money last the rest of our lives and then a little longer.
In the simplest possible terms, a bond is a loan made by an investor to an issuer. The issuer may be a government, a corporation, or some other entity. Interest is typically paid in a standard increment, like semi-annually, and the loan is repaid when the bond matures. In most cases, barring a default, the payments of both interest and principal are contractual, and hence guaranteed. Bonds are typically held for income. Bondholders do not normally participate in the success of an issuer, so getting their money back is the highest priority. Before the 1920’s only bonds were considered investments; everything else was considered speculative. Lawrence Chamberlain said in his book, Principles of Bond Investing (1911), “…the fact remains that every class of pure investment, such as bonds and mortgages and bank deposits, is safer than any class of speculation, such as stocks, real estate, and commodities. In fine*, therefore, the perfect investment is a promise to pay; it is always a loan.”
Bonds can be secured or unsecured, meaning that there may be collateral backing the issue. For instance, while US Government Bonds are backed by the full faith and credit (taxing authority and general assets) of the US Government, they are not backed by specific assets, and are considered unsecured. In addition, bonds have the right of first payment over other security holders since they are creditors, not owners. Corporate bondholders get paid before stock owners in terms of both dividends and during liquidations or bankruptcies. Typically, bonds backed by specific assets are considered safer than bonds that are backed only by the general credit of an entity, but Benjamin Graham gave extensive evidence in Security Analysis to support his, “emphatic stand that the primary aim of the bond buyer must be to avoid trouble and not to protect himself in the event of trouble.” We are going to leave the discussion about collateral for another day. We will focus our attention on interest rate risk and credit risk and describe how we utilize current rates, yields, and spreads to build a bond portfolio for you.
So how can bonds be conservative when they went down more than our stocks last year? As usual, the devil is in the details. If we decide to define risk as “fluctuations in annual price”, then bonds have the potential to be just as risky as stocks. If we define risk as “permanent loss of capital”, then most bonds are clearly safer than most stocks. If we look at the annual liquidation value of our investments, then bonds are risky. If we measure holding period return, then bonds are remarkably safe. Annually totaling up the market value of all our investments to measure our performance is a relatively recent habit. When Lawrence Chamberlain was writing about the safety of bonds, investors did not calculate the amount of cash they could convert their holdings into at the close of each day. An investor who bought a $1,000 bond at 5% wrote “Bond: $1,000” in his ledger book, logged $50 in interest each year, and then collected his $1,000 when the bond matured. Today we get up to the minute updates of how much every holding can be unloaded for. In our opinion, this system can cause more problems than it solves.
Mark-to-market vs Book Value accounting has come under scrutiny lately due to the recent failure of several banks holding bonds with large unrealized losses. In bank accounting, assets classified as “held to maturity” are reported at book value while assets classified as “available for sale” are marked to market. When bonds are used as collateral for specific obligations it is more important that current value be utilized instead of book value. Especially in cases where the liabilities backed by the depreciated bonds are available on demand and utilize fractional reserves. However, this is not the case with your retirement portfolio; especially assets that you are holding specifically to generate income.
Interest Rate Risk:
When a bond is first issued, it is purchased at prevailing interest rates. Let's imagine a 2-year US Treasury Note currently pays around 5.0%. That means if we hold a $1,000 bond until exactly 2 years from today, we will earn about $50 per year in interest and then get our $1,000 back at the end of two years. What if interest rates rise between now and then? If we wanted to sell our bond, would an investor pay us the same as we paid if they could get 7.0% over the same time period somewhere else? Obviously not. Our bond must adjust in price to reflect the fact that higher interest rates can be earned on newer bonds. If after 12 months of holding our 2-year bond prevailing interest rates rise to 7.0%, our bond will only be worth $980. This also works in reverse, and if prevailing rates drop to 3.0%, our bond will be worth about $1,020. If we hold the bond for another year, we will get our $50 in interest and our original $1,000 back. Did we really make or lose anything in these fluctuations?
A 2% fluctuation in value may be easy to dismiss as a rounding error. But let’s examine what would happen if the exact same scenario occurred, but this time we had purchased a 30-year bond. Now we would be looking at $750 for our bond if rates rise to 7.0% and we would need to wait 29 years to get our $1,000 back. If rates fell to 3.0%, we would be able to convert our bond into $1,381; we would get to capture all that extra interest up front. This phenomenon is caused by a concept called duration. Duration tells us how much the current price of our bonds will rise or fall for a 1% change in interest rates. In general, longer maturities have higher duration than short maturities, and lower rates have higher duration than high rates. Think about where bond prices were 3 years ago. A 30-year Treasury was paying 1.665%. Today that rate is 3.86%. Using our above calculations, we can see that a 30-year bond purchased in March 2020 at $1,000 is currently convertible into cash of $632 for a paper loss of 36.8%. The price has adjusted downward to reflect the fact that a higher coupon rate can be earned on new bonds. The holding period return for the next 27 years will still be 1.665%. The difference is that the extra 2.195% yield comes from your bond price getting closer to what you paid for it. Lawrence Chamberlain would not care because his ledger would still read “Bond: $1,000”.
Taking all of this into consideration makes it easier to understand why we have been sitting in 2–3-year bonds for the last few years and giving up that extra .50% in interest. Since lower rates have higher duration, bond prices were in one of the most dangerous positions ever during that period. I am sure that my constant proselytization about this fact grew tiresome to some toward the end. The odds of rates dropping further were slim, and the odds of rates rising at some point were very high. If rates dropped, we would have still only earned an extra .50% over our holding period, but by being in cash, which has a duration of 0%, we passed on the extra .50% interest and avoided the 36.8% temporary loss in purchasing power, and now we are deploying that cash at 5%. This is not an operation that we expect high praise for; this was just us doing our job.
Credit Risk:
The above examples work for bonds that have a minuscule risk of default, like US Treasury Bonds. Other bonds carry the additional risk of an investor not getting all their money back, for which they expect to be paid. This introduces credit risk, and investors expect to receive a credit spread for the additional risk. The spread is the difference in interest between a bond with credit risk and a default risk-free bond at a similar maturity. Right now, investors receive about 1.0% more interest on high credit quality bonds and 4% additional interest on low credit quality bonds. Credit spreads add another layer of complexity to the bond equation. Instead of the absolute level of nominal interest on bonds, with credit risk we normally think about them in terms of “spread expansion” and “spread contraction”. These are exactly what they sound like. Expansion means that spreads are getting wider and that an investor is getting paid more on credit risk than before, and contraction means the opposite. Spread expansion is equivalent to a rise in interest rates (bond price goes down) on a default free bond and contraction is equivalent to a rate decrease (bond price goes up).
Here is a recent history of spreads on BBB bonds:
BBB is the lowest tier of investment grade bonds. The grey shaded areas are recessions. You can see that the tendency is for a large spike in spreads to occur during a recession, followed by a large decrease. Remember, bond prices fall when spreads rise, and bond prices rise when spreads fall. While we are not in the business of predicting recessions, we do know that current spreads are razor thin and that the risk of recession is currently high given recent yield curve inversions (long-term bonds pay less than short-term bonds). We do not see the wisdom of taking on the risk of a large drop in prices and possible defaults when it is possible, or even likely, that we will have much higher spreads over the next few years. This is not a prediction; it is an evaluation of current prices and an estimate of the cost of possible outcomes. The best time to add credit risk, in our opinion, is after the default cycle starts and before spreads begin to tighten. The default cycle is when a recession causes borrowers to stop making interest payments. We do not feel that we are currently being adequately compensated for the risk of defaults and spread expansion. This is not a mathematics problem that should be calculated to 3 significant digits. It is a value assessment on how much risk we are willing to take.
Fixed Rates vs Floating Rates:
Some bonds pay fixed coupons and there are other bonds that pay interest based on a fluctuating reference rate. These bonds protect the investor against rising interest rates by adjusting payments when the reference rate rises. The main issue with floating rate bonds is that they normally have lower credit quality, and they introduce significant credit risk. When rates rise it may get more difficult for the borrower to make payments and defaults become more likely as rates rise. The typical floating rate bond fund that is available to mutual fund investors utilizes securitized bank loans. We have used floating-rate funds in the past, but we currently do not have exposure to this asset class because the spreads are thin, the covenants have deteriorated over the past few years, and many of these loans will need to be refinanced between now and 2025 at much higher rates, which may make it difficult for investors to get their money back. Floating rate notes are usually callable by the borrower which leads to adverse selection. The borrowers who have adequate capacity to refinance their debt call the notes when rates rise, and the issuers who do not have adequate capacity keep their notes active. Over time, the outstanding notes deteriorate in borrower’s capacity to pay. We will continue to watch this space and will be looking for yields to be higher and for maturities to be further into the future before committing capital to this asset class.
Inflation-Adjusted Bonds:
It seems like an obvious choice to add inflation-adjusted bonds to your portfolio when you are expecting inflation. It’s right there in the name. Unfortunately, like most things, what seems to be certain “just ain’t so”. The price on inflation-adjusted bonds responds to fluctuations in the real rate of interest, which is the rate on treasuries less the expected inflation rate on the same maturity. When real rates rise inflation-adjusted bonds fall and when real rates fall inflation adjusted bonds rise. Real rates have been in negative territory recently and the historical mean real rate has averaged slightly below 2%. This gave us pause in adding inflation adjusted bonds due to the possibility of negative returns, even in a period of rising inflation.
The average return for inflation adjusted bond funds over the past year has been about -7.5%. We will continue to monitor the real rate of interest and if it rises to a level above 2%, we will evaluate adding inflation-adjusted exposure.
Asset Backed Securities:
As mentioned earlier, some securities are explicitly backed by a pool of assets. This could be home mortgages, student loans, auto loans, credit card balances, or a dozen other things that have value and people borrow against. These loans are typically pooled together and securitized into things called collateralized mortgage obligations (CMOs) for mortgages or collateralized loan obligations (CLOs) for other loans. These securities received a lot of press during the financial crisis because they were at the center of the Lehman Brothers and Bear Stearns collapses, and the subject of the book and movie “The Big Short”. Entire books can be written about the functioning of the asset backed securities markets, but the most important thing to remember is that in asset backed securities, principal is not always paid back at the end of the loan. People prepay mortgages and other loans for a number of reasons and therefore in addition to credit risk, prepayment risk is introduced. Prepayment is not always a bad thing, but there is a tendency for prepayments to be high when rates drop and prepayments to be low when rates rise since refinancing is more advantageous in the former case. But with mortgage securities, each payment is split between principal and interest, and when rates are rising this principal payment gets to be redeployed at higher rates. This causes the duration of asset backed securities to have “negative convexity”, which means that the price of the bonds could decline when interest rates drop. Depending on the underlying collateral, ABS can experience high default rates during recessions. We do have exposure to some ABS in our bond funds due to the relatively high rates, negative convexity, and shorter maturity profile. We will continue to monitor our fund holdings to be certain that we are being adequately rewarded for risk.
Other:
The above description only scratches the surface of the features and nuances available to us and there are hybrid securities that combine some features of multiple types of fixed income assets. In addition to what is described above, the fixed income universe also contains distressed debt, private debt securities, international bonds (including emerging markets), convertible securities, preferred stock, mezzanine financing, structured notes, and municipal bonds. Each of these variations has different characteristics and exposures that respond differently to moves in interest rates, inflation, the economy, and the passage of time. Our job is to evaluate each of these different securities and build a portfolio that promises to provide income over your lifetime and to stabilize your portfolio so that we have assets to rebalance from when equity securities inevitably decline. 40 years of declining rates have fooled money managers into thinking that fixed income is a viable asset class to invest in for capital appreciation. With a few exceptions like distressed debt and risk reclassifications on lower grade securities, fixed income is good for one thing, and it is right there in the name. If we are entering a long period of rising interest rates, then all of asset management will need to make a shift to a world where bonds may depreciate in price regularly even though the income remains constant.
Passive Bond Investing vs Active Bond Investing:
The debate rages over which is better, passive investing or active investing, and we think the major problem lies in the names. Passive indicates doing nothing and active indicates constant motion. The more important focus should be on whether a portfolio manager is utilizing analysis to evaluate securities and monitor their progress over time or simply buying an index. Indexing bond portfolios is much more complicated than indexing stocks. Indexed vehicles like ETFs rarely buy the entire list of bonds listed in an index. There are four major strategies used in indexing: Full Replication, Stratified Sampling, Optimization, and Synthetic Replication.
Full Replication: Full replication is when an entire list of securities is purchased in proportion to the underlying index and when changes are made to the index the portfolio is rebalanced to exactly match the index. This is the normal course of action in equity indexes. This method provides the most accurate representation of the underlying index but has high transaction costs and may generate taxable income from activity. Full Replication is often impractical in bond indexing because many bonds are illiquid and bond indexes may have many holdings.
Stratified Sampling: Stratified Sampling involves utilizing a representative subset of the securities in an index based on issuer, credit rating, maturity, and sector. The intent is to replicate the performance of the index while keeping tracking error, trading costs, and taxes low. The downside is that your portfolio may underperform the index.
Optimization: Optimization involves utilizing mathematical models and algorithms to match characteristics of a bond index in terms of duration, credit quality, and sector exposure. The portfolio may hold bonds that are not even in the index. The main goal is to maximize return while minimizing risk by using an index as a target as opposed to a model to replicate.
Synthetic Replication: Synthetic Replication is a method of utilizing futures, options, and swaps to replicate performance as opposed to a portfolio. These portfolios may not even own bonds. There are additional risks such as counterparty risk added with this strategy, and tracking risk may be extreme.
We are old-fashioned when it comes to fixed income investing. We want an analyst evaluating credits and optimizing portfolios based on fundamentals instead of spending their time creating algorithms that do not even consider the underlying characteristics of the security. We prefer a bottom-up approach to security selection, and we allocate to certain types of fixed income securities based on available yields, spreads, and maturities. Utilizing an indexing strategy in fixed income creates an impediment to our mandate to “know what you own”.
Mutual Funds vs Individual Holdings:
It is often asked whether it is more advantageous to own individual securities instead of investing in funds. The answer is yes- if cost is your only consideration. If adequate analysis is important to you then funds are usually a better option in some asset classes unless you have institutional trading capacity and a team of many analysts. Our perspective on utilizing funds is that we are hiring a team to manage an asset class that we feel is providing adequate return for the risk taken. We spend our time on portfolio management and manager evaluation and leave most of the security selection to full time analysts that specialize in a specific asset class. In certain asset classes like US Treasury Bonds, Exchange Traded CDs, and Large Cap Value stocks we provide security selection, but in more obscure asset classes like Floating Rate Bonds, Inflation-Adjusted Bonds, Asset Backed Securities, International Stocks, and Real Estate we leave the security selection up to specialists that evaluate these securities on a daily basis. We evaluate open-end mutual funds, closed-end funds, and other vehicles to determine which structure most completely meets our objectives.
There are several reasons that we prefer this arrangement. Most importantly, we do not use every available asset class in every environment. Instead of spending our limited time mastering the art of some esoteric security, we focus on knowing the fundamental levers of an asset class so that we can deploy it at the right time. Having a specialist on staff that we only use 20% of the time is too expensive and inefficient. In addition, we do not have institutional trading capabilities, and certain asset classes are not available on retail trading platforms. We do this because our clients are almost exclusively individuals not meeting the requirements to operate institutional accounts. Our fund managers buy in scale and have specialized networks that keep them apprised of the securities that are available on any given day. In many cases issues are available on an invitation basis only, and we would not be able to participate in this pricing. Further, we manage many individual accounts instead of one large portfolio of securities. It is too hard logistically to rebalance individual asset classes on an account basis when utilizing certain primary securities. Our fund investments can be bought or sold in a single transaction if we need to add or remove exposure. While we do have block trading ability, this is difficult to administer on a wide scale with single issue bond holdings. At the current time, with our existing technology, using fund managers is more efficient, provides higher returns, and leads to more consistent portfolios for our clients.
Our goal over time is to bring more security selection in house. We will only do this when we are confident that we can adequately evaluate individual securities in addition to allocating capital among asset classes, and that the increased cost and complexity are overshadowed by the advantages. We will need to have more analysts that specialize in certain securities, and some asset classes may need to be put into pooled vehicles that we administer to gain access. We will keep you updated on our progress in this endeavor. Our commitment is that we will only venture into areas where we have confidence in our ability to provide adequate analysis, trading, monitoring, rebalancing, and performance evaluation.
Asset Allocation:
When formulating your overall exposure to fixed income and the percentage of your fixed income allocation dedicated to each of these different types of securities, we evaluate the yield landscape and try to determine where the large risks are, and which securities are paying us to take those risks. We will not always pick the best performing asset classes because we are not able to predict the future. We cannot decide that buying property insurance was unsuccessful since our house did not burn down. In a similar manner, we need to be cognizant of the unfulfilled risks that prevented us from adding a type of security and cost us an extra 1% on our bond yields to avoid a potential 36.8% decline. We will focus our attention on maximizing our current yield while avoiding large drawdowns that put strain on you financially and emotionally. When yields are high, we do not need to focus as much attention on volatility since the income payments are meeting our income goals. It does not make much sense to accept a 1.655% annual return for 30 years when you need 4-6% to reach your goals. You are better off waiting in cash and deploying capital at higher rates. If we could get 12% on 30-year treasuries, there would be little reason to invest in anything else. Like all other things in investing, fixed income analysis is about evaluating opportunities and risks.
It should be apparent that the above is a relatively superficial description of our fixed income allocation strategy. If you have any questions, or want to dig deeper, please do not hesitate to contact your Wealth Advisor, or me personally. Our aim is to construct a fixed income portfolio that will help you achieve your goals by closely monitoring the yields, spreads, and maturities available.
Warm Regards,
Allen
*”In fine” (pronounced In FEE nay) is Latin for approximately “in summary”. An artifact from the academic writings of 1911. I had to look it up too.
Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.