Looking in the Bond Direction

Aurum Weekly Access - 12/12/13
By Michael McKeown, CFA, CPA - Director of Research

For the dear readers of our (semi) weekly missive will know that our penchant for bonds fleeted over the last few years.  We do not have anything against fixed income securities per se, it is just that the value for today's price is less than historical averages.  In our view, there is no such thing as a bad asset, just a bad price to acquire that asset.

  The ideal asset purchase for us is one structured with very little downside risk with upside potential.  Simple enough, I gather this is not unique among investors.  Yet the behavior of the herd often contradicts their original collective intention.  Take for example the mutual fund flows through the third quarter of 2013 by Morningstar category.  The number one category of inflows was Bank Loans ($51 billion) followed by Nontraditional Bonds (also known as 'unconstrained bond funds,' at $44 billion).   The reason behind these allocations is for minimizing interest rate risk, but I fear in doing say, investors simply traded for credit and currency risks.

The three largest bank loan funds have an average 30-day SEC-yield of 3.28%. This is comparable to the Yield-to-Maturity, or the best estimate of future expected returns, outside of defaults, assuming it is held to maturity.  All bond portfolios, whether funds or ladders, theoretically never mature, but this is a good gauge (a "known, known" if you will) of forward returns.  Assuming a taxable investor has a marginal tax rate of 40%, an equal weighted portfolio of these three funds will return 2% net of taxes over the next few years.  Of course these portfolios of bonds have a junk credit rating, though lower default rates than high yield.  In addition, because of the very low LIBOR rates which these bonds are tied to, the floating payments may be several years out, even if Treasury interest rates rise (LIBOR must rise, often to 1.5% for the floating interest payments to increase, while 12-month LIBOR sits at below 0.6% today).

llspreadsprices

Source: Eaton Vance

While the spreads (above Treasuries) are near the median, the average bond price is at 99, with the all-time high at 101.  There is simply little chance of making more than a few percent per year after tax, but with a good chance of making less than that if volatility should increase.  For a category that can become very illiquid, has high credit risk, and just offers 2% net over cash, a dedicated allocation seems to have an above average risk of capital impairment.

The by-far largest fund in the Nontraditional Bond or 'Unconstrained' category has an SEC-yield of 1.24% and hopes to make up returns on appreciation of emerging market bonds and currencies.  We could walk through this as another example, but it ends up with similar story to bank loans.  In addition, we have yet to come across compelling managers in this category with the ability to time interest rates (as Ben Graham, the father of value investing said, "If it is virtually impossible to make worthwhile predictions about the price movements of stocks, it is completely impossible to do so for bonds.").  Another area of risk we see advisors and consultants putting clients into is shortening duration to the 2-5 year belly of the yield curve.  This is precisely the area that will likely take losses should interest rates rise rapidly.  Vanguard's Short-Term Bond Index has an SEC yield of 0.60% with a duration of 2.7 years and average maturity of 2.8 years.  And even if the rapid increase in interest rates already happened, the current interest rate risk does not seem to compensate for such a minuscule return.

rates2510

I do not believe these funds will necessarily turn out to be disastrous investment decisions.  I do, however, believe they are less than optimal.

For we understand that fixed income mandates must go somewhere.  Investment Policy Statements include the asset class, and constraints impose a minimum overall portfolio weight.  For us, we recommend an underweight to fixed income across portfolios simply because the risk premium for owning bonds at this point in time is much lower than historical data shows.  For example, high yield bonds as a whole have a yield-to-worst of 5.7%, putting it near its richest valuation since 1997.  We like to be compensated fairly for risking capital and when we are not, we will take our capital and go elsewhere.

hybondtabledec2013 

Source: St. Louis Fed

Where are we deploying fixed income mandates in this environment?  First, we are quite aware that a surprise interest rate spike will cause all bonds to have a mark-to-market loss.   The objective is to avoid a permanent impairment of capital.  Our fixed income holdings are concentrated in barbell portfolio constructions with investment grade credit ratings.  The manager and funds that we invest with focus on the very short end of the curve, where empirically, holdings have little to zero interest rate risk.  On the other end of the barbell, managers are exploiting longer dated securities that investors shunned. Specifically, we like non-agency mortgages with yields in the mid to high single digits along with floating investment grade rated Asset-Backed Securities.  Certain areas of the municipal bond sector are also beginning to look interesting as the net flows from 2010 through 2013 are flat (thanks to Meredith Whitney on 60 Minutes in late 2010 and the interest rate spike this year).

We are holding above average cash levels due to the underweight to fixed income and believe investors may be reaching for yield in the wrong spots.  We agree with Seth Klarman (one of the best investors of our time with high teens returns over the past 30 years) when he said, "By holding expensive securities with low prospective returns, people choose to risk actual loss.  We prefer the risk of lost opportunity to that of lost capital."

In this holiday season, we wish no ill will on anyone's asset holdings, but we only wish the future brings an opportunity to purchase fairly valued (or rather, very cheap) securities on behalf of our clients.

Important Disclosures 
  
This material is based on public information as of the specified date, and may be stale thereafter. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.
 
1. Strategic Insight Simfund, as of 9/30/13

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