Managing your fixed income portfolio can be a daunting taskbut is also one of the most important things you can do with your portfolio.
While managing your equity allocations can seem almost "sexy". the task of determining your fixed income allocations can seem like a thankless and intimidating task. Nothing could be further from the truth. One of the "problems" with fixed income is that it is hard to capture in a simple soundbite. It isn't uncommon for different parts of the treasury market to move different directions in a given day, let alone corporate bonds, high yield bonds, leveraged loans, foreign bonds, etc. It is complexity that both requires more effort, but can also reward that effort.
Fixed income covers such a wide swath of investments that you can construct portfolios that can do well under a variety of scenarios. Equities tend to go up or down together which is not necessarily the case for fixed income.
By diligently building and managing your fixed income allocations I believe that you can craft portfolios that not only match your views, but can significantly enhance the risk/reward of your total portfolio.
I believe that the following three steps are the key to that process
- Asset Class Evaluation.
- Scenario Determination.
- Vehicle Selection.
This is the first of a four part series meant to guide you through the process. We will explore each of the steps in more detail, but for nowI just want to highlight what each step is and how it fits into the overall process.
Asset Class Selection
This is the step where we make sure we understand the current state of each fixed income market. What are the risk/reward characteristics of each market - at a reasonably detailed level.
With all the talk about the strong dollar and the impact of that, along with lower commodity prices on emerging markets, it might surprise you that the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) had a positive total return of 1.03% for 2015 (according to Bloomberg). Compare that to the iShares MSCI Emerging Markets ETF (EEM) an equity based ETF that was -16.2% as an example of why we need to explore beyond the surface.
IBOXX European Liquid High Yield vs US Liquid High Yield (source Bloomberg)
The problems with the domestic high yield market are well known, and this index was down over 5% for the year.What is interesting, is that until the last 2 trading days of the year, this EU high yield index was positive on the year. At its worst point, it was only down just over 1.1% and has held onto its 4th quarter gains. One of the biggest reasons for this outperformance was a much lower exposure to energy related companies, highlighting, once again, the need to explore the asset classes in more than cursory fashion.
Due to the price performance in 2015, certain asset classes, like leverage loans, no longer exhibit their "traditional" risk/reward profile which impacts allocation decisions heavily.
We will explore the main fixed income asset classes more in the second part of this series.
Scenario Determination
Once we have evaluated the risk/reward of the fixed income asset classes in general, we will explore scenarios. The most likely ones, as well as the most dangerous ones. We will attempt to analyze how each asset class is likely to perform under the scenarios, given their current state. Not only are scenarios constantly changing (at one time, many people would have discounted the possibility of reasonable growth in a low inflation environment), but how asset classes respond to those scenarios also evolves over time.
The crucial, and I believe most overlooked step, is a realistic assessment of downside risk and how you will or will be able to respond to downside. Investors will often point out that for treasuries, or any bond that doesn't default, you will get your money back at maturity. That may be true, but the reality is, we as investors respond to mark to market gains and losses. It is rational that we do - my premise is that most investors under manage their fixed income allocations and don't do enough to maximize total return, with too much of a "yield" focus and a horrible tendency to go into "ostrich" mode when performance is poor - the exact opposite of what good portfolio management behavior would dictate.
This will be the third part in the series and will attempt to construct some scenarios - though each individual will need to evaluate their own scenarios and their own realistic response to them.
Vehicle Selection
Once you have finished analyzing each fixed income asset class and developed your scenarios, a key driver to performance can be vehicle selection. With the ability to invest in Mutual Funds, ETF's, Closed End Funds, Individual Bonds, etc., the right choice, for each asset class can have a significant impact on your total return.
If you knew at the start of 2015 that the 30 year treasury yield would rise from 2.75% to 3.02% , could you have profited from that? If you thought you could by buying the ProShares UltraShort 20+ Year Treasury ETF (TBT) then you would have been wrong as TBT returned -5% in 2015. That loss occurred in part, because the 20 to 25 year bonds outperformed (many are held primarily by the Fed as a result of their various QE operations), the "roll down" the curve had an impact, the cost of being short treasuries (both the coupon and the repo rate) took their toll, as well as some structural issues related to the ETF itself. The iShares 20+ Year Treasury Bond ETF (TLT) lost 1.8% for the year - so BOTH the double short and the single long ETF referencing the 20+ Year Treasury market lost money.
In the high yield space, it is possible to find some mutual funds that outperformed the indices (and the ETF's) significantly. Many closed end funds did worse, but are now trading at discounts to net asset value where the fund manager themselves have historically intervened, buying up shares in the secondary market.
It will be key to find vehicles that match the allocation horizon (generically ETF's are better for short term trading while mutual funds are preferred for very long term allocations). A mix of assets, including specific bonds, can enhance the risk/reward of your fixed income portfolio, which we will examine more closely in the fourth part of this series.
A Powerful Framework
This framework should give you the best ability to construct fixed income portfolios with good risk/reward characteristics, that match your investment outlook.
It also sets the stage for an ongoing process of examination and re-balancing. It won't immunize the portfolio from losses, but I believe it will help you better understand what is happening, which will help you respond better, which over time will generate better risk/reward in your fixed income portfolio.
Disclaimer: The content provided is property of Peter Tchir and any views or opinions expressed herein are those solely of Peter Tchir. This information is for educational and/or entertainment purposes only, so use this information at your own risk. Peter Tchir is not a broker-dealer, legal advisor, tax advisor, accounting advisor or investment advisor of any kind, and does not recommend or advise on the suitability of any trade or investment, nor provide legal, tax or any other investment advice.
