Friday, February 17, 2017

Bond Dilemma



I am often questioned by clients about the makeup of the "fixed income" or "bond" portion of their portfolio.  Most clients understand risk associated with stocks--but the risks associated with interest bearing investments is less well understood.

Portfolio Allocation often is oversimplified as "60/40" or "70/30" referring to the mix of stocks and "bonds".  (i.e. 60% stocks and 40% interest bearing fixed income.)  In reality, Portfolio Allocation is much more comprehensive in that it relates to the form and benefits of "diversification".

The purpose of the "interest bearing fixed income" portion of the portfolio is generally two-fold. First to provide investments that are more stable and therefore less risky. Second, to provide investments that often are negatively correlated to stocks. (Negative correlation is when stocks "zig" then bonds can "zag.) So, essentially the purpose of the "interest bearing fixed income" portion of the portfolio is to reduce the volatility and risk of the portfolio.

What is often misunderstood, is that many fixed income investments carry SIGNIFICANT risk of loss.  When interest rates rise, the market value of the "bond" can fall significantly.  The longer the "term" or "maturity" of the bond, the more it will fall.  So, when interest rates are historically low, an important part of risk management is to hold more stable fixed income investments----meaning short term.

The definition of "short term" is important. To some, a one year maturity is "short". To another, "short" is more like 90 days.  The markets often tend to now use the term "ultra-short" or "cash" for investments that mature in 90 days or less.













The graph shows the "dilemma".  (Click on graph to see it bigger.) In the last six months, as interest rates increased only slightly: Ultra Short Term Fixed Income was essentially unchanged at 0.12%; 1-3 year US Treasuries fell by 0.72%; Short Term Corporate Debt fell by 1.39%; and 10 year US Treasuries fell by 6.23%.

Imagine having $400,000.00 or 40% of your "60/40" so called "conservative" portfolio invested in 10 year US Treasury Bonds (thru mutual funds or ETF's) and suffering a $25,000.00 loss in portfolio value!

So, since 2014, with the FED and other Central Banks engaging in unprecedented interest rate reduction strategies, the risk of rising interest rates has created this dilemma: Make low interest but take low risk, or try for higher interest and take the risk of suffering substantial loss. Such is the "dilemma" always faced when evaluating the best investments for a truly diversified portfolio that carries the level of "appropriate and acceptable" risk.