With the large-cap equity market thought to be universally cheap today, and the Treasury market universally “overvalued” (the complete opposite of the 1990’s), how do we have client fixed-income money invested today ?
Briefly, we are “overweight” credit, and overweight “unconstrained” bond funds, own no Treasuries directly and in fact have a 10% – 15% short position in Treasuries via the TBF, and are building floating-rate positions gradually, as we prepare for higher interest rates.
I personally think it is harder to invest fixed income money today, given what we perceive to be great value in many names in the stock market, and the general frightening dynamics in bonds given the fund flows and everyone reaching for safety. Bond mutual fund inflows continue to exceed stock mutual fund inflows, which has been the case for some time. Some view this as a contrarian signal, but that isnt always the case.
Our biggest concentration in client accounts (roughly 30% – 50%) is the “unconstrained bond funds”, which are represented by the Loomis – Sayles Bond Fund, Goldman Sachs Strategic Income and the Pimco Unconstrained Bond Fund, which is the less volatile of the 3 funds. I really like the PIMCO Unconstrained Bond Fund given its lack of volatility and longer-term focus, and plan on allocating more to it in the future. The Loomis Sayles Fund yields 5%, while the Pimco Unconstrained Fund yields 2.5%, but the Pimco fund has been far less volatile the last few years, which we like to see.
The unconstrained exposure essentially delegates the decisions around Sovereign and Emerging Market debt to the bond fund manager, and lets me allocate client money to where I think there is good value.
Typically, high yield can be 5% to 20% of client accounts in most allocation models, which varies by the client, but we are tactically allocated to be more heavily-weighted in high-yield today given the quality of corporate balance sheets, not to mention the amounts of cash on corporate balance sheets, and the liquidity in the high yield market which is allowing corporations to refi higher-yielding debt. We are long both the high yield ETF’s (HYG and JNK), which give us the ability to quickly reduce the high-yield weighting of needed, but we also own the PIMCO High Yield Fund to get clients access to the higher rated portion of the high yield market, while the Pioneer High Yield Fund represents the riskier, higher-beta allocation (convertibles and even some equity exposure) to the lower end of the high-yield market. In essence, the two mutual funds barbell the high yield market for clients, while the ETF’s allow us to tactically increase or decrease the high yield weighting quickly if needed.
High grade corporates – given the yields on investment grade corporates today, we don’t have a big allocation to high-grade in client accounts, preferring instead to tactically allocate funds to the higher-rated section of the high yield market. Still high-grade is 5% – 15% of client accounts, with an itchy trigger finger once the US economy starts to strengthen rapidly (which seems like it will never happen).
Treasury short position – using the Proshares Treasury short ETF (ticker TBF), we have maintained a 5% – 12% Treasury short position in client accounts, which really represents a hedge for the high-grade corporate bond exposure. Obviously this has been a painful long, but the TBF is “unlevered” and doesn’t have the NAV erosion that “2(x) leveraged” ETF’s have like the TBT. The TBT is tactically traded for short periods, but we’ve maintained a steady long in the TBF.
While everyone and their brother thinks lending the US government your money for 10 years at 1.50% is a sucker’s game, “everyone” (i.e. most institutional investors) have been underweight their duration benchmark for years, thereby NOT getting the benefit of this interest rate and Treasury rally. In other words, despite the Treasury rally, there is no real “irrational exuberance” for the asset class, very unlike March 2000 and the Nasdaq.
Floating-rate exposure – still too early for a heavier weighting, so we use two closed-end bond funds with good yields that are bank loan funds, but with floating-rate coupons. We track the HCF and JRO, but are currently only long the HCF. The HCF is a closed-end, bank loan fund with a distribution rate of 7% (no return on capital the last few years) and which is currently trading at a 12% discount to NAV. Technically, we’d prefer to see the HCF trade back over $6.20- $6.25. We will buy the JRO and increase our floating-rate exposure once we are sure interest rates have bottomed and there looks to be an imminent change in monetary policy by the Fed.
Muni’s – in taxable and muni accounts we are barbelled between short-term muni funds and muni high fields like Nuveen’s fund managed by John Miller. However, beware that muni high yield funds have a very long duration, and when interest rates do rise, some of the municipal credit improvement from higher tax and municipal revenues will be offset by that very long duration (i.e. interest rate risk).
Cash – 5% – 10%: earning nothing, but Greece event risk compels us to keep cash on hand.
The 2008 – 2009 recession precipitated by Lehman’s collapse was every advisors nightmare, since all the various asset classes in both fixed income and equity had a “correlation of 1” (except Treasuries). We don’t think that will happen again, despite worries over Greece, but we have structured the fixed income portfolios to remain flexible and liquid.
We think credit risk is the place to be right now, at least through 2012, although Greece and event risk remain an issue.
When interest rates do rise, (and they should eventually, and it could be very ugly when it happens, much like the first leg of the Nasdaq correction in April, May of 2000) we will likely restructure client accounts and own more individual bonds than bond funds. In a rapidly rising interest rate environment, the one sure way to NOT lose money is to buy-and-hold individual bonds until maturity.
My guess is that when interest rates do rise, there will be a whole lot of individual investors caught with losses in mutual funds, that thought that they couldnt lose money in “bonds”.
It will not be a pleasant circumstance, I can assure you.