If you focus on the downside risk, the upside return will take care of itself




Sunday 4 August 2013

Bonds: careful on how its role in many portfolios is changing

When I started investing, my vision for the role of bonds in a portfolio was to help produce a steady source of income greater than the cash rate, whilst providing only a small increase in risk relative to the cash position (i.e. we did not see the risk of the issuer we bought being greater than the average bank that is holding your deposits! In fact, we would only buy the bond if we felt the bankruptcy risk was quite remote). Hence a 40% allocation to bonds offering a 5 to 6% source of income (in those good old "normal" times) supported a 60% exposure to equities that were expected to generate around a 10% return per annum over the business cycle. This would allow a portfolio to credibly generate around 8% per annum over the business cycle with the bonds reducing the volatility in the portfolio, which many clients are so afriad of (at this moment I don´t chose my clients, but deal with clients from private banks, many who are lead to believe that volatility is risk in investing: a fact that would be ridiculous for them to consider if it was applied in there family/corporate businesses). However, today this role of bonds is quite limited. Rates are so low for the senior bonds of high quality corporates with duration less than 6 years that the small premium to cash rates today are substantially below the average cash rates for the currencies we deal with (for hard currencies you can assume the average cash rate over the last 100 years is around 4.5%). It is not silly to think that current cash rates will converge to the average over the next 6 years. So to generate that 5 to 6% in bonds today one must buy fixed income securities that are lower in the capital structure. This introduces the world of subordinated and perpetual bonds, as well as preferred shares, contingent convertible securities and the like. In a sentence: you are forced to increase risk to generate the same income. However, since in your portfolio statement all these securities fall under the BONDS section, many still assume it to be near risk free, or at least considerably less risky than equities. Again, as is often the case, the problem is how we define risk. The word risk without an adjective is meaningless. Are you afraid of the size of price risk (i.e. volatility), duration risk (the affect interest rates may have on the price of your investment security), bankruptcy risk, lack of income being generated in your portfolio etc. Depending on what your objective is, it will affect which risks you will be willing to take. For me, my view of bonds has changed, at least for the moment. When I look at great investors I see many don`t buy high quality bonds, but buy junk bonds. I guess if you focus on high quality companies to buy their equity, their is some logic to take advantage of the seniority of debt and focus on the average companies. When you buy a quality stock you often ask will the company prosper. But when you buy a bond, since you do not share in the profits, you only need to ask the question, will they survive. Indeed, I compare this strategy to buying net nets. These are companies that often have deteriorating operating results, but often have no debt on their balance sheet. Hence buying the equity is effectively equivalent to buying the bond. However, in this case you have the potential of a strong capital appreciation as well as any income that may be offered to shareholders. The question would be, is it more fruitful to invest in net nets of poor companies, or the senior debt of poor companies; which historically offers the more attractive return. Note should your analysis be wrong and the company goes through chaper 11 (in the US), as a bond holder you then become the shareholder of effectively a net net company (so you get a second chance!). With a net net unexpected costs may accrue leading to a lower return of capital than expected (book value is often much less in bankruptcy than it is stated on the balance sheet). However, junk bonds role in the portfolio will not be to reduce volatility! But will be there because the risk/reward is attractive and merits its position over cash. This is the only way I think it makes sense to build portfolios. Not to assume what correlations between asset classes may be, or make macro assumptions the pillar of your asset or security selection. You focus on the risk/reward of each investment. If the potential risk adjusted return is offering a satisfactory return greater than cash, it should be considered a worthy investment. Unfortunately client facing institutions rarely think like this. Instead their aim is to make money every year, every quarter, every day. Indeed, it is for this reason value investing continues to make above average returns. The vital ingrediant of patience is simply lacking from our important financial institutions. As a side note, if it was up to me I would focus on working with clients that (1) define risk as the potential of permenantly losing capital, (2) are keen on buying the securities of good companies at good prices, and (3) assess the performance of there investments over a three year period (over apprx. half the business cycle). A client who understands and agrees with the investment philosophy of their investment manager is more likely to have a fruitful relationship in terms of results, and to be more aware when the situation requires patience, or if their manager is sub par. If you cannot explain an idea to a client in a few minutes, it is not worth investing in their portfolio. Transparency and understanding leads to loyalty, and the best possibility of generating good results.

2 comments:

  1. The great blog about Bonds: careful on how its role in many portfolios is changing. Thanks for sharing the blog, seems to be interesting and informative too. Could you help me to find out more details on compare car insurance

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