Why is a Properly Diversified Fixed Income Portfolio so Important Today?

 

strategy-compass-ssWe have a decidedly middle of the road view on growth and inflation (both should be positive, but moderate). As such, we favor neither long-duration nor short duration strategies. A long duration strategy can leave investors exposed to significant interest rate volatility even if long-term rates rise just a point. With short-term rates near 0.00%, a short-duration strategy is punitive. Based on how the Fed typically raises short-term interest rates, investors engaging in a short-duration strategy would probably need many years of rising short-term rates to equal the return of a well-constructed laddered portfolio. The problem is that Fed tightening cycles typically only last about two years. After that, the Fed begins lowering the Fed Funds Rate.

 

To see a list of high yielding CDs go here.

 

If we consider that the Fed might not begin raising the Fed Funds Rate until mid-2015 and will probably raise rates gradually and moderately, it is conceivable that we could see a cyclical peak Fed Funds Rate of about 3.00% by 2017. Considering where short-term rates are today, one might be able to purchase a three-year treasury note at 0.78% and match the return one might earn by trying to roll with the Fed. One could purchase a five-year note today around 1.53%, possibly beat the average return generated by rolling with the Fed and be locked in with a relatively attractive return for the final two years of the note as the Fed (possibly) begins lowering rates.

The thing is; we don’t know what the Fed will ultimately do. We don’t know where interest rates, inflation and growth will be. Because of this, it is imperative that investors consider a properly diversified fixed income portfolio. Strategies, such as laddering, can lock in part of the portfolio farther out on the curve to generate fairly high rates of income in case interest rates do not rise very much while the shorter duration holdings permit investors to, reinvest matured proceeds at higher rates should a rising rate scenario play out. Critics point out that with a ladder, part of the portfolio will almost always be positioned “incorrectly.” However, it also means that half the portfolio is probably positioned correctly.

The alternative is to time the markets and trade/rebalance actively. This can be difficult if not impossible to accomplish. Unconstrained strategies allow portfolio managers to easily change exposure, but unconstrained does not always mean correct. This is evidenced by the number of unconstrained bond managers who were net short long-term debt and were burnt by the unexpected drop in long-term rates. Although Bond Squad was not predicting the kind of rally seen in long-term fixed income this year, our portfolios weathered the storm fairly well because we were laddered. If we would have extended out on the curve last year, we would have hit a home run. However, if we would have taken on a low duration or duration neutral approach, it might have been painful. Our advice to fixed income investors is to resist the product and strategy du jour.

This is shaping up to be a fairly innocuous summer. The U.S. economy appears on track for 2.5% to 3.00% growth in the second half of the year, inflation pressures should crawl toward trend and long-term interest rates should mostly remain range-bound in the mid-2.00% area for the time being. Conditions are developing which should favor lower-end investment grade and upper-tier high yield corporate bonds and BBB to AA-rated municipal bonds. On the equity side, go large, watch your P/E ratios and remember, dividends matter.

 

By Thomas Byrne – Director of Fixed Income – Investment Consultantthomas bryneThomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets. Employment

  • November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
  • December 2011 – November 2012 – Bond Squad, Kunkletown, PA
  • April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
  • June 1986 – March 1988 – E.F. Hutton, New York, NY

Thomas Byrne

Director of Fixed Income
Wealth Strategies & Management LLC
570-424-1555 Office
570-234-6350 Cell
Twitter: @Bond_Squad
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.“Bond Squad is my favorite bond investing newsletter. It combines common sense with deep market knowledge.”
 

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