A Balanced Portfolio Diet

Why do you invest in fixed income? When I entered the fixed income business 25 years ago, the most popular answers would have been:

To generate income while preserving capital.

Or

To generate income while matching return of principal to expected actuarial needs (expected liabilities).

Ask this question today and you might get an answer, such as:

To have a negative correlation to equities to protect my portfolio balance in case equity price decline.

Would you answer the question;

Why do you eat vegetables?

With

To offset the impact of meat?

Of course not. When you eat, you diversify among food groups so the all contribute to a positive outcome. However, each food/food group benefits in a different way.

Since the meteoric rise of Modern Portfolio Theory and Unified Managed Accounts during the past decade, the original purpose of fixed income investments have become lost. MPT and UMA have transformed everything into meat, the total return portion of a portfolio. Most (if not all) UMA portfolios view all assets as a total return holding. When returns or the various asset classes change, the portfolio is rebalanced. Few UMA/MPT portfolios offer actual bonds. Thus, most UMA portfolios are akin to a diet of chicken, beef and pork. It appears diversified, but it really isn’t. Missing are the fruit, vegetables and grains.

The wealth management firms are keenly aware of the fact that UMA portfolios are, in some ways, investment diet deficient. This is why they often tell advisors and investors half-truths and outright prevarications, such as, one cannot buy individual bonds as cheaply as a professional manager”, or “odd-lot bond purchases are more difficult to transact due to their small size.”

There was some truth to this in the past, but advancements in technology, such as the rise of electronic communications networks (ECNs) and the implementation or bond execution reporting platforms, such as TRACE and MRSB pricing, have leveled the playing field considerably. The improved bond price clarity has narrowed bid/ask spreads. The result is often little differentiation between odd-lot and round lot pricing. Another playing field leveler are new financial regulations which limit banks in the area of proprietary trading.

New financial regulations have impacted bond market marking in two ways. For one, banks cannot easily make markets. They often must prove such activities were for the benefits of clients. Secondly, when bank trading desks do position bonds, they must hold reserve capital to offset their proprietary trading positions. This measured on a risk-weighted basis. A position on B-rated junk bonds requires a bank to hold aside more reserve capital than a positions of AA-rated municipal bonds. The result is; more odd-lot offerings pop up on ECNs. Often is the case that a 20m bond offering is prices more attractively (higher yield) than a 2mm bond offering. This runs directly counter to what wealth management firms are telling their advisors and clients.

If what wealth management firms are telling their advisors and clients, why do they do it? The answer is: Liability management. Firms want to reduce (or eliminate) the risk of an advisor choosing an inappropriate bond because he or she did not understand the credit risk, duration risk or some other feature of the bond. Is this best for the client? Probably not. A client deserved the best portfolio with properly-chosen investments, not something that is close enough and suitable.

What about the cost aspect of investing in actual bonds? Investing in a bond portfolio (ladder, barbell, bullet portfolios, etc.) on a transactional basis may or may not be the most affordable option. This depends on two things:

• How much sales credit your advisor takes per trade.
• How frequently active trading and rebalancing is done.

Most advisors I know are not piggish when charging sales credit on bond transactions. However, many investors expect the advisor work for free or to charged what a discount brokerage firm might charge. However, there is something which investors must bear in mind: When purchasing bonds via a discount brokerage, you are on your own as far as bond structure and credit stories are concerned. Unlike stock, bonds, even those issued by the same company, can be markedly different. Each bond must be viewed as a separate entity.

Bonds from the same company, even those with the similar maturities, can expose investors to different degrees of duration risk, credit risk and event risk. Call options, what is backing the bond and where bonds sit on the capital structure can differ, even among bonds which appear almost identical to the casual observer. A good and knowledgeable financial advisors will take the time to review the particulars of each bond before making a recommendation. Thus, at least in my opinion, the advisor is entitled to seek compensation for his or her work. After all, the folks managing the UMA (as well as those managing the holdings inside a UMA) are charging for their time and efforts via management fees.

This brings me to separately managed accounts (SMAs). In my opinion, a separately managed account can offer the best of all worlds to a true fixed income investors. With an SMA account, an investor actually owns his or her bonds. Thus, in times of market volatility, investors need only to clip their coupons and wait for the volatility to pass, knowing that, if the bonds’ issuers remain solvent, investors will receive par at maturity. Liquidity can be provided by laddering a portfolio (a portfolio in which each security has a significantly different maturity date and is, more or less, evenly spaced). The idea behind a bond ladder is to minimize interest-rate risk and to increase liquidity). A barbell is a more aggressive version of this strategy, with holdings focused on the short end of the curve (to provide liquidity and to allow timely reinvestment of principal in a rising rate environment) and the long end of the curve (to lock in more attractive yields in case rates do not rise very much, if at all). The ladder and barbell are, in a way, hedged portfolios as they are designed to take into account the debilitating effects of rising rates and stagnant or falling rates.

 Then there is the costs, UMA portfolios can often involve net fee expenses of around 3.0%, once mutual fund expenses are factored. One may be able to justify this for an aggressive portfolio of the aggressive portion of one’s over all investment strategy, but to charge nearly 3.0%, or even 2.00% for fixed income investment management is egregious, in my opinion, especially in this low rate environment. SMA accounts can be constructed where the net fees to the client are well under 1.0%. In many instances, fees or 50 basis points or less are available, even on relatively small portfolios.

Of course, this does not allow easy rebalancing between equity, alternative and fixed income investments, but as I stated at the beginning of this article, fixed income can be (should be) used for purposes other than inverse correlation to equities. Fixed income should be owned to provide positive outcomes, just as other asset classes, but in a different manner. Where the goal of most equity investments is total return (with a bit of dividend income thrown in), fixed income investing should be about interest income and preservation of capital (via the ability to hold to maturity).

There is no need to have one’s fixed income investments underperform when one’s equity investments are outperforming. By staggering maturities, choosing exposure wisely and (if necessary) holding to maturity, investors can use fixed income investments to augment returns from other asset classes rather than simply offset them, often while paying affordable fees.