Trimming Your Core

Aurum Weekly Access - 12/20/12

Tis the season to gather with friends and family and indulge on delicious meals, deserts, and even beverages, perhaps.  Soon after the holidays pass though, resolutions on losing the extra pounds from the festivities this time of year will be here, usually focusing on that stubborn mid-section area to slim down the core.

With investors' overindulgence in fixed income the last couple of years, many may also consider trimming 'core' bonds in portfolios, as well as 'core plus' strategies.  (Core is a moniker for the fixed income allocations comprising government, investment grade, and municipals while the 'plus' typically includes high yield corporates, CMBS, etc.)

Retail investors poured money into fixed income over the last several years and are not typically adept at asset allocation timing decisions.  As seen below, the last time flows into an asset class were so sharp was the late 1990s into Long-Only (LO) equities.


These flows comes at a time when interest rates are near 32-year lows and at the bottom end of the trend channel (the red line). Check out the long bond (30-year Treasury) below.


Starting yields matter for future returns.  Note the close between relationship the 10-year Treasury yield and the subsequent rolling 10-year return of the Barclays Aggregate Bond Index.  (The blue line stops with the last full 10-year period, which ended September 2002.)


Across the core area of intermediate fixed income, investors face paltry yields that are below today's current rate of inflation.  This is the result of financial repression in which the Central Bank influences interest rates for a number of reasons, including keeping government debt costs lower, helping financial institutions repair balance sheets, and forcing investors further out on the risk curve, buoying asset prices, to achieve a so-called 'wealth effect.'

The issue is that this policy pulls returns forward.  The Yield to Maturity (YTM) of a bond portfolio is a well-accepted estimate of future expected returns.  As of 11/30/12, the Vanguard Total Bond Market fund (a proxy for the Barclays Aggregate Bond Index) had a YTM of 1.62%.  The average 5-year AAA-rated municipal bond yields 0.85%.  Investment grade corporates are around 2% and obviously less on an after-tax basis.

With pitiful expected returns, a major risk facing investors is a rise of interest rates.  Duration is a measure of interest rate risk.  Assuming parallel shifts in the yield curve, one can estimate the expected positive return (all things equal) if interest rates fall, or the expected negative return (all things equal) if interest rates rise. As of 11/30/12, the Vanguard Total Bond Market fund has an average duration of 5.0.  Given the front end of the yield curve is near zero, the five-year is at 0.8% and the ten-year at 1.8%, we assume a theoretical 50 basis point fall in rates would provide 2.5% in capital appreciation.  A 1% rise in rates produces a 5% loss, a 2% rise in rates produces a 10% loss.

In other words, there is (mathematically) little upside in core and core plus strategies with potential downside.  Here is a scenario analysis from credit rating agency Fitch for a 10-year BBB-rated corporate bond.   While the 3.5% coupon of is relatively nice given the repressed interest rate environment, the result of a 1% rate rise is an 8% loss while a 2% interest rate rise is a 15% loss.


High yield bonds also carry similar and additional risks.  Prices of bonds are above par, nearing call provisions from companies and clearly have much less attractive valuations.  In addition, many deals are being completed at aggressive levels; there has been record issuance with little in gains for the asset class over the past several months while fund flows continue.  This is the best time ever to raise debt for companies with a junk credit rating, given the average 6.3% effective yield, but it may not be the best for the owners of these bonds.


Treasury bond yields look stretched against long-term moving averages, in fact the 10-year is the farthest from its 7-year moving average since 1993, just prior to a surprise interest rate hike in 1994.  Momentum of recent lows in interest rates also were not confirmed.  (For the technically inclined, there were negative divergences across the treasury curve.)

Further validating the risk of an interest rate rise was the Federal Reserve.  Last week, it gave an opening to raise rates sooner than the middle of 2015 if unemployment improves to 6.5% (from 7.7% currently) and inflation expectations rise above 2.5%.  This garnered little attention as most reports focused solely on the next round of Quantitative Easing.

Counter-points to the above:

1. The Federal Reserve owns the yield curve.  Its mere words can move the bond market.  There are no bond vigilantes as evidenced by the very low interest rates of the U.K. and Japan, whose monetary systems are closest to the United States.  The Federal Reserve said rates will not move until the middle of 2015 and the bond market still has the first fed funds rate hike at February 2015.

2. Demand for high quality bonds remains high among financial institutions such as banks as regulators force them to shore up their balance sheets.  Insurance companies and pension plans have long-dated liabilities which will continue to keep demand for paper quite high.  Baby boomers will continue to de-risk portfolios and seek income in retirement.

3. Per fixed income manager Van Hoisington's commentary from 3Q 2010 – "According to the Fisher equation, one of the most tested and documented pillars of economics, the long risk-free yield (or the nominal yield) equals the real rate on long Treasury bonds (30-year) plus the expected rate of inflation.... The real rate is very volatile and not predictable over the short-run. However, it averaged 2.1% over the long run and is mean reverting.  Over time the long Treasury bond yield moves in the direction of inflationary expectations.  Inflationary expectations lag actual inflation by a considerable period of time, sometimes more than several years.  If the low point in inflation is well down the road, as cyclical analysis would suggest, then the low in bond yields lies ahead."

While interest rates look set to remain lower for longer over a secular time frame, rates are much closer to the bottom of the historical range and have a risk of going towards the top end over the medium-term resulting in mark to market losses for investors.  Even without a move higher in interest rates, expected returns from traditional core and core plus bond strategies remain below inflation and uninspiring.

Now enjoy those holiday cookies and worry about your body's 'core' later.  After all, it's only once a year, right?

Important Disclosures

This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein.

Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein.  This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.  Persons should not use any information contained herein or linked presentations as a primary reason for investment or tax decisions.

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