Sunday, March 20, 2011

Do We Have to Stay in the Fixed Income Trap?

Many institutional investors and wealthy individual investors are constrained by asset allocation policies that were appropriate when high quality yields of 5% or more were available. That is not now the case and instead of adapting this policy, we place capital at risk that we should not.

The Risk Reduction Concept of Asset Allocation

The original format for managing other people’s money and endowment was to have elements of the portfolio rising in value at the same time as other portions were going down. This concept worked well when interest rates rose, because the demand for funds sent down bond prices of issues already trading at the same time as the spiked demand increased the likelihood that prices would rise. Thus, Balanced funds of stocks and bonds were the first type of popular mutual fund in the US in the 1920s. From this practice, Balanced funds’ investment allocations were codified in their prospectuses to 60% in stocks and 40% in bonds within a 10% range of these midpoints. Over the last ninety years trustees looked to bonds first as a strategic reserve element that could recapitalize the stock portion of the portfolio when stock prices lowered the equity commitment to below 50%. Thus, the portfolio would have the ability to actually buy low at depressed prices. In subsequent years the bond portion was able to supply most, if not all, the current income needs to the family or endowment beneficiaries. This worked particularly well in high, by today’s standards, interest periods where there was need to pay out 5% of the principal. (One believes the 5% requirement instigated by the IRS on charitable funds was a subtle attempt to end the immortality of these funds.) In today’s world of high inflation, the expected spending rate should be no higher than 4% on average over an investment cycle. For tax-paying accounts, like wealthy families, the long term payout ratio should be 3%. I will be happy to discuss these views privately with both the receivers and givers of these funds.

Today’s Reality

With the interest rate on high quality bonds (for sake of argument, US Treasuries) historically low today and likely to rise due to inflation, the outlook for bond prices of the high quality nature is dim. Inflation is expected to rise in the near term due to the government and central banks’ manipulation through quantitative easing and similar measures, including this week’s currency intervention. Notice when the government does these things, it is called intervention; the same moves in the private/commercial world would be called manipulation. The second and more natural cause for increased inflation expectation is the cyclical recovery of many of the world’s economies, as demand comes up against short term supply capacity constraints.

Thus, I believe there is significant price risk to bonds larger than their annual coupon. The professionals call this interest rate risk, to identify when interest rates go up, forcing the prices of existing bonds to decline.

Current Practice

I sit on a number of non-profit investment committees who have evolved an asset allocation strategy of roughly 60% equities (split between so-called domestic and foreign stocks), 30% in bonds and 10% in short term cash instruments. The reason for the last 10% is to assure the recipients of a 5% spending rate that, even if the investment world would collapse and the other assets would be wiped out, they would receive payments for two years.

The Dilemma

We cannot produce a cash income equal to the desired long term spending rates from today’s portfolios. None of the allocations are producing current cash returns to meet the assigned needs. The last several years have demonstrated that while stocks in the long run produce superior results, the variability of their returns do not meet the annual needs each and every year. In today’s environment there are four methods of dealing with this problem:

  1. Accept some capital risk and use lower quality (high yield) paper, usually bonds or very high dividend paying stocks.

  2. Use an averaging technique in setting the spending rate on the basis of the average of a certain number of years. The most popular period advocated by many consultants (for their own business reasons) is three years. There is much history to indicate that one can get three year movements in one direction, unlikely then to be repeated in the immediate future. Four years works better in the US, perhaps due to the presidential cycle. My personal preference is five years, as it often links well with the strategies of many corporate CEOs.

  3. Accept long term defeat by accepting a limit to the institution’s or family’s mortality by recognizing that the asset pool will shrink into eventual oblivion.

  4. Adjust the current spending practices to today’s reality.

I have dealt with all four approaches and each can be appropriate depending upon the situation. My preferred approach is to turn my back on fixed income, keep a short strategic reserve for capital opportunities and adjust the spending rate to a long term average. To the extent that bonds are required, we have recently reduced our commitment to Intermediate US Treasuries in favor TIPS. There is a substantial give up in income, approximately 240 basis points at the ten year level. However, since the end of 2010, a TIPS fund has gained 2.88% compared with 1.04% for an Intermediate Treasury fund, roughly making up ¾ of the yield gap.

The Vacuum Will Be Filled

Among the most creative members of the financial community are the investment bankers focused on fixed income. I fully expect that the minds that created securitization of mortgages, credit card asset backed securities and other asset types are at work to fill the vacuum created by asset allocation requirements. This time, let us hope that they produce sounder products for investors. The other solution is that the courts will decide that including fixed income in asset allocation is not necessarily prudent. One has difficulty thinking of many large fortunes made through investing in bonds, but there are a number that have been diminished.

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