Thursday, April 2, 2009

A Turning Tide in Fixed Income

If you were fortunate and bright enough to have balanced your portfolio over the past year with a healthy dose of treasury bonds, you did well. Now the trick is to keep it. The entire point of diversification is to benefit from rebalancing. While many are still shell shocked from equity performance last year, others may be straining to pat themselves on the back.

Lately I have seen too many portfolios which should now be rebalancing as they move back toward riskier investments, but are unable to because of near 100% allocations to stocks. Now is not really the time to be fleeing risky asset classes. That ship has sailed. But a diversified portfolio with its sizable allocation of fixed income has a new challenge ahead.

The economic conditions that caused a 20+ year bull market in bonds are in the process of reversing. Pay attention. While the true diversification of treasury bonds in a flight to safety benefited mightly last year, it is now arguable that treasury bonds have created their own bubble. Like all bubbles, when it goes, it goes fast and painfully.

For this reason bond allocation should be focusing on "spread product." That is, the higher risk bonds which suffered along with the equity market last year. If an investor maintains a large bond allocation on principal, the coming year will present crucial decisions. Below is the first quarter 2009 bond performance of: the 20+yr treasury bond, the short position in 20+yr treasuries, high yield bonds, the aggregate bond index of a diversified range of bonds, corporate bonds, mortgage backed securities and finally, emerging markets bonds.

The 20+ treasury did quite poorly this past quarter losing 11%. Mortgage backed securities fared somewhat better with 1.5% gains, while the short position in 20+ Treasuries did as expected and was higher by almost 16%

This new bubble suggests somewhat of a dilemma in allocation strategy. In fact the only truly diversifying bond is the risk free treasury. In a crisis it provides powerful protection. The other bonds on the risk curve act substantially like equities and move as broad markets move. In other words what is the advantage of having ANY bond allocation now? The alternative is to short the one diversifying asset class, treasuries. Does that then bring any benefit not accrued to simply investing that portion in equities?

It is entirely possible as some are predicting that corporate bonds, beaten down in the previous year will perform better than stocks. Therefore the bond allocation may be no longer a question of diversification, but rather of performance.

Our clients will be encouraged to maintain a modest exposure to treasury bonds, higher allocations of spread product, i.e. corporates, high yield and emerging market fixed income allocations, but overall, bond allocations will migrate to the lower levels of strategic allocation.

John Barnyak