Tag Archives: Interest Rate Risk

Analyzing This Year’s Market Returns

Many investors assume their accounts have achieved good returns this year. After all, the S&P 500 Index is up nearly 9.5% through October 8, including dividends. But that doesn’t necessarily mean your account has an inflation-beating return for the year depending on your bond and international stock exposure.

And while bonds and foreign stocks have been drags on portfolios this year, owning them is no reason to change your allocation. But now is a good time for a portfolio assessment or a moment of understanding what you own and why – and how asset class returns have diverged this year.

A Tale of Two Balanced Portfolios

Let’s say you’re a balanced investor (around 60% stocks and 40% bonds) and you have all your money in one fund – the Vanguard Balanced Index fund (VBINX). That fund keeps 60% of its assets in U.S. stocks and 40% of its assets in U.S. bonds, and it’s up 4.29% for this year through yesterday. That’s a decent return, but it seems far away from the 9.5% return of U.S. stocks.

If you’re guessing that bonds have been a drag on portfolios this year, you’re right. The Bloomberg Barclays U.S. Aggregate Index, the main U.S. bond benchmark is down 2.53% for the year. When 40% of your portfolio is down it will necessarily damp the effect from the part of the portfolio that has done well. And while that can make you wish you didn’t own any bonds, your bonds will save you the next time the stock market tanks – especially if they are government bonds. A 100% domestic stock portfolio – especially when the S&P 500 is trading at expensive valuations – probably isn’t a good idea for any investor. Most people can’t handle the volatility of a 100% stock portfolio even when the market is cheap on reliable long-term metrics like the Shiller PE. And you own bonds as a kind of insurance policy that happened not to pay off this year. That’s fine; you’re not supposed to make an insurance claim every year. So if you’ve captured a 4% return from your balanced portfolio so far this year, that’s a good return.

If you own a balanced portfolio that’s diversified into international stocks, your returns are less appealing (though still not awful). That’s because the global stock market, measured by the MSCI ACWI Index, is up only 1.56%, a far cry from the 9.5% return of the S&P 500 Index. International stocks, both developed country and emerging markets, have posted losses this year in U.S. dollar terms. And since U.S. bonds are down 2.53%, a balanced portfolio of global stocks (assuming unhedged currency exposure) and domestic bonds is down 0.76% for the year. That’s a modest loss, but any loss feels worse than a 4.29% gain or a 9.5% gain.

But, again, nobody should make dramatic changes to their portfolios or fire their advisor if their balanced portfolio has posted a loss. Many good investors have argued that foreign stocks are cheaper than U.S. stocks. They are likely to outperform over the next 7-10 years, so there’s a good reason to hold them. Also, as recently as last year, international stocks outperformed U.S. stocks. In 2017, the S&P 500 Index delivered a 22% return including dividends. But the MSCI EAFE Index for developed country foreign stocks returned 25% and the MSCI EM Index for emerging markets stocks returned a whopping 37%, both in U.S. dollar terms. So sometimes diversification benefits you, and sometimes it doesn’t. Sometimes owning a cheaper asset doesn’t pay off immediately. And it could happen that international stocks outperform domestic stocks next year again, despite a slowing global economy and currency issues for emerging markets due to a rising U.S. dollar. As it happens, Lance Roberts, who manages portfolios at Clarity Financial, has avoided international stocks for most of the year, and that has been a benefit to portfolios. He has written about his avoidance of international stocks here.

Above all, remember also that you’re not in this for one year’s worth of returns. It’s true that analysts and pundits focus on ridiculously long periods of time that no normal human being has for investment purposes – 100 years, for example. But you don’t have one year either if you have stock exposure. You probably have at least 10 years, maybe 20, and possibly even 30, if you’re about to retire. That doesn’t mean poor years should be taken cavalierly, especially early in retirement. But If you have bond exposure and international stock exposure, understand why you have them and that it’s not always easy to predict how any asset classes will perform from year to year.

Overall, if you have any kind of positive return from a balanced portfolio this year, you’re doing reasonably well. Please feel free to contact us if you have questions about this year’s returns, asset allocation, or retirement planning.

Inflation Or Deflation? And How to Cope With Both.

The following is a slightly adjusted email I’ve sent to clients concerned about inflation lately. Sometimes retail investors have legitimate fear and anticipate economic trends correctly, but sometimes they don’t It’s striking how many investors have been gripped by inflation fears recently. Please understand that different clients have different needs, and not all portfolios are the same.


Dear Client — I’ve been thinking about the problem of increasing inflation, and preparing for it. Here’s a run-down of the major asset classes, and how they typically respond to inflation (or have been responding to rising rates and inflation fears lately).

Bonds – except the shortest term bonds or the most cash-like bonds – their value declines because they’re paying a fixed dollar return and, sort of by definition, are not keeping up with inflation. But short term bonds and cash are decent choices. Short term bonds and cash instruments like money markets just tend to pay higher and higher interest rates when rates are going up. In our own portfolios, we use short-duration bonds, floating rating investments and CD’s for liquidity needs as they mature quickly to capture new, higher rates when rates move up.

We’re seeing those yields move up now as the yield on the 2-year US Treasury is up to 2.5% or so. That doesn’t sound like much, but it’s a huge jump from where it was a year or two ago TIPS (Treasury inflation-protected bonds) also protect against inflation. Their principal gets adjusted according to the consumer price index (CPI), which is the main indicator of inflation.

Stocks tend to produce better-than-inflation returns over long periods of time, but not necessarily when inflation is running at its highest clip, and not necessarily from high starting valuations (such as we have now). Stocks didn’t do well in the 1970s, for example. Over time companies pass through higher costs, but that’s not always reflected in the stock prices immediately. That’s because higher interest rates tend to send all financial asset prices down. And that’s probably why the stock market has been more volatile this year.

REITs act mostly like stocks in the long run. (And they are, in fact, stocks or ownership units.) They will pass through the higher costs over time by charging higher rents, but that won’t necessarily be reflected in stock prices immediately. And the truth is we’ve already had a lot of rent inflation since the financial crisis that hasn’t been captured in the official inflation numbers in my opinion. Residential rents have been skyrocketing for a long time now. They’ve been in such a long cycle that they are actually slowing down a lot in NYC and SF.  I think REITs are just to expensive now, and they are reacting badly this year to inflation fears. They’ve tended to trade more like long-term bonds in recent years, which they do from time to time, and have faltered every time rates have moved up this year. That doesn’t bode well for how they might perform if we get higher inflation. Early this year, when rates were moving higher (inflation fear), REITs stumbled badly. Only when rates stopped going up, did REITs recover a bit. The following graph shows that REITs have been more volatile than Treasuries, but have moved somewhat in line with them this year.

That leaves commodities. In standard asset allocation models, around 5% of the portfolio in normally allocated to commodity type funds. However, over time, commodities don’t do so well though, so manage commodity exposure very carefully. A bet on commodities is, in some sense, a bet against human ingenuity, after all.

Last, keep in mind the economy is still kind of tepid, despite the very low unemployment numbers. The Labor Force Participation Rate is low, and middle class incomes aren’t rising. The most interesting question is whether we’ll get deflation because of a sluggish economy (and we haven’t had a recession in a while) or inflation because of the reasons you state – a lot of money printing, growing deficits, and tariffs. We have to be prepared for different scenarios, and we’ve structured the portfolio to withstand a variety of outcomes.

How’s Your Bond Fund Doing?

It’s been a tough year for bonds so far. Of course, a tough year for bonds can be a tough day for stocks. But investors seem equally disturbed by a 2% loss in bonds as by a 10% or more loss in stocks, so it’s worth looking at how bond funds have weathered the most recent storm. We looked at some of the most popular funds that reside in Morningstar’s intermediate term bond fund category. That category contains funds whose duration is moderate and whose holdings tend to be almost all investment grade, and so those funds tend to be the workhorses of most investors’ portfolios.

Through May 1, the BloombergBarclays US Aggregate is down 2.42%. That’s a total return number, so it includes the difference in price plus interest payments. The Morningstar intermediate term bond fund category average is down 2.11%, a slightly better showing likely owing to the higher corporate bond exposure and slightly lower duration of many funds compared to the Treasury -heavy index.

Duration Hurts

First, all of our selected funds have beaten the index so far this year except for the Western Asset Core Bond fund. The fund’s portfolio doesn’t appear unusual, although it has more of its assets in Agency Pass-Throughs than its peers (35% versus 21%), according to Morningstar. It has nearly 22% of its portfolio in Government bonds, according to Morningstar. Almost all of that is in U.S. Treasuries with a small part scattered in U.S. Agencies and Non-U.S. government debt. Nearly 8% of the fund’s portfolio is in emerging markets debt.

However, the fund’s average effective duration, a measure of interest rate risk, is nearly seven years, and that has likely contributed to its underperformance. No other fund’s duration is over seven, and the next highest three are barely over six. Five of the funds have durations around 4 years, and they’ve tended to hold up better this year.

Things Besides Duration Matter Too

Two funds stand out for bucking the trend of duration dictating performance. First, the Delaware Diversified Income Fund clocks in with a duration of 6.09, but the fund has still been able to eke out a gain over the Morningstar intermediate term category average and the Bloomberg Barclays U.S. Aggregate. This fund has traditionally held a lot of corporate bonds, including more high yield bonds than its peers. Currently the fund has 13% of its portfolio in BB-rated bonds (the highest level of junk or high yield), and those have held up better than more highly rated bonds this year. So the fund’s credit risk has likely helped it in an environment when interest rate risk has inflicted more pain.

Second, PIMCO Total Return has the lowest duration of the group at 3.99 years, but has lost more than the category average. The fund has been lighter in corporates than its peers – 19% versus 30%, according to Morningstar. It also has a significant allocation to what it classifies as “US Government Related,” which, according to PIMCO’s website, could include “nominal and inflation-protected Treasuries, Treasury futures and options, agencies, FDIC-guaranteed and government-guaranteed corporate securities, and interest-rate swaps.” Morningstar has its Agency MBS Pass-Through allocation at 39%, relative to 22% for its peer average. The fund’s most recent quarterly commentary mentions that positions in Agency MBS along with short exposure to the Japanese Yen, short exposure to duration in Japan and Canada, and exposure to high yield corporates” detracted from performance. The fund’s most recent monthly commentary lists non-U.S. rate strategies, positions in non-Agency MBS, and high yield corporates as the largest detractors.

It should be said that the new managers of PIMCO Total Return have done quite well since taking over in the fall of 2014. The new management team has been running the fund for a little over three years now, and, after a choppy start, the fund ranks in the 28th percentile of Morningstar’s intermediate term category for the three-year period ending in April 2018. A quarter’s worth of underperformance shouldn’t discourage any investor from choosing a particular fund or manager, though it’s useful to check in on asset classes and particular funds from time to time.

The Other Face Of Risk – Bonds

Usually, when it’s a good time to own high quality intermediate term bonds – those that serve as workhorses of most investors’ portfolios, it’s a bad time to own “high yield” (a nice marketing term for “junk”) bonds, and vice versa. That’s because lower interest rates provide a good climate for relatively safe bonds that don’t deliver much yield, and because the economic weakness that low rates signal is often a danger to shaky borrowers.

Conversely, the rising rates that can inflict duration-related damage to safer, lower yielding bonds usually coincide with a robust economy that’s good for junk bonds. So it’s not often that the climate is good or bad for both high-quality intermediate term bonds and high yielding junk bonds.

But, in a note to its investors, the Los Angeles-based value investment firm FPA Funds has just argued that the current environment is bad for both the typical portfolio bond workhorses and more exotic high yielding fare. First, there is a disagreement between the yield curve and the implied inflation that the 10-Year TIPS bond is signaling. The yield curve is flat, implying that investors anticipate deflation. After all, the only reason an investor in longer term bonds would accept a marginally higher yield over a shorter term bond is if the investor anticipates deflation and lower rates in the future. However, that seems unlikely to FPA New Income Fund (FPNIX) portfolio managers Thomas Atteberry and Abhijeet Patwardhan and FPA product specialist Ryan Leggio, since the difference in yield between the 10-year TIPS bond and the 10-Year Treasury is around 2 percentage points now, indicating an anticipation of 2% inflation.

But if inflation – or at least some tepid alternative to deflation – is on the horizon, doesn’t that mean that it’s a good environment for junk bonds? Not so fast say Atteberry, Patwardhan, and Leggio. The high yield “spread” – the difference in yield between high yielding corporate bonds and Treasuries – is very low. That means investors aren’t getting paid much to take the credit risk of owning high yield bonds. That’s especially true since leverage is high among corporate borrowers and covenant quality levels are low. A covenant is a legally binding agreement between borrowers and lenders designed to protect the interests of both parties. Low covenant quality means borrowers don’t have to meet specific requirements.

The authors note that “this is only the third time in the past twenty years when the yield curve has been this flat while at the same time high yield spreads have been this tight.” The upshot of their analysis is that it’s a good time for bond investors to reduce both credit and duration risks. The FPA New Income fund, accordingly, has a short duration, and is reducing credit risk. The fund is avoiding unsecured corporate bonds, and favors secured bonds, for example. It has around 8% of its portfolio in corporate bonds overall compared to 31% and 39%, respectively for funds in the Morningstar Intermediate-Term  Bond and Short-Term Bond Fund categories. As an alternative the fund prefers highly rated asset-backed securities which absorb 57% of its assets. Altogether, 71% of the fund’s assets are in AAA-rated securities.

FPA New Income has always been a “belt-and-suspenders” bond fund from the time legendary investor Bob Rodriguez ran it. It’s managers dislike posting negative return numbers. This has caused them to miss some rallies in bonds. For example, the fund has posted a 2.04% annualized return for the past decade ending in February 2018, while the Bloomberg Barclays US Aggregate Index has delivered a 3.60% annualized return over that time. But the fund’s willingness to “shoot only in a target rich environment” also means it has kept investors safe since 1984, including a 4.31% return during the financial crisis year of 2008 when so many bond funds missed the credit problems of their holdings and faltered as a result. Also, besides never posting a negative return in a calendar year since inception, over the 30 year period ending in February 2018, the fund achieved a 5.85% annualized return versus the 6.13% annualized return of the index. Ten years is a long time, but it’s worth considering whether the fund’s underperformance over the last decade indicates more alarming things about the prevailing credit and interest rate conditions than about its approach.