While many investors view bonds as merely income producing securities, we take a different and much broader view of bond investing. We believe that bonds can not only produce rewarding returns, but can also reduce risk and provide effective portfolio diversification—at the very times when diversification proves most elusive.
A Portfolio Role different From Stocks
Bonds can, in essence, become a risk thermostat within an asset allocation plan. Just as a room thermometer can help keep its occupants comfortable during uncomfortable weather, bonds can help dial portfolio risk into a client’s comfort zone. Bonds can play an important role in smoothing the ride along the way that is part of every investment experience. But to do that effectively, only bonds with risk characteristics different from stocks can be used.
When interest rates are rising, long-term bonds can decline in value similar to stocks. In our view this is an outcome inconsistent with the role bonds are intended to play within a portfolio. We therefore focus on bonds with short to intermediate term maturities to help minimize risk. The chart to the right (click it for a larger view) helps explain this using historical data.
Likewise, in periods of elevated economic stress and uncertainty, low credit quality bonds can suffer equity-like declines. Again, this is unacceptable if bonds are to deliver effective diversification. It is in just such periods of duress for stocks and most other assets which also coincide with increased joblessness, soft real estate valuations and personal financial stresses, that diversification proves illusive. The chart below (click it for a larger view) provides some historical perspective.
For this reason, we typically invest in high quality taxable and tax free bonds.
In addition to investing in high quality bonds with modest interest rate risk characteristics, we also actively manage the fundamental parameters of our clients’ bond investments.
The fundamental parameters are:
• Prospective return profile of bonds
• Prospective risk profile of bonds
• Correlation profile, or how bonds and other assets may inter-relate in the future
Because these parameters are themselves dynamic and can significantly change at different points in time, active management of these variables is necessary if bonds are to fulfill their intended roles within a portfolio.
In our “toolkit” for actively managing the dynamic risk/reward/correlation parameters are computer simulation scenarios. We start by assessing the best and worst case scenarios for interest rates, bond yields and economic conditions for the coming twelve months
We use a computer simulation to calculate the total return potential for bonds of varying maturities and quality. This information then forms the basis for managing portfolios around bonds that offer a low probability of loss should interest rates rise while also maximizing the probability that bonds will deliver the desired correlation properties relative to other portfolio investments.
The following series of tables (click each one for a larger view) reflects the output of a sample simulation exercise:
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