Bonds Today Are Risky; If Preservation of Principal Is Your Main Objective, It’s Time to Shift Your Asset Allocation

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Eric Matheson submits:

A senior municipal bond portfolio manager who mentored me when I first entered the investment management business (our firm's published minimum account size was $10 MM) asked me one time, "Do you know the difference between an investor with $1 MM and an investor with $10 MM? The investor with $1 MM wants a return on his principal. The investor with $10 MM wants a return of his principal ."

That firm pioneered separately managed municipal bond accounts for a reasonable annual management fee in a time when broker commissions on bond transactions ranged between 1% and 5% per trade. The singular stated goal of the firm and mandate to our clients was preservation of principal, which meant for us, protecting very sophisticated and wealthy clients from all sorts of risks in this historically safe asset class they never even imagined. Ask a wealthy balanced investor today what he knows about bonds and he will say something about the price, the coupon, interest rate and maybe the rating on the bond. Our main job was to look at those and a host of other risks, including credit risk, default risk, duration risk, interest rate risk, call risk and others, to make sure the client got all of their money back and more.

Now, a decade later, last week marked the anniversary since the Monday morning, September 15, 2008, following the weekend that likely changed Wall Street and capitalism as we know them forever. The shock and awe the markets subsequently reveled on private and institutional investors alike provided a definitive answer to a debate that was begun a little over a year beforehand in 2007, when the term "sub-prime" was introduced to the public discourse and literally became a household term.

In the years, months and weeks leading up to the collapse, many firms and advisors freely stated in their marketing brochures and face-to-face meetings with clients that preservation of principal was one of their most primary concerns. But most did not fare too well in this objective in 2008. From an asset allocation perspective, there's no question that strategic and substantial changes to an investor's asset allocation anytime from when the debate heated up in 2007 through the first nine months of 2008 could have mitigated much of the losses to individual portfolios. That being said, most advisors and portfolio managers were not equipped for this type of decision-making. Besides some hedge fund managers (who the average investor did not have access to), few managers available to everyday investors had the flexibility or strategy in place to access the right asset classes to avoid huge losses, and therefore preserve principal.

This article (1) revisits the 2007 debate among economists and strategists that preceded the 2008 collapse, (2) examines what could have been done to protect the typical investor before the 2008 collapse, and (3) most importantly, frames the strategic asset allocation considerations investors and advisors alike must pay closer attention to avoid the next potential investment catastrophe.

2007 Revisited

As horrific as the third and fourth quarters of 2008 were, 2007 was a long and challenging year in the United States for those who were paying attention. After four consecutive years of positive S&P 500 returns (28.% in 2003, 10.9% in 2004, 4.9% in 2005, and 15.8% in 2006), sub-prime and the forecast of slowing GDP shaped the debate of whether the US economy was heading into a recession. For some, the writing was on the wall. For others, slowing growth alone did not signal a recession.

The firm I was working for at the time, highly regarded and respected on Wall Street as an independent investment research and management firm, was in the optimist camp. According to our analysts, the market fundamentals did not signal a recession at all; to the contrary, they and others argued, investors were likely to be rewarded for maintaining a significant allocation to equities. As a result, many clients maintained or increased their equity allocation -and risk - in their portfolios.

Performance-wise, 2007 passed without much fanfare with the S&P returning 5.5 % despite slowing growth. Many investors and advisors maintained their established strategic asset allocations they believed would protect them over the long run regardless of whether there was a downturn or not. On the other side of the coin, some pessimistic investors and their advisors sold enough equities to make small, token 5% or 10% shifts from their long term strategic allocations. This was fine for 2007, but not sufficient to protect clients from what was to come in 2008.

What Could Have Been Done to Protect Investor Portfolios in 2008?

Looking through the rear view mirror, whether in investing or after the big game, is easy. But some managers and advisors made significant moves in anticipation of the downturn and eventual collapse that made huge differences in protecting their portfolios. Here are just two strategies that worked well.

  1. Sell Equities and Buy Bonds, Treasuries and/or Cash. A substantial move to municipal bonds, US Treasuries or cash could have substantially protected clients from the 2008 collapse and even made a nice return as money poured into those asset classes. In fact, Treasuries were the best performing asset class in 2008. But such market timing moves are frowned upon by Wall Street advisors and many adherents to the principals of long term investing. One reason is that few managers are set up to move money in and out of otherwise long term strategies, even when they see trouble coming and would have liked to. Another likely reason is the inherent conflict of investment managers and advisors who charge higher fees (usually 1-2%) for equities than for bonds and cash (usually 0-0.50%). (Probably a good idea to read this last sentence again.)
  2. Move Assets from Traditional Managers to a New Strategy. Another option would have been to change strategies completely. There are a handful of managers with long historical track record and near-shocking outperformance to equity benchmarks over both short and long time periods going back in some cases over 30 years. The outperformance stems from an uncanny ability to have avoided the drops in the most recent recessions (October 1987, Tech Bubble of 2000-2002 and the current global financial crisis), while keeping pace with equity indices in bull markets in up years such as 2003. These managers as a whole are known as Global Flexible managers, and have recently gained popularity. In perhaps an admission that traditional long term investing and Modern Portfolio Theory may be a relic of the past, and for sure to capitalize on the increased flow of funds and demand, many firms, including the largest names on Wall Street, have recently launched global asset allocation strategies. The historic performance of this class of managers as a whole is mixed, but a few have been stellar.

Today's Debate: Bond Bubble, S&P (around) 500 or Both

The 2007 debate was an important one, but if you are an investor or an advisor with preservation of principal as one of your stated mandates, it is time to start paying more attention than you might have in 2007, or even 2008 for that matter. The issue in 2007 was simpler: Are we heading into a recession or not? Today much more is at stake for the investor who wants a return of his principal. Questions abound: Is the economy and the US stock market in a recovery, or are we in store for a double-dip recession that could send equities down 50% or more? To complicate matters, respectable economists and strategists wonder if bonds are in for a tumble as well? And I have not even raised the most insidious question affecting our financial health: Are we in for inflation or deflation, not to mention, when and for how long?

Just like 2007, the economists and strategists seem to be split on the issue of slow recovery v. double-dip recession. Wharton Professor and capital market historian Jeremy Siegel, known for his work, Stocks for the Long Run, sparked the debate by his Aug. 18th WSJ article co-authored with Jeremy Schwartz, entitled " The Great American Bond Bubble ." A decade ago Siegel penned another WSJ article at the peak of the tech bubble in March 2000 entitled, " Big-Cap Tech Stocks Are a Sucker Bet " (.pdf). In his more recent bond bubble article he and Schwartz argue:

Ten years ago we experienced the biggest bubble in U.S. stock market history-the Internet and technology mania that saw high-flying tech stocks selling at an excess of 100 times earnings. The aftermath was predictable: Most of these highfliers declined 80% or more, and the NASDAQ today sells at less than half the peak it reached a decade ago. The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows. We believe what is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic. Those who are now crowding into bonds and bond funds are courting disaster.

It did not take long for Princeton University Economist Paul Krugman to retort in his NY Times column on Aug. 22nd that he does not see a bond bubble, but sees the US following a more Japan-like period of low short and long term interest rates for the foreseeable future. Respected Wall Street economist, David Rosenberg, jumped in as well in his Aug. 19th letter , Breakfast with Dave. He admits with some good humor that one of the reasons he responded to Siegel and Schwartz was that he himself submitted an article to the WSJ three months earlier entitled, "Bond Bubble," and was turned down, only to have the Financial Times publish it. In short, Rosenberg thinks Siegel and Schwartz's comparisons of the tech bubble to treasury bonds is "silly," but concedes that a large move in interest rates would cause significant losses for a bondholder such that the investor would potentially need to wait to maturity to get their principal back. The problem is that if we have a long, steady period of inflation and a bondholder owns relatively long term bonds, assuming he gets back all of his principal in x years, by that time it won't be worth that much. And most wealthy investors have the reality of skyrocketing health care costs and other increasing essential services to pay for over their lifetimes not reflected in the government's current inflation computation.

Then there's Robert Prechter, the market forecaster and social theorist featured in a July 9th NY Times article and who, according to the Times, "is in another league entirely." Here are some excerpts:

[Prechter says] 'Winter is coming. Buy a coat. Other people are advising people to stay naked. If I'm wrong, you're not hurt. If they're wrong, you're dead. It's pretty benign advice to opt for safety for a while."

His advice: individual investors should move completely out of the market and hold cash and cash equivalents like Treasury Bills for years to come. But ultimately, "the decline will lead to one of the best investment opportunities ever," he said. [But] [b]uy-and-hold stock investors will be devastated in a crash much worse than the declines of 2008 and early 2009 or the worst years of the Great Depression or The Panic of 1873, he predicted. For a rough parallel, he said, go all the way back to England and the collapse of the South Sea Bubble in 1720, a crash that deterred people "from buying stocks for 100 years," he said. This time, he said, "If I'm right, it will be such a shock that people will be telling their grandkids many years from now, 'Don't touch stocks.' "

What Does This Mean for Client Asset Allocation?

It is always more popular to bear good news. That's one of the number one rules in being successful. People who are positive and confident attract other people. People who are negative and pessimistic are usually avoided. But an advisor - especially one with a mandate of preservation of his client's principal - is not being paid to be positive all the time.

What concerns me most today is that many individual investors and their advisors are still taking on too much risk in their portfolios, far more than they realize. The argument today is different in that it is not focused exclusively on historically riskier equities, but on municipal bonds and treasuries as well. What makes this especially troubling is that these bonds are still thought to be the safest asset classes by individual investors and their advisors. I know from experience that most investors will have a difficult time changing their behavior now in the face of these new heightened risks to what they believe to be the core safety net of their portfolio. This in part is because even the wealthiest bond investors do not actually appreciate or even understand the inherent risks associated with bond investing. They better soon. With record amounts of debt generated from the printing press of the last two US administrations and with no end in sight, things are setting up to end badly. And having a true understanding in the real risks associated with historically safe asset classes, or at least an advisor who does, may well make the difference in an investment portfolio's chances of surviving, let alone succeeding, in the coming weeks, months and years.

So here's what I am recommending to clients:

  • Reduce exposure to Treasuries (they're up 20% year to date) and municipal bonds (they're up around 6-8% on average).
  • Consider other income-oriented investments, like high grade corporate bonds, high quality dividend paying equities, bank loans, international high quality bonds, and MLPs.
  • Be sure to own enough gold, and get more comfortable at going multi-currency against the risk of devaluation of the dollar.

These may seem like tactical shifts, but the debt the US owes is not going away anytime soon, so to preserve capital and make a decent return along the way I am advising my clients to prepare for winter. Recall the investor with $1 MM my colleague asked me about when I began my investment management career. I strongly believe it's time for that investor to start thinking a lot more like the one with $10 MM.

Disclosure: None

See also Nouriel Roubini's Talk at Google's Zeitgeistminds on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , US Markets



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