The Financial Lexicon
This is the first piece in Seeking Alpha's
Positioning for 2014
series. This year we have once again asked experts on a range of
different asset classes and investing strategies to offer their
vision for the coming year and beyond. As always, the focus is on
an overall approach to portfolio construction.
The Financial Lexicon (See
Seeking Alpha's policy on anonymous authors
) has more than a decade's worth of experience in the world of
finance, the last eight years of which have been spent as a
proprietary trader and investor. Before becoming a full-time trader
and investor, The Financial Lexicon worked for one of the largest
investment management companies in the world. Additionally, The
Financial Lexicon is the author of two books,
The 5 Fundamentals of Building a Retirement
Options Strategies Every Investor Should Know
, and writes for LearnBonds.com.
Seeking Alpha's Abby Carmel recently spoke with The Financial
Lexicon to find out how his views on a range of bond asset classes
were shaping up as 2013 turns into 2014 - with an eye on actionable
fixed income asset allocation advice.
Abby Carmel ((AC)):
How would you describe your investing philosophy, broadly
The Financial Lexicon ((
I am open to investing in all sorts of financial instruments,
including stocks, bonds, options, commodities, currencies, and
anything else that has what I consider an attractive risk-reward
profile. At this time, my focus is on generating reliable and
diversified streams of income. Additionally, I strongly believe
that each investor's situation is unique, and that there is no
one-size-fits-all strategy suitable for everyone. Finally, I am not
the type of investor who assigns merit to an idea or investment
thesis simply because of who said it or who wrote it. On the whole,
I think that occurs far too often in the financial community.
What are the major catalysts/risks for bond markets in 2014?
Let me begin by saying that no matter what happens, investors who
build a diversified allocation to individual bonds and have the
wherewithal to hold the bonds to maturity can rest peacefully.
Should mark-to-market movements in your bonds cause you anxiety,
you should ask yourself the following four questions:
Has the issuer of any of your bonds defaulted on its debt
Is the issuer of any of your bonds in danger of defaulting
on its debt obligations in the foreseeable future?
Will the bonds that are causing you uneasiness mature at
In the foreseeable future, do you anticipate being forced to
sell any of your bonds in order to raise cash?
If you answer the questions as follows: 1) No, 2) No, 3) Yes,
and 4) No, you should be able to rest easy.
It is difficult to summarize the catalysts and risks for bonds
because the bond market has so many different segments. In general,
I think shorter-term benchmark yields have very little risk. The
chances are quite good that the Fed will not raise rates for at
least a couple of more years. And the taper has largely been priced
into the short end of the market. Intermediate-to-long-term bonds
could certainly move higher in yield if bond traders decide to
price in a series of rate hikes years ahead of time. The bond
market has done this repeatedly over the past several years, so it
shouldn't be a surprise if it happens again. The 4.70% to 4.90%
region is as high as I would expect the long bond (Treasury) to go.
The 3.75% to 4.00% region would be the highest I could imagine the
10-year Treasury in 2014, assuming bond traders once again
incorrectly price in impending rate hikes.
On the other hand, a strong selloff in stocks or a mild
recession will bring with it benchmark yields that fall so fast it
will stun the chorus of bond bears that currently dominates the
fixed-income discussion. Bonds might be the single most hated asset
around. The overwhelming majority of investors appear to think
certain yields can only head higher from here. Sentiment is so
strongly tilted in one direction, and the economy has been so
dependent on the positive feedback loop resulting from rising stock
prices (which have been heavily influenced by high levels of
electronic money printing), that it won't take much bad news for
Treasury yields to quickly reverse and head lower.
Concerning spreads, there is much more upside potential in
broad-market spreads than downside potential. While spreads are not
yet at historic lows, they have fallen far enough that, on a
broad-market basis, spread contraction will no longer provide the
amount of cushion it has in recent years to rising benchmark
yields. Any serious slowdown in economic activity, or any serious
stock market selloff, will send spreads much higher.
The 10-year Treasury yield has recovered a fair bit since we spoke
this time last year but still remains at low levels historically
speaking. With bonds selling off for the first time in years on
fears of tapering, where have you been having yield-hungry
investors turn for income in this environment?
See the sixth question, below.
Now that the Fed has begun to taper, what's your take on whether
tapering is tightening?
I think that tapering
tightening. QE is the form of easing that became in vogue with the
federal funds rate at the zero-bound. If the implementation of QE
is a form of easing (the flow of QE is a form of easing), then
pulling back on QE is a form of tightening. With that said,
tapering is a very different form of tightening than raising the
federal funds rate. Traders in the intermediate-to-long term parts
of the Treasury curve are already looking beyond tapering and
pricing in a series of future rate hikes (which the Fed is nowhere
Let's talk risk/reward assessments as they relate to the yield
curve. Where is the sweet spot currently located? (i.e. the spot
offering the best yield relative to interest rate risk)
If you are a bond fund investor, stick with short-term funds.
Individual bond investors, however, can venture further out on
the curve. I think the yield curve's sweet spot is in the 5- to
10-year space. But the yield curve flattening that occurred in the
wake of the recent taper did take away some of those
Which fixed income asset classes do you feel currently offer the
best yields relative to risk?
If you are trying to roll down the yield curve, you'll find the
best opportunities in 5- to 10-year benchmark Treasuries. But those
securities are not the ones that I am most drawn to at this time.
Instead, I am finding compelling fixed-income opportunities in the
following two places:
Corporate bonds, specifically in the triple-B region of the
credit spectrum. Occasionally, double-B or single-A bonds pop
up at the right combo of yield and credit risk. But I think
investors will generally find the most compelling opportunities
in triple-B corporates.
So many preferred stocks and exchange-traded debt are
currently trading at moderate-to-large discounts to their
liquidation preference/call price/maturity price with yields in
the 6% to 8% range. I think it is time to begin building an
allocation to those securities.
Do you have any significant allocation to foreign bonds? How about
emerging market sovereign debt?
I do have dollar-denominated individual bond exposure to companies
from the emerging markets. Also, let's not forget that in today's
global economy, many companies from non-emerging markets derive
revenues from the emerging markets. With that in mind, I also have
exposure to those types of companies.
Are there segments of the bond market you feel investors should be
avoiding entirely right now?
At the short end of the triple-A to single-A investment grade
corporate bond space, the yields are so low that investors are
generally better off buying CDs. Avoid those corporate bonds.
Also, I'd like to add that I don't think this is the environment
in which long-term-focused investors should own
non-defined-maturity bond funds. In my opinion, individual bonds
are the way to go. No matter what happens with benchmark yields and
spreads, if you build a diversified portfolio of individual bonds
and have the wherewithal to hold the bonds to maturity, assuming no
default, you can rest peacefully. And remember, if you have the
skill set to choose individual companies for stock purchases (as
many SA readers do), you likely also have the skill set to pick
individual bonds. Moreover, with today's low commissions and
generally low minimum purchase sizes, many people that once didn't
have the resources to build a diversified allocation to individual
bonds now do.
What is your assessment of the Muni market heading into 2014,
especially following Detroit's bankruptcy?
In a nutshell, for the next several years, I expect more of the
same type of environment we've recently had. This includes plenty
of news about cash-strapped municipalities and an occasional
bankruptcy causing broader-market jitters (like with Detroit).
What advice would you offer a 'do-it-yourself' fixed income
investor as we approach the New Year?
Two things immediately come to mind:
Do not overpay when purchasing individual bonds. Nowadays,
there is simply no excuse for paying more than $1 to $2 per
bond. And yet, nearly every day, I see examples of trades being
executed in which an investor paid an obscene markup or
commission in order to purchase a bond.
Carefully consider the opportunity cost of waiting to
purchase a bond that is already trading at a yield-to-credit
risk you find enticing. The bond bears have gotten many
investors to park their cash in short duration fixed-income
products that have provided negative real yields over the past
five years. If you consider the risk of foregoing 4% to 8%
yields in intermediate-to-long term fixed-income products in
anticipation of yields heading higher over the coming years,
you may discover that in the long run, you end up worse off
than had you simply taken the 4% to 8% yields in the first
place and ignored the mark-to-market movements over time.
I am long numerous individual common stocks, individual preferred
stocks, and individual bonds. The bond allocation includes
investment grade and non-investment grade corporates as well as
Treasuries. I am also long two equity ETFs not mentioned in this
article as well as gold and silver.
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