The Financial Lexicon Positions For 2014: Individual Bonds Are The Way To Go

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By 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 Portfolio and 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 speaking?

The Financial Lexicon (( FL )): 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.

((AC)): What are the major catalysts/risks for bond markets in 2014?

(( FL )): 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:

  1. Has the issuer of any of your bonds defaulted on its debt obligations?

  2. Is the issuer of any of your bonds in danger of defaulting on its debt obligations in the foreseeable future?

  3. Will the bonds that are causing you uneasiness mature at par?

  4. 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.

((AC)): 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?

(( FL )): See the sixth question, below.

((AC)): Now that the Fed has begun to taper, what's your take on whether tapering is tightening?

(( FL )): I think that tapering is 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 near doing).

((AC)): 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)

(( FL )): 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 opportunities.

((AC)): Which fixed income asset classes do you feel currently offer the best yields relative to risk?

(( FL )): 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:

  1. 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.

  2. 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.

((AC)): Do you have any significant allocation to foreign bonds? How about emerging market sovereign debt?

(( FL )): 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.

((AC)): Are there segments of the bond market you feel investors should be avoiding entirely right now?

(( FL )): 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.

((AC)): What is your assessment of the Muni market heading into 2014, especially following Detroit's bankruptcy?

(( FL )): 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).

((AC)): What advice would you offer a 'do-it-yourself' fixed income investor as we approach the New Year?

(( FL )): Two things immediately come to mind:

  1. 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.

  2. 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.

Disclosure: 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.

See also S&P 500 - Jingle All The Way Higher on seekingalpha.com



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 , Stocks

Referenced Stocks: AGG , DIA , FL , HYD , IVV

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