Current Portfolio Allocation

[quote=planrcoach] but I believe the more money you have or manage for
others, and the more experience you get, the more we work off a
modified model. What think you generally for your clients in
2007?[/quote]



60/40 is always right, all through with current market conditions 50:50 is probably better.

Good to hear 50:50 for current conditions. The trimming in and around 50:50 and 60:40 gives a lot of client contact, which is good for business. But I would not mind seeing a down market next year (please give us one more easy year without a major correction) to help with moving new money.

[quote=planrcoach]

Good to hear 50:50 for current conditions. The
trimming in and around 50:50 and 60:40 gives a lot of client contact,
which is good for business. But I would not mind seeing a down market
next year (please give us one more easy year without a major
correction) to help with moving new money.

That focus on higher quality is a nice way to backfill the many years of steady economic growth. Any number of factors could quickly lessen confidence in the business environment. Just interesting to fully feel this particular point in time: great market prospects balanced upon the invevitable correction. It feels like 50:50. I like the idea of bringing in TIPS now. Do you think a floating rate high income fund could see much downside if things fall apart, compared to its ability to add some portfolio pop, if things do well.

FYI, Fidelity Advisor Floating Rate Income fund has a 6% yield and very now NAV fluctuation from 2000 to 2006. And then there is their Strategic Real Return fund, mainly for inflation with a 3.9% yield. That fund has 30% TIPS, 25% floating rate, 25% commodity linked notes, 20% real estate. I'm using that with some strategic income funds, and/or national muni bond funds. Letting the fund managers trim the junk portion of strategic income as they see fit.

" I like the idea of bringing in TIPS now. Do you think a floating rate high income fund could see much downside if things fall apart, compared to its ability to add some portfolio pop, if things do well."

I'm a Depression Era echo and an Inflation Era bang. When I think of inflation and I think of "things fall apart" I start to twitch!

TIPS now? Are you expecting further inflation? So much further from here that the inflation that we've had up until this point...? It didn't seem to get you to load up on TIPS before, why now?

I own loads and loads of the CPI based floating rate bonds, so I'm always routing for higher inflation. But I've owned them and they are now a Tums factor in that I wonder about getting out of them if there isn't continued higher CPIage.

The good news to business (so far) is that the consumer seems to have accepted the idea that price inflation happens. Begining of 2005 the consumer wouldn't go for higher prices, then came the oil spike and price hikes seemed only fair. Meanwhile Christmas was more of a JESUS CHRIST!mas and retailers didn't get to sell as much of those price inflated goods as they had hoped. So when you ask if a high yield bond fund can hold it together if "things fall apart" it's going to depend on which things fall where.

IF as in big If, housing goes completely sewer pipe, and your junk portfolio has junk builders, junk suppliers, junk R/E plays chances are that your fund is in for a rocky road (something that fixed income people NEVER like, in my mind, junk is an equity play, never a bond play, buy junk when you think it's going to be upgraded and take the coupon to pay you while you wait or as part of your total return, never use junk to replace a fixed income position).

If the consumer has finally hit the wall, and your fund is big into Heelies bonds, you're going for a ride!

Junk is junk because the risk of the company flatlining when things go bad are greater than for investment grade companies (I know you know this, but it bears repeating!) Things can't go much badder than your costs going higher faster than your prices can.

OTOH, things can't go much better than your prices rise faster than your costs do and the dollars you're using to pay off debt are worth less than the dollars you borrowed. But how much "Pop" is that going to add from a fund? I'd prefer to selected preferreds (discount of course) Convertible if you can get them, a good yield stock (good meaning I think it's good, not good as in Con Ed) with growth potential and look for a 20% move, then move it on out and look for another. You're not cutting down the risk with a junk fund, not from these levels.

Mr. A

You’re pretty bright Mr. A. I mean that as a compliment. Well said.

Yep, good idea to think of junk as equity and not fixed. I guess you hold the preferreds as individual securities and not funds?

I'm noting the current Investment News reports analyst consensus of S&P + 7% this year. That should get everyone's attention - that would be 7%, withstanding political risk, etc. - best case.

So your preferreds would seem a risk-wise idea. And your CPIage exposure, well, now that Christ is back in Christmas, economists would say the demand should just flow somewhere else, aren't we all worried about consumers. I just can't believe that inflation is dispensed so easily. Unless we get into something wierd, like stagflation, have not really run money through that type of enviroment in a significant way.

Everyone would agree, fixed income takes on ever more importance in such an environment as today's? Consider doing your homework and portfolio adjustments now, while the going is good.

I think the old 60/40 is a simplistic and outdated notion.  A high dividend paying stock has both equity and bond characteristics. A high yield bond may act more like equity.  Where do you classify a convert? 

60/40 is black and white when there are a lot of shades of grey.

Our job should always be to get the highest rate of return with the least amount of risk.

The risk vs reward on bonds is AWFUL in the current rate environment.

[quote=planrcoach]I like the idea of bringing in TIPS now. Do you think
a floating rate high income fund could see much downside if things fall
apart, compared to its ability to add some portfolio pop, if things do
well. [/quote]



Seth Klarman had a famous saying about junk bank loans. “The Banks are senior but everybody is at risk”.



If the underlying company goes BK, you don’t want any part of the
capital stack. These funds all own the same names. and look at spread
between your bank loan funds and MMFs/USB funds,  you are going
from AAA credit to BB and worse for only 150bp more yeild. That’s a
sucker trade.



I don’t invest for portfolio “pop”. Bubbles pop. And I want no part of
that. I set people up with the most conservative investments that will
fulfill their goals, the first rule of investing is don’t lose money,
the rest is commentary.



As for TIPS, they are cheap. The spread on 10-y tips is 230bp, so if
you think inflation will be higher than that over the next ten years,
tips are the way to go. They also diversify a portfolio real well as
they are uncorrelated to bonds and stocks.

[quote=planrcoach]

FYI, Fidelity Advisor Floating Rate Income fund
has a 6% yield and very now NAV fluctuation from 2000 to 2006. And then
there is their Strategic Real Return fund, mainly for inflation with a
3.9% yield. That fund has 30% TIPS, 25% floating rate, 25% commodity
linked notes, 20% real estate. I’m using that with some strategic
income funds, and/or national muni bond funds. Letting the fund
managers trim the junk portion of strategic income as they see fit.

Some great points. Especially about conserving principal and keeping it simple and basic. And the economic cycle continues to repeat, we'll see what M&A, and increased global economic and political interdependcy do to credit quality and inflation. Your points are well taken and appreciated.

What is the context of your Klarman quote?

(I mean your footer Klarman quote.)

[quote=mranonymous2u]Something that fixed income people
NEVER like, in my mind, junk is an equity play, never a bond play, buy
junk when you think it’s going to be upgraded and take the coupon to
pay you while you wait or as part of your total return, never use junk
to replace a fixed income position

Junk is junk because the risk of the company flatlining when things go bad are greater than for investment grade companies (I know you know this, but it bears repeating!)

[quote=AllREIT][quote=planrcoach]I like the idea of bringing in TIPS now. Do you think
a floating rate high income fund could see much downside if things fall
apart, compared to its ability to add some portfolio pop, if things do
well. [/quote]



Seth Klarman had a famous saying about junk bank loans. “The Banks are senior but everybody is at risk”.



If the underlying company goes BK, you don’t want any part of the
capital stack. These funds all own the same names. and look at spread
between your bank loan funds and MMFs/USB funds,  you are going
from AAA credit to BB and worse for only 150bp more yeild. That’s a
sucker trade.



I don’t invest for portfolio “pop”. Bubbles pop. And I want no part of
that. I set people up with the most conservative investments that will
fulfill their goals, the first rule of investing is don’t lose money,
the rest is commentary.



As for TIPS, they are cheap. The spread on 10-y tips is 230bp, so if
you think inflation will be higher than that over the next ten years,
tips are the way to go. They also diversify a portfolio real well as
they are uncorrelated to bonds and stocks.





[/quote]

I like your turn of phrase that "I don’t invest portfolios for pop.  Bubbles pop."

I have almost completed selling out all of my senior bank adjustable rate loan funds based on comments that I read on this forum that I found disturbing.  Spreads are too tight, and folks are too complacent as to risk.

I would rather lose an opportunity than lose capital.

'nuf said.

[quote=joedabrkr]
I have almost completed selling out all of my
senior bank adjustable rate loan funds based on comments that I read on
this forum that I found disturbing.  Spreads are too tight, and
folks are too complacent as to risk.

I would rather lose an opportunity than lose capital.

'nuf said.[/quote]



I miss quoted Klarman, "“The Banks are senior but everyone is at risk.”



People have ignored the fact that these are junk loans, and the main point for them is

Most companies which junk bank loans also have junk bonds out, and so people who own both loans and bonds have correlated risks.



I have no problem with junk bonds, if you use them thoughtfully and
openly. But it is very dangerious when they lurk inside of a “Real
Return fund” or “floating rate income fund”.



The “Fidelity Leveraged Company Stock Fund” (FLVCX) is similarly dubious idea. Good performance so far…

Well, to advocate for the devil, it's not just a question of your bonds going bellykupt.

Most bonds don't default, most don't go completely, something happens for most bonds, somebody buys the company, they restructure, the market turns, something.

However, just the widening of spreads means lower pricing which Whacks NAV, which makes for uncomfortable talks with clients about the goodness of having a 10% yield and a 20% hickey in the portfolio.

I don't want to dissuade anyone from doing anything for their clients, the are a thousand ways to skin a cat.

Mr. A

[quote=AllREIT]

I have no problem with junk bonds, if you use them thoughtfully and
openly. But it is very dangerious when they lurk inside of a “Real
Return fund” or “floating rate income fund”.



[/quote]

That little bit sorta sums it all up for me.  I bought one of the closed ends about a year ago when it was trading at a discount to NAV and about 15% below the offering price(as a ‘broken IPO’).  It was managed by Highland, and I’d been extremely impressed with them on the roadshow.

Now, however, it’s essentially at PAR to NAV and my clients are up 10-20% on a capital gains basis.  That plus a 9% dividend yield is certainly better than a sharp stick in the eye!  Thankfully, I ate a little of my own cooking on this one too.

The fund is still paying a high single digit yield, so it’s tempting to hang on.  But when I look at spreads and the likely direction of short term rates, the outlook becomes a little less exciting.  (Remember, the dividends on these puppies will track short-term rates for the most part.)  Then, I read some of the commentary on another thread about these funds.  My takeaway-folks were jazzed up about the yields(which they couldn’t find anywhere else) and pretty complacent about the risk.  Plus-the volume in this sector has EXPLODED in the last five years, and now EVERYBODY is trading in the bank-loan game.  So, to me, that just has all the hallmarks of future problems, maybe the near future.

Much like I said before, I’m happy to leave a little on the table for the next guy to make sure I leave the party before everyone else tries to get out the door.  It’s a sickening feeling to take a round trip on a 20% profit.  I know, I’ve done it plenty.

Question is-now where do I go with the money?  This yield curve environment makes it a tough decision, at least for me.  Any thoughts are welcome.

Joe,

Is there something wrong with going to cash for now?

If you are right about the reasons for selling (which I admire) then isn't it somewhat likely that there will be a pull back into which you can redeploy?

You are up 10 to 20%, you can eat those gains for a year or two waiting for the right opening elsewhere without "invading principal". Put the principal into a 5 yr cd @ 5% and your 20% gain will turn into a 9% return for the next 5 years (4% from the gains plus the 5%)!

I like to have an idea to go into when I take a profit, but I think it is just a bad habit and I've tried to separate the two investment decisions. I've found that it changes the mindset of my clients too in that they see each move based on it's merits as opposed to this being a game of "Frogger" where we hop from one idea to the next.

Mr. A

I have invested in floating rate funds since 1990 and still think they are a good investment. There have been good economic cycles and bad and they have held up through all of them. Is every company rated BB or below going to go out of business? That would mean the private sector, who if rated would be below BB, would all dissapear. All the banks would go under and the second coming would happen. Things are not that bad. Also, a 48% drop in the s&p did not kill theses investments.My main concern in the economy is the comsumer personal real estate debt which is the real bubble waiting to explode.

I know how this is gonna fly, but here goes:

JUST BUY BONDS.

Keep it simple, don't predict rates, don't predict the market.

Make your client's portfolio an income generating machine that gives them more income than they can spend.

If rates go up, what do we do?

Good news, we buy more bonds.

If rates go down what do we do?

Good news, we buy more bonds.

We don't predict the markets, we just keep buying bonds. The income keeps flowing. The client always gets 100 percent of their principal at maturity, never any splaining to do. And the excess can be DCA"d into more income or the equity market.

It's really simple, clients get it, and it blows away any power point/efficient frontier/Sharpes ratio presentation the competition cares to give.

Plus, we never know when another 01-02 market is going to show up and wipe away all those inflation hedging gains along with a great deal of the client's principal. Funny thing about all those slick PP pressos, none show losing 40% plus on the equity side in years one and two. Yet for those unfortunate enough to have jumped in during 01, that's their reality. What's the plan then? How exactly does one recover from losing 40% or more on 60% of a portfolio?

As for funds for the fixed side, I'm not a big believer. That said, I do use some, mostly for high yield. Funds, even the cheap ones, take too big a chunk of the return to manage an asset that essentially doesn't need to be managed. Putting say $100k into a bond fund with say a .5% expense ratio for ten years will cost the client in the neighborhood of $5000 in fees. Had that same client bought a ten year bond with a point and a half in it their cost is only $1500. Will the fund return enough to pay for the extra cost? Unknowable. Is the client taking more risk? Absolutely! So there are cost/risk factors. Then there's the questionable management. Most investors would have been better off without managers in the 94 and 98/99 bond market slides. These two periods are the benchmark tests for managers in modern times. How did they do? Not good! Loses were massive. Managers moved quickly to save their own skins by adjusting porfolios to the new market environment. Read that to say they locked in their fund's losses. In many cases never to be recovered. A wrong guess followed by another wrong guess. Their share holders paid the price with their net worth. Yet, clients who owned bonds, not funds, and who didn't panic, didn't lose a dime.

Good point, in a fund like Fidelity Advisor Floating Rate High Income, there has been little NAV fluctuation since 2000, for example. I see a parallel in your arguement to high yield muni bond funds like Oppenheimer Rochester National muni, the world would have to fall apart, and munis are still backed by the taxing power of local governments.

Seems like a fund, with full time professional management, should be able to steer clear of some potholes that could arise in individual security portfolio management. But with the current point in the economic cycle, is now the time to buy? Maybe hold these nexts to a TIPS fund, and total return bond, for some clients. The non correlation to stocks and bonds of TIPS is a very solid idea, too.

And of course, bond guy, if you can competently manage a portfolio of individual bonds, more power to you. For we wee generalists, or predictable returns on larger portfolios for that matter, I think by the time you bring in the more attractive high yield munis, developed country high quality, developing country, TIPs, etc. in addition to the traditional core bonds- these funds provide effective active management, at effective cost. In my estimation, the cost is justfied. But if you want to put it together yourself and do a good job, with less complexity, your fees are justifed.

I have invested in floating rate funds since 1990 and still think they are a good investment. There have been good economic cycles and bad and they have held up through all of them. Is every company rated BB or below going to go out of business?

Historically, about 1.5-2.5% of BB rated debt defaults each year.

[QUOTE] That would mean the private sector, who if rated would be below BB, would all dissapear. All the banks would go under and the second coming would happen.[/quote]

First of all, private companies can get credit ratings and bank loans, but they pay alot more for privilege. For example if my company wanted to get a loan, we would pay prime+2, or about 10% APR.

[quote]Things are not that bad. Also, a 48% drop in the s&p did not kill theses investments.[/quote]

Given that stock performance and credit performance are only weakly related, thats not at all surprising. Mr Market sets stock prices, reality sets credit prices and outcomes.

I saw the guy from Rochester (Mike Rosen). The ink on the Oppenheimer check was still wet when he was talking.

Here was a guy who just made millions in three funds, Long term Munis, Limited term Munis and Bond Fund For Growth. What was it he said?

"If you buy a long term Muni Fund and leave your money in it, You Are A MORON!"

The ink was wet but the check was cashed!

He pitched the Bond Fund For Growth, a convertible fund, I bought Mainstay instead. They had identical track records, but I knew the manager of BFFG had other things on his mind than running the fund.

Mr. A

[quote=BondGuy]Managers moved quickly to save their own skins by adjusting porfolios to the new market environment. Read that to say they locked in their fund's losses. In many cases never to be recovered. A wrong guess followed by another wrong guess. Their share holders paid the price with their net worth. Yet, clients who owned bonds, not funds, and who didn't panic, didn't lose a dime.[/quote]

I dunno, I think you need a huge amount of assets to create a diversified bond portfolio. I'm not going to spend the time doing credit analysis on bunch of bonds, when for 20bp you can own AGG, and get the entire investable bond universe. For clients who are more risk senstive, I use MBDFX (aka PIMCO Total Return)

In few months, the full set of Lehman government/credit indexes will be out as ETF's, and at that point bond funds are going to be mostly obsolete.

The only places I'd pay for bond management are for specialites like high yeild, and global.

BTW, in my experience clients do complain about "losing money" in bonds, even if you have to explain that they will get it all back.

I see a parallel in your arguement to high yield muni bond funds like Oppenheimer Rochester National muni, the world would have to fall apart, and munis are still backed by the taxing power of local governments.

High yeild muni's are their own sector, people have figured out that the HYmuni's are far far less risky than equivalent corp/ABS/synthetic debt.

*However* There is just so little default history that we don't know the risk of the current set of HY muni's. This is the same situation as in the early 1980s, where the only data on junk bonds came from "fallen angels" vs new issue junk.

Alot of states don't have as much taxing power as you would think, because of things like prop 13, etc. Taxing power is only worth something if you can tax and there is something to tax. The vast majority of HY-muni's are not GO's backed by taxing power, but instead revenue bonds, securitisations of cash flow streams, or secured by a lien on state funding.

Again, the basic rule is that if you lose clients money, you will lose clients.

[quote]Seems like a fund, with full time professional management, should be able to steer clear of some potholes that could arise in individual security portfolio management.[/quote]

But you pay alot for it.

[quote]But with the current point in the economic cycle, is now the time to buy?[/quote]

No, the yield curve sucks, 1 year T-Bills are the place to be.

[quote]Maybe hold these nexts to a TIPS fund, and total return bond, for some clients. The non correlation to stocks and bonds of TIPS is a very solid idea, too.[/quote]

But TIPS are bouncy as well, since they are deathly sensitive to changes in real interest rates. When real rates went from 75bp to 250bp, low yield TIPS got hosed.

"TIPS real duration are longer than nominal bonds because their real yields are low. However, their effective nominal duration is much shorter because they are not as sensitive to changes in expected inflation."

This confuses the heck out people, TIPS are barely affected by that part of the nominal interest rate that relates to inflation and expected inflation. They are very sensitive to real interest rates because of the very low real yeild.

This is a good intro to TIPS.

http://www.aicpa.org/PUBS/jofa/jan2007/boes.htm

[quote=AllREIT][quote=planrcoach]I see a parallel in your arguement to high yield muni bond funds like Oppenheimer Rochester National muni, the world would have to fall apart, and munis are still backed by the taxing power of local governments.[/quote]

Yup. That's tough to beat.

High yeild muni's are their own sector, people have figured out that the HYmuni's are far far less risky than equivalent corp/ABS/synthetic debt.

Yup again. Even though they may carry the same ratings, there is a world of difference between corp and munis.

*However* There is just so little default history that we don't know the risk of the current set of HY muni's. This is the same situation as in the early 1980s, where the only data on junk bonds came from "fallen angels" vs new issue junk.

There was a sea change within the corp junk market. Milken started an entirely new catagory of junk bonds. These bonds eventually collapsed the market. Milken was the fall guy. I don't see a similar pattern of runaway greed in the muni markets. There are some soft spots, like tobacco bonds, but if you know what you're doing you can steer clear of the absolute crap like hospital bonds etc. and you can be selective on tobacco.

Alot of states don't have as much taxing power as you would think, because of things like prop 13, etc. Taxing power is only worth something if you can tax and there is something to tax. The vast majority of HY-muni's are not GO's backed by taxing power, but instead revenue bonds, securitisations of cash flow streams, or secured by a lien on state funding.

There are many strong rev bonds, NJTP comes to mind.

Again, the basic rule is that if you lose clients money, you will lose clients.

You can't lose if you don't sell. So, don't sell. The client's income stream is unaffected by int rate moves. We remind clients that the income stream is what they signed up for. Rate moves do not change that. If rates move up buy more bonds at the higher rates. If the client wants out of the bonds it's on them. Of course there is a win win with a bond swap into a higher coupon.

[quote]Seems like a fund, with full time professional management, should be able to steer clear of some potholes that could arise in individual security portfolio management.[/quote]

The only true test was 94 and 98/99. Chk out how well they did then. Some are OK, but many aren't. Problem is, funds are managed for total return. If the bottom falls out of the market,as it did during these times, many managers make short sighted moves to sure up the portfolio. Those moves get expensive by locking in losses. 

But you pay alot for it.

[quote]But with the current point in the economic cycle, is now the time to buy?[/quote]

Do you know something about the future of interest rates that the rest of us don't?

No, the yield curve sucks, 1 year T-Bills are the place to be.

Very predictive. Try this "Mrs. client i have no idea where interest rates are headed. Now, my firm pays people millions of dollars a year to tell us where rates are going but honestly I couldn't tell you. And to be honest with you, I don't think those million dollar guys know either. All I know is that rates go up and then they go down and the best time to buy is when you have money to invest."

[quote]Maybe hold these nexts to a TIPS fund, and total return bond, for some clients. The non correlation to stocks and bonds of TIPS is a very solid idea, too.[/quote]

But TIPS are bouncy as well, since they are deathly sensitive to changes in real interest rates. When real rates went from 75bp to 250bp, low yield TIPS got hosed.

"TIPS real duration are longer than nominal bonds because their real yields are low. However, their effective nominal duration is much shorter because they are not as sensitive to changes in expected inflation."

Volatility, duration, inflation sensitivity... doesn't all this get tiring to keep track of? Find a good bond with a decent rating and JUST buy it. You can play to your heart's content with the yield curve thus controlling the volatiliy, duration, and inflation sensitivity. How hard does this have to be?

This confuses the heck out people, TIPS are barely affected by that part of the nominal interest rate that relates to inflation and expected inflation. They are very sensitive to real interest rates because of the very low real yeild.

Confusing people is never good. Seriously, if it's complecated and loses money you're sunk as well with the client.

This is a good intro to TIPS.

http://www.aicpa.org/PUBS/jofa/jan2007/boes.htm

Wow, great discussion. I will be reviewing to absorb some of the insights, obviously gleaned over time and experience. I don't think fixed income is truly easy for anyone to do well, but I get the feeling we should be revisiting it now.

Obviously holding individual issues beats funds for turnover/not holding to maturity issues, even fund liquidation/NAV problems which go back to the early 90s, I reckon, to be fully appreciated. A perfect storm.

So those of us who use funds, anyway, for pragmatic purposes, need to choose wisely.

[quote=planrcoach]

Yep, good idea to think of junk as equity and not fixed. I guess you hold the preferreds as individual securities and not funds?

I’m noting the current Investment News reports analyst consensus of S&P + 7% this year. That should get everyone’s attention - that would be 7%, withstanding political risk, etc. - best case.

So your preferreds would seem a risk-wise idea. And your CPIage exposure, well, now that Christ is back in Christmas, economists would say the demand should just flow somewhere else, aren’t we all worried about consumers. I just can’t believe that inflation is dispensed so easily. Unless we get into something wierd, like stagflation, have not really run money through that type of enviroment in a significant way.

Everyone would agree, fixed income takes on ever more importance in such an environment as today’s? Consider doing your homework and portfolio adjustments now, while the going is good.