The Traditional Approach

The asset allocation approach to income investing, as practiced, contains some serious flaws. Most important among them is the old bond/stock mix (60%/40%, for example), which intends that one always be invested in that allocation. But what if it’s not a favorable time to be invested? They can’t all be, can they? It is challenging, at any time, to argue that stocks are overvalued, because a stock’s value is – with so many variables – so debatable. The beauty of the bond market, though, is that a bond lends itself to fairly objective valuation. If $1 million invested in a 10-year Treasury yields less than 2%, or $20,000 of pre-tax income, but the risk of interest rates rising from merely 2% to 4% means a loss of 15%, or $150,000, that is objectively not a good value. Perhaps one shouldn’t be investing at that point. The traditional asset allocation model does not make that differentiation.

An Alternative Approach

We believe in an absolute return minded approach to selecting income investments. Sometimes, the most important factor of all is to recognize that there are no securities being offered that are worth the risk. Unlike stocks, the maximum return of a bond is typically limited by its face value. Accordingly, one should not lightly trade away safety for just a touch more yield. The goals of income investing are perhaps more modest, so the risk tolerance must be far lower. Because favorable opportunities for income investing tend to be episodic, we invest more actively in some periods and less, or not at all, in others.

Another challenge is that standard income strategies are marketed on the basis of specific indexes or sectors. Unfortunately, this is often more about labels than changing opportunity and risk in the market, as if a high-yield investor should always be in high-yield securities, or as if a tax-exempt investor like a 401(k) owner should not look at a discounted closed-end municipal bond fund even if it has a superior yield and higher credit quality. Would you prefer a 2% 10-year corporate bond fund in your 401(k) or a 3% 5-year closed-end tax-exempt municipal bond fund of AA credit quality? In any marketplace, prices will vary – sometimes dramatically. This applies not only for individual securities, but for entire classes of securities. It is on such occasions that an overly rigid reliance on semantic guidelines for investing can undo otherwise good intentions. And it is during such periods of excess demand for the popular or refusal to transact in the unpopular, that asymmetrically favorable risk/reward opportunities arise.


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