The Traditional Approach

The traditional asset allocation approach to income investing contains some serious flaws. Most important among them is the old bond/stock mix (60%/40%, for example), which assumes 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. It is always challenging, even at market peaks, to irrefutably 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 objective valuation. If $1 million invested in a 10-year Treasury yields 1%, or $10,000 of pre-tax income, but the risk of interest rates rising from merely 1% to 2% means a loss of 9%, or $90,000 – which is over 9 years’ worth of income – that is objectively not a good value. And if, at the same time, the official measure of inflation of 2% guarantees that one will actually lose purchasing power over the 10 years, that is objectively a dangerous investment. 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 about changes in opportunity and risk, 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. Should you prefer a 2% 10-year corporate bond fund in your 401(k) to a 3% 5-year tax-exempt 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. 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.

Money Losing Proposition for Bond Investors

With debt levels around the world now at record levels, including the U.S., governments cannot risk a rise in interest rates – the increased financing costs could wreck their economies. Central banks will have to continue to create more money, debasing their currencies, to buy their bonds, in order to suppress rates. This condition will allow, over the coming decades, debt to be repaid with ever cheaper currency. Ultimately, bonds will be more dangerous than equities. The bond/stock asset allocation standards of the past are over. Bond investors now face a binary choice:

• Either the government is able to maintain interest rates where they are or even lower, in which case bonds lose value, via inflation, relatively slowly.

• Or rates rise, in which case bonds lose value fast. What could make rates rise? When governments around the world publish the size of their budget deficits, credit rating downgrades of sovereign debt should be expected. Debt rating agencies like Moody’s follow strict criteria, such as debt/GDP ratios.

• A 10-year Treasury, now has a 0.96% yield. If the yield rises from 1% to just 3%, the price drops 17%. A 30-year Treasury, is now 1.72%. If the yield rises to 3%, it loses 25%.

So there is no scenario in which investors escape losing money in bonds. One of the most important elements in asset management in the coming decades will be finding inflation beneficiaries and business models that are protected from inflationary pressures.