Some Practical Thoughts on Asset Allocation

When I think about asset allocation, I typically begin with my model that chooses between BBB corporate bonds and common stocks.  The model still favors corporate bonds.  After that, I look at the bond market, and ask myself where I think risks have more than adequate compensation.  I look at the following factors:

  • Duration (Average Maturity is similar, sort of) — do we get fair compensation for lending long?
  • Convexity — does the bond benefit or get hurt by interest rate volatility?
  • Credit — are we getting decent compensation for credit risk?
  • Structure — Structured notes always trade cheap to rating, but how cheap?
  • Collateral/Sectors — Are there any collateral classes or sectors that are trading cheap to their fundamentals?
  • Illiquidity — are illiquid issues trading stupidly cheap?
  • Taxes — How are munis trading relative to tax rates and creditworthiness?
  • Inflation — is the CPI expected to accelerate?
  • Foreign currency — if nothing looks good on the above (or few things look good), perhaps it is time to buy non-dollar denominated notes.  My view is buy foreign currencies when nothing else looks good, because foreigners will do the same.

At present, I am not crazy about corporate credit relative to other bonds.  I would move up in quality.

We are getting decent compensation for duration risks, so I would buy some amount of long Treasuries.  I would also hold some cash, running a barbell.

On convexity, I would be market weight in conforming mortgages.  If I had an edge in analyzing non-conforming mortgages, I would buy highly rated tranches of seasoned deals (2005 and before).

I would do a lot of analysis, and buy seasoned CMBS (2005 and before) — there are real risks, but the seniors should not get killed.

Munis offer promise for taxable accounts — the difficulty is doing the credit analysis on long bonds.

On inflation — I am not a fan of TIPS right now.  I would rather buy foreign bonds.  The actions of foreign nations lend themselves to dollar depreciation.

So, where would I go with a portfolio that has an intermediate horizon, say, 5-10 years out?

  • 30% global equities — half US, half foreign (emphasize value, but not financials)
  • 15% long Treasuries
  • 15% residential mortgages — seniors, conforming
  • 10% CMBS seniors
  • 15% cash
  • 15% foreign bonds

Yeah, I know this seems conservative, but I am not a believer in the current rally in stocks or corporate debt.  This is a time to preserve capital, not hunt for yield.