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.