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.
“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.”
Have you considered adopting conservative option strategies to accomplish that preservation of capital requirement – and still allow for decent profits?
Collars do the trick for most investor portfolios. Losses and gains are both limited, but it’s a wonderful trade-off to know that you will never again suffer through a 20% portfolio loss, let alone anything resembling double those losses seen in 2008.
http://blog.mdwoptions.com/options_for_rookies/
How would you go about choosing foreign bonds?
1) While I greatly admire your writings and take your suggestions into consideration, I don’t know for whom you are suggesting this portfolio. Your recommendations do change once every few months. To follow them an investor with less than 500k would incur an extraordinary amount of friction loss buying and selling. I found bonds to have pretty large spreads and I don’t see a way to effectively reallocate them more often than once every few years.
2) Where does a retail investor find residential mortgages, CMBS seniors or foreign bonds except through mutual funds and ETFs? Who offers foreign bonds (except maybe Interactive Brokers or specialized shops)? I’ve read German Government bond offerings in German and they explicitly did not target US markets. My best guess is that the German government (a supposedly sovereign entity?) did not want to deal with the SEC? (As a contrast most German brokers offer bonds from all over the world for direct purchase.)
@IF: You can find information on German sovereign bonds in English here: http://www.deutsche-finanzagentur.de/cln_117/nn_105602/EN/Home/homepage__node.html?__nnn=true
David,
Would you elaborate on why you’ve turned against TIPS after being in favor of them earlier in the year?