On Bond Management

After the recent piece Waters Uncharted, I received this comment:

Why do you have a large portion of your fixed income portfolio allocated to foreign bonds?

Are you afraid of a large devaluation in the U.S. dollar?

It seems like American corporate balance sheets are very healthy (especially relative to sovereigns and personal balance sheets).

I have a rule.  I look at the spreads offered for various classes of domestic bond risk.  I buy bonds in the areas where I believe the incremental risks are more than adequately rewarded in the spreads.  If few or no areas offer adequate compensation for risk, I invest in foreign debts, because it is a statement that the US Dollar itself is overvalued.

Think of it this way: if I were a Swiss investor looking in at the US, and concluded that the opportunities weren’t great, would I buy anyway?  No, I would look elsewhere in the world for opportunities.

At present, my bond portfolios are invested:

  • 40% in Foreign Bonds
  • 30% in long US Treasuries
  • 20% in preferred stocks, and
  • 10% in US Dollar-denominated emerging markets bonds

There are several forces at play here.  The actions of the US Government and the Fed tend to weaken the US Dollar — it’s the additional debt, and low fed funds rates, as well as the residual effects of QE.  So I invest in foreign bonds; it’s not ideal, but it is the best of a bunch of opportunities.

The US is still a safe haven currency.  With the difficulties in the Eurozone, some are giving up yield to gain safety, or at least predictability for now. That’s why the position in Long  Treasuries, and my, hasn’t it run of late.

The preferred stocks reflect a part of the credit market that hasn’t gotten whacked too bad, offering a decent yield for the junior debt on healthy companies risk.

I used to hold more emerging markets debt, but I have been trading out of it as the momentum has been weakening.  Economic troubles are rising in the emerging markets, and the eventual result might be ugly.

Back to the original question, yes, corporate balance sheets are in good shape, aside from the banks. But spreads reflect that or better, and so I don’t want to play there now.

Will any decrease in the valuation of the dollar be large? No, I expect it to be moderate, but yes, a decline.

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I have a saying, “Fast moves mean-revert, slow moves persist.”  It makes me a little edgy with the long Treasuries, because the move has been so fast.  I may sell some in the near term if prices rocket higher.  If they edge higher, I might not sell.  Flat or slight selloff, do nothing.  Big selloff, sell into it.

Bonds are a funny mix of momentum and mean reversion.  Good bond managers get a sense of when momentum is overdone, and act against it, but follow when the momentum is gentle.

It’s difficult balance.  I remember buying long Treasury bonds in 2006 when the timing was just right.  Hard negative momentum had just broken.  I remember the trader coming back to me weeks later and saying, “How do you do it?” and I said, “I don’t,”  then saying that nothing is certain when you enter into such a trade.  Market sentiment was horrible, so we legged into the trade, nibbling as prices fell, entering the full position as prices began to rise, once the cascade of forced selling abated.  A few months later, we legged out of the position for a good-sized profit in bond terms.

It’s my opinion that bonds trend more than equities, and that it is easier to calculate the downside risk of most positions.  There are cycles:

  • Credit
  • Currency
  • Hedging of interest-rate-sensitivity (otherwise known as duration)
  • Liquidity

These are not totally independent of each other, but neither are they totally dependent, which makes the game complex.  At present, credit conditions are declining, the US Dollar is not attractive, except compared to the Euro.  There seems to be a grab for the long end of the yield curve, agents buying bit of the far future, perhaps to fund or immunize long liabilities.  Finally, liquidity seems to be slipping — too many markets with abnormalities in the short end of the yield curve.  That will eventually affect the prices of bonds where the value proposition is less than clear, unless the Central bankers decide to do another round of ill advised “stimulus.”

Enough for now, we’re still in uncharted waters, but maybe we have a few guides to aid us in managing fixed income in an era where monetary policy does not work, and governments borrow madly.

1 Comment

  • matt says:

    Unrelated question:

    Many insurance companies have fallen to levels that justify me branching into research to find relative value. (I.e., the naive signal of the price being much lower than it has been, justifying inquiry into what has changed fundamentally).

    Do you know of a good way to learn about how to analyze insurance companies? Is there a good book/white paper that can act as a primer for analyzing these companies? Clearly, insurance companies are a diverse group of companies with diverse business lines (and associated liability structures).

    In addition to learning to analyze insurance companies on a relative value basis, I think that it is tremendously useful to learn how to judge a company vis-a-vis business sustainability and [more qualitatively] the term orientation of management.