During periods of market uncertainty, investors often try to reduce risk by shifting assets from the more volatile sectors of their portfolios--usually equities--to less risky assets like bonds, or in the extreme case, cash. This "flight to safety" has been the case for most of the last 12 months. The result of this large-scale asset transfer is reflected in the relatively high returns on Treasuries over the last year as well as in their current low yields. But market-leading performance notwithstanding, the real appeal of this asset class to advisors should be the diversification benefits it offers.
While fixed income securities, Treasuries in particular, have long been a staple in the asset allocation process, for most of the last decade investors have been pursuing bonds in search of higher yields--regardless of the risks associated with those yields. This yield chase has led to an emphasis on "spread" products in the bond market, and that means portfolios are primarily invested in taxable fixed-income securities other than Treasuries. These issues would include corporate bonds--especially lower rated issues--and mortgage-backed and asset-backed securities. The primary advantage of these issues is the increased yield, or risk premium, over Treasuries, which usually, but not always, translates into a total return advantage for investors. Corporate bonds, for example, had sharply negative returns over the 12 months ended September 30, compared to positive returns from Treasuries and mortgage-backed securities.
The reality, of course, is that advisors should always be looking forward in making decisions about both asset allocation and manager selection, and that requires a careful evaluation of current conditions. Right now, short-term Treasuries are offering markedly low yields--and in some cases negative "real" yields--and little potential for capital appreciation. Corporate bonds, for their part, are offering very attractive current yields, but come loaded with a great deal of uncertainty regarding the current economic environment. Mortgage-backed securities, meanwhile, fall somewhere between corporates and Treasuries in terms of yield and expected volatility.
While we would suggest that advisors and investors looking to build pure Treasury portfolios are best served by low-cost index mutual funds, those looking to add additional bond exposure may find a more active management solution a better fit. One "holistic" recommendation would be to combine a conservatively managed Government/Corporate SMA portfolio with a mortgage-backed security mutual fund. The advantage of using an SMA for a portion of the allocation is that it provides the ability to customize the risk levels--credit and maturity in particular--by working directly with the investment manager.
One experienced manager with an important offering in the fixed-income arena is RNC Genter Capital Management and its Taxable, Quality Intermediate portfolio which emphasizes capital preservation first and income second. This strategy is highlighted in the way the firm manages its corporate bond portfolio where maturity on all bonds is less than five years, minimizing price volatility and the probability of default. A good companion to the RNC portfolio would be a mortgage-backed security fund like TCW's Total Return Bond. TCW takes a slightly more aggressive approach to mortgage-backed securities in terms of maturity, but balances this by maintaining an average credit rating of AAA.
Fixed income is the diversification tool of first choice for investors with longer time horizons, and the virtual mainstay for investors with shorter time horizons. But since last year's flight to quality made Treasuries the best performing asset class (surprisingly, mortgage-backed securities were second-best), it's reasonable to think they have little to offer but safety going forward. We would suggest, then, the dual approach outlined above: a customizable Government/Credit SMA portfolio with a MBS fund weighted to an investor's risk tolerance.
J. Gibson Watson III is president and CEO of Prima Capital, a Denver-based firm (www.primacapital.com) that conducts objective, institutional-quality research and due diligence on SMAs, mutual funds, ETFs and alternatives.
