A Wolf in Sheep’s Clothing
As I have witnessed investor behavior over the past year or so, I have found that this metaphor (“a wolf in sheep’s clothing") is increasingly apt as it pertains to fixed income investments. Many investors view all securities with fixed rates of “interest” as similar members of a docile flock of sheep. They are cute, fluffy and harmless . . . in investing terminology: low risk. Investors with this bias may be in for a rude awakening, as we believe the flock is actually interspersed with wolves in disguise.
A bit of background might be helpful here, because we are not suggesting investor behavior is irrational. In fact, this behavior is actually being encouraged, if not forced, by central bankers the world over. By keeping short-term interest rates well below the rate of inflation, policy makers are enticing investors to look to beyond traditional low risk investments (money markets, T-bills, etc.) for yield, expanding their “flock,” as it were. We’ve been witnessing this phenomenon for several years as investors have, step-by-step, inched out the risk curve in search of higher yield. Corporate bonds were a logical first step, but we now see high quality corporate bonds yielding a paltry 2-3%. The progression continued to other higher yielding instruments such as lower quality corporate bonds (a.k.a. high yield), Real Estate Investment Trusts (REITs), Preferred Stocks, and Master Limited Partnerships (MLPs).
Like any other product or service, these investments are subject to the rules of supply and demand. As new money has moved into these asset classes, prices have risen and yields have declined. Compared to low risk bonds, the yields still look relatively attractive. However, relative to their own history and growth assets like stocks, these higher yielding investments are now more expensive than any time in the last several decades. Issuers have not failed to notice the shift in investor behavior. In an environment of virtually insatiable demand (assets in high yield mutual funds and ETFs have swelled), even very low quality companies have found a ready market for their securities.
Are we suggesting investors trim their flock of these charlatans? Not necessarily.
Our point is not that wolves are bad, just that they are not sheep and the difference is important. How does this apply to portfolio management? To us, it is simple. True core fixed income investments (sheep) tend to be inversely correlated to risk assets like stocks in periods of stress. Other types of high yielding investments (our masquerading wolves) are more aggressive and can behave quite differently. During stock market corrections, core fixed income investments tend to rise because of their consistent income and low credit risk. The crisis of 2008 provides a perfect barometer (see chart below). The true sheep, like Treasuries and high quality municipal bonds, were their warm and cuddly (a.k.a. low risk) selves. The wolves showed their true colors, snarling their teeth and behaving much more like growth investments.
In terms of portfolio management, we suggest the following:
- Lump the wolves into their own category;
- View these investments as hybrids, recognizing they tend to perform well in good economic periods but have the potential to generate significant losses during market corrections
- Based upon each investor’s risk tolerance, balance the portfolio between sheep and wolves, recognizing the potential benefits and drawbacks of each asset class
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