I love bonds…and BBQ. Whenever there is a good BBQ and we get to talk about bonds, well, that is my happy place. IR+M has its very own Pit Master – Rob Lund. If you ever get invited to a Rob Lund BBQ, RSVP yes, and arrive hungry.
One of the most important things about smoking a brisket is heat consistency – there is little margin for error. You might not see where I am going with how this is related to fixed income. Margin for error has been steadily declining in the fixed income universe for the last 30+ years as rates have been declining. When IR+M was founded back on March 16, 1987, the 10-year Treasury yield was 7.20%. On August 4, 2020, the yield was 0.51%. To put this margin for error into a portfolio context using that 7.20% yield from 1987, if you had 1% of the portfolio default with $0 recovery rate, your yield would get you back to flat in about seven weeks. Today, it would take about a year and a half.
So what is the key ingredient to protecting your portfolio? Diversification. For clients that have been with us for a long time, you might have noticed that, as rates have fallen, so too have the position sizes in the portfolio. We hold more bonds in a portfolio today, and therefore on average have smaller position sizes than we had back when rates were higher. Diversification is the first and second most important ingredient in risk management, especially in a low rate environment. This fact reigns true regardless of the fixed income asset class from corporates and securitized, to municipals and any other spread sector.
Fortunately, the market has given us an increasingly growing opportunity to fund this diversification, and we like to Take What The Market Gives Us. In less than 10 years, the number of tickers in the Bloomberg Barclays Intermediate Corporate Index has risen by 14%. When you add in the large and growing number of 144a, securitized, and taxable municipal securities that are not in the Index, the ability to diversify the portfolio has continued to grow while also offering correlation benefits and additional potential sources for alpha. Just as our portfolios have become more diversified to reflect market dynamics, so too has the Index – the top 10 issuers 10 years ago represented over 22% of the Bloomberg Barclays Intermediate Corporate Index; today this figure is closer to 17%.
Just as temperature consistency is important, so is cooking time. Six hours for a five-pound brisket is ideal – if you take too short of a view and remove it early, you’ll never be happy with the result. The same is true with portfolio management. We truly believe you should take a long-term view of every investment. And as we note above, given today’s reduced margin for error, this is more important now than ever.
While diversification is important today, this does not mean you should own everything – there is diminishing marginal utility. Just like at the family BBQ, it is okay to pass on the green bean casserole or the Jello mold; you always want to make sure your best ideas and favorite foods are well represented. You should expect to continue to see meaningful active positioning in our portfolios where and when appropriate – both overweight and underweight. Bottom up security selection and relative value will continue to drive positioning – just as taste preferences will dictate side selection.
So how do you diversify your BBQ? Well, first invite as many people as possible (this part is more appropriate in a post social-distancing era) and the more people, the merrier. You can always have a little too much food, but you can never have too many friends. You should also have lots of different sides, including at least two types of potato salad and baked beans – both with and without bacon. Finally, when it comes to hydration, you only need one type of iced tea – sweet (i.e. making sure your best idea is well represented). Happy grillin’ this summer!
Sources: Bloomberg Barclays. Data as of 08/03/2020. The above examples are for illustrative purposes only. Actual results may differ. Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith. The views contained in this report are those of IR+M and are based on information obtained by IR+M from sources that are believed to be reliable. This report is for informational purposes only and is not intended to provide specific advice, recommendations for, or projected returns of any particular IR+M product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Income Research & Management.