The games we played as kids can serve as good teachers for us as adults.
Did you ever throw rocks into a small puddle to try to displace the water? The first kid would throw in a small rock, creating a small splash, and the rock would be completely submerged. Then another kid would toss in a bigger rock, making a bigger splash, leaving the tip of the rock poking out of the surface. And then someone would always find the monster boulder, stagger over and drop it on the whole puddle. Mud and water would be everywhere except where the hole was. There would be shrieks, howls and peals of laughter. And the band of rapscallions would move on, looking for other ways to amuse themselves.
And so the analogy gets transferred to the mundane world of finance.
The pebbles started dropping into the water about 25 years ago, and gradually displaced the water from most investors’ portfolios. The water being the ballast that sustained the portfolio during period of intense volatility – bonds.
Only in this case, there was no big boulder that took out all of the water. It was just a gradual deployment of pebbles, or falling interest rates, which slowly displaced the yield on the bonds and reduced it to practically zero.
As with the muddy puddle analogy, when the water is displaced from the hole it goes everywhere in search of a new home. And so it is that money has sought out alternatives to conservative bond yields. Investors have moved their money into high yield bonds, dividend paying stocks, real estate and other asset classes that they ordinarily might not have chosen. Along with this decision comes increased risk that otherwise might not have been present – the mud came along with the water.
For some investors, a portfolio that is fully concentrated in equities is entirely appropriate. They understand the risk involved, and are prepared to ride out the volatility. But other investors, especially institutions like pension funds, require the income and stability that bonds have traditionally delivered. These characteristics of bonds have served to offset the volatility that is inherent in equities.
When bonds and equities are blended appropriately in a portfolio, an optimal combination of growth and income can be achieved, while mitigating risk and volatility. This is true for individual and institutional investors alike. At least that worked with the historical model.
Over the past 25 years, the flow of money away from bonds to other investments has served to inflate those other asset classes, creating the current historical anomaly. What we can now say is that the next 25 years will not be like the past 25.
While it is fully expected that equities will continue to deliver growth, it is realistic to expect increased volatility as we move forward into a new interest rate environment. The question is how can we dampen volatility, and what role will bonds or fixed income play as we move forward?
Twenty or more years ago, the bond component of a portfolio would mostly have been represented by government issues. Some might have high quality corporates, especially if they held bond funds, but they were still generally investment grade, recognizable names. Today the yields have almost completely been displaced from these bonds leaving investors little incentive to buy them, except as a form of risk mitigation.
Instead we find a proliferation of yield enhancement products and tools that have entered into the space where bonds once lived. High yield bonds, otherwise known as junk, have seen a surge in interest. Global diversification has also entered the realm that typically focused on bonds closer to home, sometimes adding currency risk for yield enhancement. In the process many of these bond holdings have lost their portfolio ballasting characteristics, and instead taken on the same traits as equities but many without the benefits of equities.
While some of these innovations have improved the choice and access to the fixed income markets, they have also introduced more risk, in order to satisfy the appetite for yield. The real risk is that investors will chase the yield, and be trapped when the market goes the other way. It is at times like these that it pays to review why certain securities were purchased – particularly bonds.
Bonds must perform for the reason they were purchased. If we are entering a time of volatility, then they should deliver on being the ballast for the portfolio.
As mentioned earlier, the case is still strong for equities to deliver on growth. Bonds or fixed income will certainly be tested, especially in the short term as interest rates begin to normalize or through other shocks of market volatility. Now is the time to take a close look at the bond component of the portfolio to ensure that it will fulfill its desired function.
For the prudent, patient, long term investor opportunities arise when the mud starts flying. But it pays to stay out of harm’s way, and maintain an appropriately balanced portfolio with each asset class performing its role.