We believe that we are facing a treacherous time for bond investments that have been made without regard to pricing and interest rate sensitivity. The mad rush to bonds resulted from extreme risk aversion to stocks. After cashing out of stocks at the wrong time, investors rushed into bonds at a time of historically low yields (and at very high prices), and during a time of unprecedented levels of government intervention in the bond market.

During the three year period ending December 31, 2012, investors plowed record amounts of assets into bonds, with $622 billion added to taxable bond funds and $51.9 billion added to tax-free municipal bonds. These huge cash flows have increased prices, lowered yields and affected performance. Wescott’s investment approach is to use diversified bond strategies in the portfolio to protect capital, provide a source of cash flow and liquidity, and be the least volatile portion of a portfolio for stability.

We have structured our bond portfolios to be very defensive in response to current conditions in the bond market. In December 2012, the Fed provided greater clarity about its plans to keep interest rates low, and removed reference to dates. The Fed aims to keep rates low until the unemployment rate drops below 6.5% without triggering inflation above 2.5%. Market demand and economic conditions could work against the Fed’s large scale purchases of long term Treasuries and mortgage-backed securities and have unintended consequences, as we discussed last quarter.

In this article, we discuss the highly unusual bond market of 2012 as a backdrop for what may lie ahead in 2013. Herd-like behavior led many investors to accept negative real yields (adjusted for inflation). Treasury Inflation Protected Securities (TIPS) offer some of the best examples of negative real yields accepted at auctions in 2012, since the demand for them has far exceeded the available supply. Through December 31, 2012, the entire inventory of TIPS securities issued and not yet matured consists of 25 TIPS bonds (maturing in 16 to 30 years), and 55 TIPS notes which mature in 10 years or less, for a current total of only 80 securities. While stock investors have thousands of companies in which to invest, investors in TIPS, including all available TIPS portfolios, are limited to so few individual securities.

The Pricing and Yields of TIPS
What is commonly known is that the principal value of a TIPS rises and falls with inflation. The Treasury uses the Core CPI, which does not include food and energy, to make the adjustments. At maturity of an individually held bond, the bond owner receives the greater of the inflation-adjusted principal, or the original face amount, or par value (which would happen after a period of deflation.In a taxable account, the investor pays tax annually on the non-cash principal adjustments.

What is less understood is how the auction process can experience such extremes from overwhelming demand that results in bonds issued at a premium (lowering the yield from the stated coupon), even to the point of a negative real yield at issue. In April 2011, auction rules were modified to provide that, in the event of an auction of a new issue at a negative yield, the minimum interest payment would be 0.125%.

Every TIPS Note auction in 2012 executed at negative yields; the three TIPS Bond auctions resulted in yields of less than 1%. As you can see in the chart below, the minimum interest payment applied to all the TIPS Notes auctioned in 2012. Of the three auctions of TIPS Bonds (maturing in more than 10 years) during 2012, only one of them sold for a price slightly under par ($100). The principal is protected through maturity, however, the market value of an outstanding TIPS will fluctuate when interest rates change.

We have not included TIPS as a dedicated strategy in our bond portfolios, due to current market conditions. We have recently updated “Wescott’s Perspective on TIPS”, originally published in 2009.

Wescott’s Overall Positioning
In both Taxable and Tax-Exempt portfolios, we have a current emphasis on shorter term maturities. For diversification purposes, we include an allocation in both strategies to Metropolitan West, a manager who invests in taxable bonds and can migrate to longer term maturities on a valuation sensitive basis. Our bond portfolios are positioned defensively with high-quality securities and lower interest rate sensitivity than the broad bond market. As interest rates return to normalized levels, our positioning will evolve to be opportunistically positioned by maturity range. We do not know when; however, we are confident that the economy will eventually force the Fed’s hand and/or demand for bonds will abate, driving yields up. When this happens, the prices will fall for outstanding bonds issued at lower yields. A bond’s duration is used as a rule of thumb to determine how sensitive a security is to interest rate movements. For example, if a bond has a duration of five years, a 1% increase in yield would result in a 5% decline in the existing bond’s price. Offsetting the price decline is the interest payment, however, as you can see in the charts on the following pages, historically low yields provide very little cushioning.

Wescott’s Taxable Bond Portfolio
In the chart below, we provide information about the positioning and interest rate sensitivity of our managers in Wescott’s Taxable Bond strategy and the benchmark, under a hypothetical 1% change in interest rates based on their 2012 positioning.

Portfolio Positioning as of September 30, 2012
(For compliance reasons, we receive full holdings on a lagging basis.)

We use the Vanguard Total Bond Market Index Fund as the market benchmark since it provides broad exposure to the U.S. bond market and is investable. Prior to 2010, the Vanguard Total Bond Market Index strategy replicated the Barclays U.S. Aggregate Index. The Fed’s purchases of Treasuries and agency mortgages dramatically changed the Aggregate Index, which is now dominated by government securities. In 2010 Vanguard shifted to the Barclays US Aggregate Float-Adjusted Index, created to exclude the Treasuries, agencies and mortgage-backed-Securities held in Federal Reserve accounts (since they are not available to the market).

Other key statistics about our bond portfolio:

  • In the aggregate, the average price of the bonds in the Wescott portfolio was $101.24, versus a price of $112.53 for the Vanguard Total Bond Market Index as of September 30, 2012. Our managers have been more valuation sensitive than the passively managed Vanguard strategy.
  • Wescott’s portfolio has 85% of its bonds rated A and higher, with 70% rated AAA.
  • Wescott’s portfolio is well diversified by sectors. As compared to the Vanguard Total Bond Market Index, our portfolio had less in US government-related securities (29% versus 46% for the Index), more in mortgage-backed securities (40% versus 26% for the Index) and more in corporates (27% versus 21% for the Index). We also have 28% of the Wescott portfolio (which is captured within the other categories above) invested in securities with floating and/or adjustable interest rates, which includes adjustable rate mortgages.

Wescott’s Tax-Exempt Bond Portfolio
In the chart below, we provide information about the positioning and interest rate sensitivity of our managers in Wescott’s Tax-Exempt Bond strategy and the benchmark, under a hypothetical 1% change in interest rates based on their 2012 positioning.

Portfolio Positioning as of September 30, 2012
(For compliance reasons, we receive full holdings on a lagging basis.)

We use the Vanguard Intermediate-Term Tax Exempt Fund as the benchmark for the Wescott Tax-Exempt portfolio; Vanguard uses the Barclays 1–15 Year Municipal Bond Index for its strategy. As you can see above, the Wescott portfolio has a shorter duration than the benchmark, which will provide better protection when interest rates go up.

Other key statistics about our bond portfolio:

  • In the aggregate, the average price of the bonds in the Wescott Tax-Exempt Bond portfolio was $106.86 as of September 30, 2012, versus an average price of $113.59 for the bonds held in the Vanguard Intermediate Term Tax-Exempt portfolio, reflecting Wescott’s more conservative bias.
  • Wescott’s Tax-Exempt Bond portfolio has 88% of its bonds rated A and higher.
  • As compared to its benchmark, Wescott’s Tax-Exempt Bond portfolio has a higher allocation to the sectors of general obligation bonds and utility bonds, and a lesser allocation to education bonds

 

An original article authored by the Investment Research Group of Wescott Financial Advisory Group LLC
© Copyright 2013, Wescott Financial Advisory Group LLC All Rights Reserved

http://www.wescott.com/documents/resources/Yield_With_Care–Thoughts_on_a_High-Dividend_Paying_Strategy_-_April_2012.pdf