Wednesday, January 29, 2014

Rebalancing in a Manipulated Interest-Rate Environment

A continuing issue for 2014.

Rebalancing, in the broadest sense, just means selling an asset that is inappropriately large for a portfolio and using the proceeds to buy other assets.  Rebalancing in that broad sense was discussed in this blog on December 4, 2010, in a posting entitled “Investing PART 1:Background music.”  That posting was about diversification and asset allocation in general.  It presented a number of tools and data (e.g., guilt chart and asset class correlation matrix) relevant to the issue.

Rebalancing was specifically the target of a posting on December 12, 2010.  It was entitled “Investing PART 2: Adjust the treble and base.”  It was discussed again on December 31, 2010 in a posting entitled “Investing PART 7: “To every thing there is a season.”  Between them, those postings present reasonable strategies for rebalancing, as well as limitations.  This posting addresses some issues related to rebalancing that are particular to the financial environment over the last few years.

Most often rebalancing is discussed in connection with the mix of bonds and stocks.  However, as was discussed in connection with the previous postings this year, it also applies to equity holdings within a portfolio.  In many respects, for the last few years, rebalancing within the equity holdings has been easier than rebalancing between bonds and equities. 

The oft-quoted argument for a fixed portion of bonds within the portfolio is based upon the assumption that the unpredictability of equity markets creates a need for potential liquidity at any point.  Also, the return on bonds tends not to be correlated with the return on equities.  Consequently, rebalancing involves selling bonds when their returns have been high, on the assumption that that would be when stocks have had low returns or have gone down.  However, that argument rests on an assumption about the investor’s time horizon.

Bond holdings are, in many respects, always problematic.  There are major shortcomings of bond mutual funds.  Specifically, they defeat the principal purpose of bonds, which is to ensure a return of a specific amount at a specific time.  Even holding individual bonds presents a problem, mainly because they historically have a lower return than equities.  Thus, a reasonable approach is to only hold bonds with maturity dates designed to coincide with the investor’s need for liquidity. 

For the last few years, the Federal Reserve has completely undermined the logic and desirability of bond holdings.  Not only have they manipulated short-run rates, but through operation twist and quantitative easing, they are manipulating the entire yield curve as well as the spread between treasuries and mortgage-backed securities.  The net effect is what is known as financial repression.  It is worth noting that the repression focuses on fixed income investors.

One should keep in mind that every investment, even money (which always has a negative real return during periods of inflation), carries certain risks while hedging others.  As the Fed expanded its rate manipulation to include longer maturities, negative real returns became characteristic of bonds as well as money.  A logical response to the Fed's policy has been to look for substitutes for bonds. 

As mentioned in the postings cited above, one's investment options are not static.  New options arise over time.  Some of those new options can be used to hedge some of the same risks that bonds would hedge.  It is also possible to pick investment options that provide some return characteristics similar to bonds.  Options that are currently far more accessible to investors than they were a decade ago are Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), and Limited Liability Partnerships (LLPs) in general.  Those options now trade like the shares of other companies.

One similarity with bonds is that they are backed by specific assets.  Granted, the claim on those assets is a lower priority than with senior secured bonds, but there is a claim, and, in many cases, that claim is on an asset that is more liquid than those of many corporate bonds.  Further, like bonds, the return on investment is the cash flow from the asset.  Some bonds’ only asset is the discounted cash flow from other financial assets they hold.  Thus, in some instances, one might judge an equity position in a REIT or MLP as better secured than some bonds. 

Interest rate risk manifests itself in a different way.  With a bond, one can always hold it until maturity, at which point it no longer has any interest rate risk.  There is no equivalent maturity date for equity positions in REITs or MLPs.  A rise in interest rates can be secular or long-term.  In which case, one cannot wait out the impact of the interest-rate change.  However, REITs and MLPs can raise their dividends to offset the impact of an interest rate increase.  Bonds offer no similar option.  Consequently, the cash flow from an investment in a REIT or MLP has a different profile from that of a bond.  One has to weigh the risks associated with the two differently structured cash flows and judge the degree to which the REIT or MLP is an acceptable substitute.  The same is true of utilities which were the traditional bond-like equity investment.

The Fed's policy has killed bond holdings as a conservative investment that could be held to maturity and rolled over.  As will be explained in the next posting with examples, bonds and bond substitutes have become more of a trade than an investment.  That is particularly true of bonds where fluctuations in the value of the bond can easily be a multiple of the interest earned over any period of time short of its full maturity.  The need to trade potential substitutes for bonds is partially a result of interest rate manipulation, but it is also related to other features of the substitutes.

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