Weekly Risk Report 6/14/2010
Recently the realization has come that the government deficit spending will have to eventually be paid off, written down or inflated to being inconsequential. This has been happening not only in the U.S. but in countries around the world. The European Union has been in the news almost constantly since the Greek debt crisis hit the headlines. The realization has brought to bear questions relative to what is done during such times relative to bonds and funds that use them as part of their portfolios.
One school of thought is to build a “laddered” bond portfolio oneself. Another is to use professional bond fund managers and trust their abilities to build such structures themselves. There are now bond fund portfolios with specific maturity dates that one could use for such a ladder.
We currently use a variety of corporate bond funds from lower grade high yield to investment grade bonds. Some of these bonds are owned through ETF structures and some are owned via Closed End Funds (CEFs). None of what we are doing is as structured as the specific maturity year funds mentioned above. Those target a maturity date at some point in the future and represent an “index” of various bonds of that same maturity year. The funds we currently are using are of a “rolling maturity” nature.
We are dependent upon the individual fund managers to judge the structure of laddering for us as part of managing those funds. As for managing the “timing” of the use of our ETFs and CEFs, we allow the dividends and internal incremental selling of those bond funds to create a highly liquid reserve. The cash reserves are then redeployed when suitable discounts are available.
It can be expected that as interest rates rise, existing individual bonds will fall in “face value.” Corresponding to this drop, any bond funds that own such debt instruments will fall in net asset value to correspond to the drop in face value of their portfolios. We don’t intend to try to outguess when the inflation/interest rate train will pass, but we also don’t intend to stand completely in its way. The SignalPoint Process is strategically designed to take advantage of market price swings. Yes, the NAV of our longer term bond funds will be compromised. If compromised enough to satisfy our Process, we’ll start to utilize our reserve money market funds to help average down our NAV, Share Price and average up our Effective Yield. (As price/share and NAV drop – assuming no change in distribution per share – the effective yield rises. )
So, rather than attempt to guess at the specifics of a bond ladder’s structure, we choose to manage the price fluctuations as they occur. Again, our model is “retrospective” rather than “predictive.” Our SignalPoint Process is used on Government, Corporate and Real Estate income funds. All of these will be influenced to various degrees as the Yield Curve and the and the overall interest rates change or rise. Usually the most direct change is to government bond funds as they have only the competitiveness of their yield to guide investors as to the proper price/share – there is no “growth” potential. With corporate and real estate income funds the effect is of different magnitude and duration because of the other aspects of the investment beyond the competitiveness of yield. In other words, long term appreciation potential plays a part in how these two are valued. Short term they’re affected nearly as directly as government paper, but in the longer term, their core value and potential growth come into play.
As an example, here’s the modeled results of one of Calamos’ products that we use in our High Income portfolio:
During the ’08 – ’09 panic we accumulated shares at a nice discount from the original price/share. At the time of the additions, the distribution yield was far higher than the starting date. This gave us a lower average price/share and higher yield per share. Then as prices started to recover, when the SignalPoint model was satisfied with the gain, we took some profits and set aside the proceeds in money market funds until they are again needed. While money market rates are essentially nonexistent right now, the cash had previously earned us nearly a 30% short term gain. So, we can afford to let it rest for a while before reuse and not lose much in the way of time-value.
So, rather than building ladders ourselves, we manage the “fund managers” relative to how the fund price/share, NAV and yield is concerned. We can’t predict the timing or control the extent of the changes we’ll see to interest rates, inflation or shape of the yield curve. We can react appropriately when the changes are realized, however.
In summary, medium to long term bond funds of a “rolling maturity” are very suitable for long term management using SignalPoint’s Process. Fixed maturity funds face possibly greater volatility because of being date sensitive against an unknown future. While the anticipated interest rate changes most likely won’t be as sudden as during the recent panic, the same strategy will be used, just over an extended period of time.
In the mean time, the recent pullback in the markets has had the effect of lowering the market’s risk back below its 10th percentile (since 1982). This has come through contraction of both our Speculation and Relative Valuation metrics. Relative Valuation remains bullish while the other three components remain neutral.
