Maintaining a Disciplined Approach in Challenging Times

Fixed-income investors are now passing through the most painful and dangerous part of the interest rate cycle.  The pain is coming from the prolonged absence of investment yield.  It has now been almost two years since the Federal Reserve dropped its short-term rate target to 0-0.25%, effectively pinning all short-term yields near zero.  Longer-term rates have also dropped, particularly given recent doubts about the sustainability of economic recovery in the United States.  The danger arises from impulsive investors doing too much to add yield by assuming a substantially higher level of credit risk, or by extending portfolio maturities to capture the benefit of the upward-sloping yield curve.

We are now well into the Fed’s current policy cycle and Treasury yields are at historically low levels, so the potential for market-price increases in bonds is quite limited.  At the same time the markets have a history of anticipating (some would say forcing) changes in Fed policy.  For example, in the one-year interval between the Fed’s last cyclical ease in June 2003 and its first target rate increase in June 2004, yields on 5-year U.S. Treasury notes rose by more than 1.6% and on 10-year notes roughly 1.4% from their cyclical lows.  Market yields moved up well before the Fed acted.

SNW Asset Management has not been idle as rates have fallen, nor have we over-reached for yield.  Over the past 2 years we have opportunistically added yield through selectively adding securities that offer higher yields while maintaining portfolio durations.  For example, investors in taxable bonds may have noticed a modest increase in the level of their credit risk via the careful selection of corporate credits and sale of short maturity bonds.  Because of these trades, we have been able to increase the yield on our client portfolios while keeping them concentrated on the steepest sections of the intermediate yield curve (3 to 4 years).  Clients invested in tax-exempt bonds may have noticed that a select number of healthcare and public utility credits were added to their portfolios.  In some cases we used funds from maturities to make these shifts.  In other cases we sold short maturity bonds, which allowed us to book profits and increase yield.  These subtle shifts in allocation have added value without adding unacceptable amounts of either credit or interest rate risk to our client portfolios.  As with all of the relative value swaps we implement, the trades are executed with each individual client’s mandate in mind.  For this very reason, we encourage all of our clients to take a moment to revisit their Investment Objectives to ensure that the portfolio objectives and risk tolerances we have on record are up to date.

SNW Asset Management would like the opportunity to review your investment objectives with you to assess which of our recommended approaches to the current market is appropriate.  We welcome your phone calls and look forward to having a discussion with you.  Please click here to find a copy of our Investment Objectives form, which outlines the key characteristics of the strategies we offer.

A Post-Holiday Letter from Scrooge

It is a brand new year. The President is pre-occupied with a costly and controversial war. The U.S. economy is struggling to recover from a sharp recession. The Federal Reserve chairman, whose surname begins with the letter “B,” is printing a lot of money while assuring one and all that the Fed has the will and the tools to avoid triggering an inflationary outburst. Meanwhile, oil is getting more expensive, and the U.S. dollar is under substantial trading pressure and losing value in the currency markets. Investors – particularly bond holders – are worried about the future.

Does this sound familiar? Actually, the year I am thinking about isn’t 2010. It’s 1972. The President was Richard Nixon, the war was Vietnam, the Fed chairman was Arthur Burns, and the aftermath was the great inflation of the 1970s, which proved devastating to fixed-income investors. Measured by changes in the Consumer Price Index, the dollar lost more than half its purchasing power between the end of 1971 and the end of 1980. Admittedly, the inflation of the 1970s was aggravated by the first oil shock of 1973, but it was first set in motion by ultra-easy monetary policy. And my basic point is that inflation is toxic to fixed-income investors. A bond portfolio that produced a nice annual income when I was a college student in the mid-1960s would need to produce seven times more income today to generate the same purchasing power. Even if your salad days were in, say, the 1980s, the income dollars produced then by fixed-income portfolios have lost more than half their purchasing power by now. Think about that for a moment. That’s a lot of loss for fixed-income investors.

The two great risks to bond investors are credit risk and inflation. You can deal with the former through diversification and careful selection of portfolio holdings. But dealing with inflation is much harder. You have to have cash available to invest after interest rates have adjusted to the inflationary outlook. If you invest too long, too early, the value of your portfolio will drop as rates rise to compensate investors for the loss of their purchasing power. Right now is a very perilous time for bond investors. The difference between short-term rates and longer-term rates is near record levels, so it is tempting to invest in longer-maturing bonds to capture higher yields. But longer bonds have much greater price volatility than do shorter-maturing ones, and they will lose much of their market value if inflation proves higher than anticipated and rates move higher still. This is why SNW Asset Management is recommending to our clients that they remain patient and keep their bond money relatively short. Fed Chairman Bernanke may indeed be successful in weaning the economy away from enormous monetary stimulus without triggering an inflationary outbreak. Investors in long bonds are betting on exactly that. At SNW Asset Management, we think that may be a triumph of hope over experience, and we urge our clients to keep their investment powder dry.

Oh, by the way, happy New Year.

-E. Scrooge

Do I Need TIPS?

SNW Asset Management is often asked about TIPS and whether it is an appropriate time for investors to purchase them. TIPS offer some unique benefits to investors, but you have to be very careful about how they are used. First and foremost, we recommend investors only own them in accounts that are tax-advantaged. The inflation adjustment of the principal amount on TIPS can lead to a tax liability in the current year even though the inflation benefit is only realized when the bond is sold or matures. Any tax accountant will tell you it can be a nightmare to account for them properly from a tax standpoint.

While TIPS do look attractive from an inflation TIPS of view, we are still concerned about them from a value perspective. When inflation rises, often times that coincides with the economy doing better. As the economy grows, companies are able to charge more for their products or services, demand for commodities rises causing prices to adjust upwards, and workers are able to demand more income from employers as demand for certain skills increases. Economic growth can lead to the real level of interest rates rising as well, which can ultimately hurt the value of TIPS. So, TIPS can perform well in a rising inflation environment, but they are not completely immune from the effects of rising interest rates.
One final concern with TIPS is availability. The structure of TIPS calls for the maturity value to be the higher of par or the inflation adjusted principal amount. While the risks of future inflation are currently growing, we are currently in a deflationary environment, which could cause the principal value of outstanding TIPS to be adjusted downwards. It is in the client’s best interest to purchase TIPS as close to par as possible to avoid the risk of future deflation reducing the principal investment value. Currently the Treasury is only issuing five, ten year and 20-year TIPS quarterly. This can make it difficult to structure a portfolio of TIPS for clients with shorter maturity constraints.

SNW Asset Management is not currently holding TIPS in our client portfolios. Instead, we have made the decision to hold corporate bonds were appropriate. Corporate bonds perform well in inflationary environments as the credit quality of corporations credit tends to improve under these circumstances. Typically companies are able to raise prices on the goods they produce to offset inflationary forces, while their financial obligations tend to rise much slower. Also, at present corporate bonds offer much higher yields than TIPS which helps to offset the effects of future inflation. Corporate bonds do introduce credit risk to the portfolio, so they are not suitable for everyone.

In conclusion, TIPS are not a strategy that we would recommend in the current deflationary environment and global economic conditions ensure that inflation, while on the horizon, is not imminent.