The biggest challenge facing Money For the Rest of Us listeners is how to allocate their assets in order to be able to retire. In this episode, I discuss how I am going to help you overcome that challenge.
In this episode you’ll learn:
- How diversification can be misused.
- The big asset allocation mistake I made with a former university client.
- The current environment for non-investment grade bonds.
- Content I will be providing to help you with asset allocation and portfolio structure.
- What are life settlements.
- A preview of some upcoming episodes.
Show Notes
MNY014: Are You A Complacent Investor?
MNY021: Investing Without a Map
Carl Richards – Behavior Gap
Carl Richards New York Times Sketches
The One Page Financial Plan by Carl Richards
The Practical Guy
The Retirement Miracle by Patrick Kelly
Become a Better Investor With Our Investing Checklist
Become a Better Investor With Our Investing Checklist
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Summary Article
A Classic Investment Mistake
In early 1998, two and a half years into my tenure as an institutional investment advisor, I was the consultant to a $150 million endowment fund for a liberal arts college located in the Midwest.
Each quarter, I met with the college’s investment committee who held their meetings at a trustee’s law office on the 54th floor of a skyscraper with views of the cityscape below and the cornfields that stretched out for miles in all directions.
I felt as if I was at the top of the world, while at the same time feeling like I was in over my head when it came to advising this committee on how to allocate the institution’s investment portfolio.
My transportation to and from the meetings was a white Toyota Tercel with huge black bumpers. The car was a gutless four speed-manual, and it smelled like vinyl and plastic. It even came with an extra four pack of plastic hubcaps in case the originals fell off.
We called it “The Little Auto,” and I made a point of parking it several blocks from my meeting place as my humble vehicle embarrassed me.
Non Investment Grade Bonds
My agenda at the January 1998 meeting was to convince the committee to invest in non-investment grade bonds.
Non-investment grade bonds are debt instruments issued by companies that have been rated speculative by the major rating agencies.
They are considered speculative because the cash flow the companies generate to cover principal and interest payments is less certain, and the amount of free cash flow remaining after debt service that acts as a margin of safety is lower relative to higher grade credits.
High yield bonds are attractive to investors because they carry a higher interest rate compared to government bonds and investment grade corporates. This means high yield bonds can potentially generate a higher annualized rate of return compared to other bond sectors if default rates remain low.
In the case of this college, their existing bond manager was ultraconservative, and I felt high yield bonds would be a good diversifier that could increase the bond portfolio’s return.
Diversification
I was a novice on non-investment grade bonds, and it wasn’t something our firm had recommended previously so most of my education on the sector came from non-investment grade bond managers, who were more than happy to bring me up to speed on the bright prospects for this asset type while also emphasizing their expertise in selecting high yield credits.
I was pleased the college accepted my recommendation to allocate approximately 5% of their portfolio to high yield bonds. At the next meeting, they selected a fixed income manager to oversee the allocation.
After that meeting, our firm’s founder asked me why I would make such a recommendation, given all the capital that was flooding into the sector, pushing down yields and lowering expected returns.
“Diversification,” was my answer.
This was still early in our firm history before we had a dedicated research group and consistent, firm-wide recommendations.
I basically could do what I thought was in the best interest of my clients.
In this case, it turns out I was wrong.
The Misuse of Diversification
In the investment arena, diversification is often used to justify investments that are ill timed or should not have been undertaken at all.
An asset class that performs differently than the portfolio at large does indeed provide diversification.
Yet, it is of little benefit if the new investment goes down in price while the rest of the portfolio continues to appreciate.
My Mistake
For this client, I made a classic investment mistake. I was enamored with historical performance while ignoring the primary driver of those historical returns and the current investment conditions that would influence future returns.
When my client made their allocation, non-investment grade bonds had outperformed U.S. Treasury bonds and investment grade corporates over the previous six years.
This outperformance was due not only to inherently higher interest rates on non-investment grade bonds compared to other bond sectors, but also because their prices were increasing as the bonds became more popular.
After the 1991 recession, investors became more comfortable with non-investment grade bonds as defaults decreased. This resulted in more capital flowing into the sector, pushing up bond prices and lowering their yields.
At the peak of the 1991 recession, high yield bonds yielded more than 12 percentage points above 10-year Treasury bond yields
By 1998, non-investment grade bonds were yielding less than four percentage points above 10-yield Treasury bonds.
Investor appetite for high yield bonds was large given their strong performance so there was a great deal of new issuance, much of which was being used to build out communication networks for the expanding Internet.
The Results
I had no way of knowing nor could the high yield bond managers that helped educate me on the space that 1998 was the top for this credit cycle. But I should have known these bonds were richly priced and had benefited from a strong tailwind.
Later in 1998, the Asian financial crisis hit, followed a few years later by the Internet bust, 9/11 and a recession.
Non-investment grade yields rose on an absolute basis and relative to U.S. Treasuries, causing the value of those high yield bonds to fall. Default rates increased.
My client’s allocation severely underperformed relative to their existing bond manager over the subsequent years.
High Yield Bonds Today
Of course, things are always more clear in hindsight. Today, high yield bonds yield over 7%, about five percentage points more than 10-year Treasuries, in line with historical average spreads.
Non-investment grade bonds are not overvalued and overhyped like they were in 1997. Nor are they extremely cheap like in 2009.
They exist in that in-between space called fairly valued or average. Consequently, I have a small allocation and I’ll wait to see what happens.
In the meantime, I have learned to stay clear of overvalued asset classes even if an allocation theoretically increases diversification.
