Mullooly Asset Management

Fiduciary Fee-Only Financial Planner | Investment Advisor in Wall, NJ

Bonds

Tim’s Top Links – 1/10/17

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Tim's Top LinksLast night something amazing happened.  Alabama lost a football game.  It doesn’t happen very often, so remember this moment.  It got me thinking about the markets though.  Recency bias has a way of making people think the current leaders will never fail, or make it difficult to imagine that happening.  For the longest time it was hard to imagine a college football world where Alabama wasn’t the top team.  However, that was obviously going to happen at some point.  Now it’s time to make way for a new champion: Clemson.  The same goes for the markets.  Eventually whatever is the very best performer at the moment will fall out of favor.

Here’s what I’ve been reading this morning:

‘Grandmasters of Work’ – Morgan Housel – Collaborative Fund

‘The Hardest Thing’ – Charlie Bilello – Pension Partners

‘4 Reasons to Buy Bonds in 2017’ – Peter Lazaroff

‘Dividend Stocks are the Worst’ – Meb Faber – Meb Faber Research

‘Does the 200-Day Moving Average Still Matter?’ – David Fabian – FMD Capital Management

ENJOY!

Making the Band: Investing Edition

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When people think of the world of investing and the world of music, there are very few comparisons that come to mind.  How can stocks and bonds resemble a bass line or guitar riff?  Can an epic drum solo be compared to a new, hot IPO?  It’s safe to say those comparisons would be a bit of a reach.

However, there is one comparison that comes to mind.  When you think of the way a band comes together piece by piece, it resembles a similar process of constructing an investment portfolio.  Let’s break it down, piece by piece:

Drums:  The drummer in a band has a great deal of responsibility.  Whether recording in the studio, or performing live on stage, the drums always keep the band in time.  When the drummer is perfectly on time, it allows the rest of the band to shine and freely do their thing.  Sometimes, you might even forget the drummer is there when he or she is sitting in the back, but they’re holding it all together.  The ‘drums’ of an investment portfolio are the bonds.  No, not those crazy high-yield, low quality bonds, but the aggregate bond funds or treasury bonds.  Bonds that have the potential to be stable when the equity markets are flying all over the place.  The bonds have the potential to be a shock absorber, or cushion, in the portfolio when the more ‘flashy’ stuff might not be doing so hot.  Owning bonds may appear like you are playing it safe, but when things are going wrong while your portfolio is “up on stage”, you may be glad you owned bonds to keep everybody on time.

Bass:  The bass player in a band has almost the same ‘boring’ responsibilities as the drums.  Most of the time you forget the bass is even there, but most songs would sound weird without it.  Every once in a while, the bassist can throw a crazy riff in there, but for the most part, he or she is just keeping the rhythm.  The ‘bass’ of an investment portfolio could be some broad market index funds.  These index funds do their best to track whatever index they are assigned to (ex. S&P 500, NASDAQ, Russell 2000, etc.).  There are even a number of broad index ETF’s out there with very low costs, making it cheaper for investors to get exposure.  For the most part, these funds will quietly offer the performance (or close to it) of the index it’s tracking.  For the most part, these funds will be justdownload keeping you in time with the market ups and downs.

Guitar: Guitars are an extremely versatile instrument.  They can make an enormous variety of sounds depending on the tuning, shape, style, and strings.  If you want something soft and smooth, a jazz riff or acoustic guitar might be a good option.  If you want something grungy and heavy, an electric with the distortion pedal blasting is what you want.  There’s a million different ways to play a guitar, and even more ways to fit them into a band.  Most bands have a rhythm guitar and a lead guitar.  The rhythm guitar does what its name implies, keeps the rhythm and strums some chords.  That’s not to say the rhythm guitarist can’t rock out and have his or her time to shine.  However, the lead guitarist gets all the solos and best riffs throughout the song.

The ‘lead’ and ‘rhythm’ guitars in an investment portfolio are the equity funds.  For simplicity’s sake, let’s categorize equities as “domestic” and “international”.  It wouldn’t be fair to pin domestic or international equities as the lead all the time.  These things come in and out of favor, just like every other investment known to man.  For the sake of this analogy though, we’ll say domestic equities funds are the lead.  The equity funds offer even more rhythm and feel to the group, and provide the big solos during the bright times.  An awesome solo, or equity portion, can make or break a song.  If the guitarist hits every note and nails the solo, the song is a hit!  If the guitarist messes up and misses some notes, well, we’ve all failed at Guitar Hero before so we know what happens.

Throughout a set list, the two guitarists can take turns being the lead and rhythm.  The same goes for domestic and international equities.  Most guitar solos would not sound as powerful without a rhythm section.  The same goes for equities.  There is a place for both domestic and international in a portfolio, and learning how to ‘play both guitar parts’ will ultimately help make the portfolio more balanced.

Vocals:  Some of the best bands in the world don’t have a lead singer.  Instrumental songs can be just as beautiful as a vocally driven song.  It all depends on the timing and what feels right in the moment.  A band shouldn’t force vocals into a song if it’s not necessary.  Therefore, the ‘vocals’ portion of the band resembles a commodity portion of the portfolio.

Horrible vocals can ruin a song, but at the same time a beautiful vocal melody could turn a mediocre song into a smash hit.  The same thing goes for commodities.  When used correctly, a commodity portion of a portfolio could really add an extra spark.  However, a poorly utilized commodity trade could potentially blow up an account.  These commodities, and lead singers, tend to be temperamental, so it’s important to always keep an extremely close eye on them.

The last thing anybody wants is a lead singer getting out of control, or a commodity position destroying their account.  That’s why it always needs to be determined if vocals, or commodities, are even necessary in the song or portfolio.  If the song can get by without vocals, or the portfolio can perform without commodities, just let it be and don’t mess with it.

There are hundreds of different instruments that can be used to make amazing music, but the basics will do for now.  The same goes for investment options as well.  Every day there are new products being rolled out for investors to utilize.  Some bands don’t have drums, or guitars at all.  It all depends on what is right for the band.  The same thing goes for investors.  Whether it’s a mix of bonds, equities, index funds, commodities, or none of the above, if the portfolio makes sense for the investor based on his or her needs, that’s all that matters.

Some of these comparisons might have been a bit of a reach, but it’s always nice to make a refreshing, creative connection to the usually-confusing world of investing.  Making sure clients understand the way their portfolios operate is something not enough people in the industry make a priority.  Laying out the structure of the clients’ portfolio in terms THEY can understand, whether it’s a sports analogy, music, or something totally different, should always take precedent.  At Mullooly Asset Management, we strive to make sure our clients understand our process and how we put together our portfolios.  If you’re reading this and DON’T understand any of the investments in your current portfolio, don’t hesitate to pick up the phone and give us a call.

Reaching for Yield and Baseball’s Steroid Era

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Remember how cool the home run race was back in 1998? Sammy Sosa and Mark McGwire both broke Roger Maris’s single season record of 61 homers in a season. It was pretty easy to get swept up in this exciting story line, and it was fun too. It was a home run hitter’s game, and guys like McGwire, Sosa, and later Barry Bonds ruled the headlines.

In hindsight we were overlooking one big thing: they were all taking performance enhancing drugs. This period in baseball history is widely referred to as the Steroid Era, and now the only headlines featuring Bonds, Sosa, or McGwire are about not letting them into the Hall of Fame to punish them for cheating.

In the back of our minds, we all knew something was up in the late 90’s. However, the overarching story of the home run race and watching these players rip 500 foot home runs was too much fun. Did we really believe that hitters magically figured out a better way to hit pitching? Remember the story that Sammy Sosa cooked up about his bad wisdom tooth that apparently made it normal for him to go from looking like this to this? We all blatantly ignored the signs. As they say, “Chicks dig the long ball”, so we continued enjoying the fun, believing everything was awesome. This has a tendency to happen with stories we buy into. Bob Seawright explains that:

“Once we have bought-in to a particular narrative we’re mostly cheering our side on rather than doing substantive analysis. Our favored narratives become increasingly more difficult to falsify, even (especially!) when presented with contradicting fact.”

Josh Brown’s recent description of Third Avenue’s Focused Credit fund as a, “junk bond portfolio on steroids”, immediately made me think of baseball’s Steroid Era. I think a lot of the fund’s investors fell for some type of narrative as well: “Bonds are always safe investments” or “I need a higher yield to live on” come to mind here.

It’s pretty obvious at this point that the Third Avenue Focused Credit fund wasn’t your every day junk bond fund. When a fund is yielding 11.3% while investment grade corporate bonds are yielding 3.43%, long term treasuries are yielding 2.62%, and other high yield bond funds are yielding 6.32%, something is up.* People just don’t want to believe that yields are as low as they are, so they convince themselves they deserve or must have something better. Jason Zweig recently had this to offer on the subject:

“In short, you can’t get higher income just because you want or need to. There isn’t a safe way to make, say, 6% in a world of 2% bonds.”

Ben Carlson also has some good thoughts on yield:

“Want a higher yield? You’ll likely have to endure periodic losses and more price fluctuations. Want to avoid severe price fluctuations? You’ll likely have to endure a lower yield. Chasing yield after prices have risen is generally a terrible strategy, yet one that investors make on a consistent basis at the wrong point in the cycle.”

Unfortunately, humans have a propensity for loving good stories. If you believe you must have higher yielding investments, they’re out there for you if you’re willing to take more risk. It seems that many investors in Third Ave’s ‘roided out junk bond fund thought it would be “different this time” in terms of the usual risk-reward relationship we’ve grown used to seeing. There is no way to obtain significantly higher returns or yield without increasing the level of volatility in your investments. Despite this often touted rule, we see investors, perhaps aided by unscrupulous advisors or brokers, believe just the opposite quite frequently.

The reach for higher yield in a low interest rate environment has been a story for a while now, and it looks like Third Avenue’s Focused Credit fund is a textbook example of what can happen when you reach for yield. If you want the higher yield, be ready for more risk. Bonds tend to be regarded as a safe investment, but when you reach for yields higher than the market is currently offering, that description becomes less true. Junk bonds are a lot more correlated to the equity markets than higher quality fixed income, and as Josh said, Third Avenue’s fund wasn’t your average junk bond fund.

Kind of like the home run race in 1998, investors in Third Avenue’s Focused Credit fund probably had a clue that an 11.3% yield was fishy. Many decided to ignore that warning sign. If you recognize the risk for volatile events like last week’s to occur, by all means consider distressed junk bond funds. I’m not here to dissuade anybody from a strategy they fully understand. However, don’t fool yourself, or allow yourself to be fooled, into believing that funds with abnormally high yields are safe investments.

*Yields as of 11/30/15 for TFCIX, LQD, TLT, and JNK obtained via Yahoo Finance

MAM 178: Floating Rate Bond Funds – Trading Rate Risk for Credit Risk

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It’s important to remember that eliminating one type of risk almost always results in assuming another when it comes to investing. There are no returns without some degree of risk taking. You’d know that to be true if you were tried out litecoin to bitcoin margin trading: highly lucrative but also highly volatile. Floating rate bond funds are a great example of risk elimination actually being a risk trade.

Floating rate bond funds significantly reduce one of the biggest worries of fixed income investors, interest rate risk. It’s pretty commonly known that when interest rates go up, bond prices go down. Bond rates and prices are negatively correlated. Floating rate bond funds differ from traditional bond funds because their interest rates aren’t fixed. They’re periodically adjusted based on a floating reference point, such as LIBOR or the Fed funds rate plus a built in spread. It’s typical to see these rates adjust to reflect changes every 30-90 days. Since their rates adjust to current yield conditions, their prices are not affected in the same way most bond funds are when rates rise.

A bond fund with little to no interest rate risk? Sounds too good to be true!

Let’s return to the concept of there being no returns without some degree of risk taking. What’s the catch with floating rate bond funds? In return for muted interest rate risk, these funds assume far more credit risk. Credit risk refers to the possibility that the loans making up the bond fund will not be repaid in a timely fashion (or at all).

Floating rate bond funds are notorious for serving as a source of financing for companies with poor credit. Think of smaller or midsize businesses whose credit is not good enough to issue their own bonds. This means that the loans held in floating rate funds are significantly more likely to default than those held in higher quality fixed income products. In fact, returns on floating rate funds are most highly correlated to high yield (junk) bonds.

If you’re relying on a bond allocation to lower your portfolio’s overall volatility, you may want to think twice about investing in floating rate bond funds. When credit spreads widen, these funds are at a higher default risk. This is likely to be poor timing for your bond investments to become riskier. According to Morningstar, in 2008 the average bank-loan fund lost 30% while the average intermediate term bond fund lost 4.7%. This all occurred while the S&P 500 index dropped by over 40%. If your reason for owning bonds is to diversify and have a lower overall portfolio volatility, floating rate bond funds failed pretty miserably at providing that in the last real crisis we saw.

Many investors have misused these funds in the last few years as a way to express their prediction on the direction of interest rates. Just look back to the 12 months preceding June 30, 2013 for an example: Assets in floating rate bond funds increased by more than 70% seeing inflows of $45 billion. Those numbers include the infamous taper tantrum. We’re still waiting on the great rising rate environment, and I’m not smart enough to predict when we’ll see it. If somebody knows exactly when and by how much rates will rise…by all means, take advantage and pile into floating rate bond funds for their decreased interest rate risk. Just make sure to know when rates will stop rising too so you can time you exit from them.

Investors would do well to remember that they’re always trading one type of risk for another when it comes to investing. In the case of floating rate bond funds, the trade is accepting higher credit risk for lower interest rate risk.

Sources:

https://pressroom.vanguard.com/content/nonindexed/9.2013_Floating_rate_bond_funds.pdf

http://www.wsj.com/articles/SB10001424052702303948104579535611564175746

http://www.wsj.com/articles/SB10001424052702303393804579308490476037048

The 1950’s Bond Market May Be A Template For Today

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From this awesome article on A Wealth Of Common Sense, all we need is Potsie and Fonzie!  The article draws some GREAT parallels to the current bond market and interest rate scenario we are staring down in 2015.

A line that had specific importance to us was:

“When risk strikes and stocks get hit, investors will almost certainly switch to the ‘perceived safety’ of high quality bonds.”

Bond investors are often fearful of another 1970’s type market, but with differing interest rate levels, and inflation rates, using the blueprint from the 1950’s could potentially be a much more useful tactic.  In the 1950’s, with low inflation, and slowly raising rates, bond investors did not get killed in the market.  This could be a good sign for bond investors in today’s market.  Happy days!

 

Source: 

http://awealthofcommonsense.com/the-blueprint-for-a-bond-bear-market/

Equity Risk Premium: No Free Lunch Principle

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With all the recent volatility in the market, it’s provided a good opportunity to remind people what risk premium is all about. Owning equity (stocks) inherently means you’re taking on more risk in return for the possibility of a larger reward. This is something a lot of investors forget. Josh Brown of The Reformed Broker recently had a great post about why stock investors get paid where he wrote:

“Bond investors, the lenders in this example, only ever get principal back and their interest payments – and over long stretches of time their after-tax, after-inflation profits from this activity are nowhere near what they could be had they owned equity.

Owners (equity investors) on the other hand, have a share in the future productivity of the enterprise – a much greater potential payout over time than bond interest and the return of their original capital – but they endure greater risk in order to earn this (the No Free Lunch principle).”

I enjoy Josh’s simple style of writing. He puts it into terms that are clear and understandable. My favorite part from the quote above is the “No Free Lunch principle”. Wouldn’t it be great it investors could earn higher returns without taking on more risk? Alas, you cannot have one without the other.

In the midst of a week like we’re currently experiencing, it’s a good opportunity to remind equity investors why they get paid a risk premium over bond investors.

Source:

http://thereformedbroker.com/2014/10/16/why-stock-investors-get-paid/