The Continuing Fat Pitch: Non-Traditional Bonds

Over the long term, we believe fundamentals and valuations converge. Our approach to portfolio construction is to set a strategic allocation we believe is appropriate for a client based on their risk profile and then tactically deviate from it when our research convinces us that a compelling opportunity, or “fat pitch,” exists. Through AdvisorIntelligence, Litman Gregory shares its proprietary asset class research and real-time portfolio guidance with fellow advisors. Learn how AdvisorIntelligence can help you build resilient portfolios for the long term: In the piece below, we walk through our current fixed-income allocations and what led us to seek out non-traditional bond strategies.

The Continuing Fat Pitch: Non-Traditional Bonds

While we like the protection that traditional bonds provide, their yields have been paltry for years, and our return expectations for the asset class have been in the low single digits under a wide range of economic and interest rate scenarios. Our analysis also indicated that if interest rates were to rise sharply, traditional bonds would be susceptible to potentially large short-term downside. So in the years following the financial crisis, we moved a significant portion of our fixed-income exposure into flexible bond funds and then later added an allocation to floating-rate loans:

• The flexible bond funds we selected are distinctive, actively managed strategies with a history of success, run by experienced portfolio managers. Generally, they have unconstrained mandates and possess the flexibility to take on higher credit risk, invest in floating-rate versus fixed-rate securities, or even hold cash if opportunities are scarce.
• The actively managed floating-rate loan funds we own should generate returns that are comparable to the passive leveraged loan options over a cycle, despite being more conservatively positioned. Floating-rate loans are attractive to us because of their higher yields compared to traditional bonds and their structural advantages over high-yield bonds: their seniority in the capital structure leads to lower defaults and higher recovery rates, and their coupons adjust upward with rising rates, resulting in next to no interest rate risk.

The motivation behind this move away from traditional bonds was to lower our risk to rising interest rates, while also increasing returns in most scenarios. The tradeoff is that we took on increased credit risk. But by combining traditional bonds with more credit-oriented strategies—each exposed to a different uncorrelated primary risk—we believe we have built a balanced fixed-income allocation. Our positive view of the prospective performance of our bond portfolios is reinforced by the fact that they have an overall higher yield and lower duration than our benchmark (the Vanguard Total Bond Market Index).

Let’s look at the results. Since we initiated our move away from traditional bonds in December 2008, our fixed-income portfolios have far and away outperformed the traditional bond market index fund, with nearly identical volatility. Clearly, “safer” traditional bonds are not without risk, they are simply exposed to different risks, namely interest rate risk. The last two years are very illustrative. Credit-oriented bonds fell at the start of 2016 along with equity indexes, but the impact on our portfolios was muted. Later in the fall of that year, traditional bonds suffered a drawdown of their own on expectations of a pro-growth Trump presidency during which our non-traditional bond holdings protected the portfolios.

From the table of metrics below, one can see that the increased credit risk resulted in a higher correlation to equities. We were willing to accept this in exchange for higher long-term returns and less interest rate sensitivity; Litman Gregory’s bond allocation had a correlation to U.S. stocks of about 0.55 in the period, versus traditional bonds’ slightly negative correlation. We’d point out, though, that correlation only tells you about the direction of returns, not the magnitude of returns. In fact, the sensitivity of our bond portfolio to the equity market over the past two-plus years has been less than 0.15, implying that if relationships hold, the downside of our bond portfolios in the event of an equity/credit selloff would be a fraction of what stocks would experience. In addition, we have high conviction in our active managers’ bottom-up security selection. We continue to believe the added credit risk of our non-traditional holdings is more than offset by the protection they provide against the prospect of rising interest rates.

We want to specifically highlight the maximum drawdown of our bond allocation over this time, because we believe that metric approximates how many clients “feel” risk. This period encompassed market dislocations related to rising rates and to declines in risk assets—our portfolios held up well through each. The max drawdown of our bond allocation was much lower than the benchmark’s, despite the higher equity correlation and beta. This lower drawdown was not surprising to us; it was the intentional goal of our portfolio construction. Our exposure to non-traditional bonds protected the portfolio against declines in traditional bonds, and vice versa, leading to a superior Sharpe ratio, a measure of risk-adjusted return.

The insight to execute this portfolio decision derived from the intersection of Litman Gregory’s asset class analysis and fund research capabilities. Our work on expected returns—both long-term returns and 12-month downside—and the various stress tests we run identified the risk of rising rates, while our due diligence experience in selecting successful funds allowed us to take advantage of the opportunity presented by more flexible strategies and floating-rate loans.

The AdvisorIntelligence service is more than just access to real-time portfolio guidance. We continue to support advisors over the duration of a fat pitch by supplying regular research updates and client communications that lay out our continuing opinion and talking points to use in their practice. We also host monthly and quarterly webinars where we solicit questions from advisors, and our research consultants are available to walk through our views with subscribers in more detail.

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