1. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Bloomberg.
Thought for the Week (279):
Is The DIAS Conservative Income Portfolio Still Conservative?
Synopsis
The gradual shift towards higher equity exposure in the DIAS Conservative Income (CI) portfolio has prompted many investors to ask if it is still a conservative portfolio.
The historical methods for income generation no longer work, particularly in the face of zero interest rates and looming inflation, and we have made changes to keep CI conservative.
Given recent insight into Fed policy, a return to normalized rates seems even further out than what we had anticipated, and attractive risk-adjusted income will continue to require active management.
How Conservative is CI?
The chart below shows the asset allocation for the DIAS Conservative Income (CI) portfolio as of November 21, 2013. The composition has changed quite dramatically since 2010, back when it was purely a fixed income portfolio.
Equities typically carry more volatility in the short-term, and historically stocks were used for capital appreciation rather than preservation. Therefore, one may infer that CI is no longer conservative given the material rise in equity allocation.
However, we still believe that CI is conservative for three key reasons, which are detailed below:
1. The risk paradigm has changed
2. Liquidity is high
3. High quality at a low price
2. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Bloomberg.
The Risk Paradigm Has Changed
Over the last thirty years, most investors would have considered a bond portfolio consisting of investment grade securities and government bonds to be conservative. Given the continual strong returns from bonds along with capital preservation, investors were certain that they would earn good income and get their principal back.
However, times are changing and the Fed’s policy of zero interest rates has taken what was once considered to be conservative and turned it into a much riskier proposition.
Interest rate risk is looming and principal values of bonds will fall as interest rates begin to rise. Therefore, we have lowered our fixed income allocation in CI and shifted to bond sectors with low interest rate sensitivity - short maturity, high quality, high yield, and bank loans with floating rates.
Now one may argue that an investor can avoid interest rate risk on a portfolio of high quality bonds by simply holding to maturity. While this is more than likely true, the problem that remains then is inflation risk. Locking up principal for 10 – 20 years will leave an investment susceptible to the dangers of rising consumer prices.
Therefore, we do not consider this hypothetical portfolio to be as conservative as it once was, and we have adjusted CI’s fixed income allocation to play defense in the face of rising interest rates and inflation in order to maintain a conservative approach.
Since we see heightened risk in owning bonds, some investors have asked us why we hold any bonds at all in CI. There are two key reasons for keeping bonds in the portfolio:
1. Diversification: CI is a highly diversified portfolio, and the benefits of diversification warrant a percentage in fixed income at all times in order to reduce overall portfolio risk.
2. Income Generation: Although the safe places in the bond market produce less than stellar income, they still deliver steady returns and act as a dampening effect for portfolio volatility.
Despite our preference for the safest sectors within fixed income, CI is still exposed to interest rate risk. Therefore, we have chosen to hedge some of this risk using an exchange-traded fund (ETF) called TBT. This fund is designed to profit from weakness in Treasury bonds. Since rising interest rates reduces the principal and not the income, we can continue to collect the yield while lowering principal risk.
NOTE: A rise in interest rates will cause the price of the Treasuries to fall because holders of these Treasuries will sell them in order to buy the new bonds with the higher interest rate. As the price of Treasuries falls, the TBT fund should rise because it profits when Treasury prices fall, and it should then offset losses in principal.
Simply put, the notion of conservative has changed, therefore, forcing investors to endure short-term volatility in equities to avoid near certain losses in many sectors within the fixed income market.
Liquidity is High
A conservative portfolio must adhere to strict risk management, and a vital component to overall risk is the asset’s “liquidity”, or how easy it is to buy and sell the asset. To ensure proper risk controls in CI, we maintain a very high level of liquidity at all times.
3. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Bloomberg.
Let’s walk through an example to see what can happen to the value of an illiquid asset when things go bad. Back in 2007, several Americans had just spent four years watching the value of their homes skyrocket until the financial crisis reared its ugly head.
Housing is an illiquid asset, meaning that there may not always be a buyer to match every seller, and we witnessed this situation play out when the housing bubble burst – the market was flooded with sellers but little to no buyers.
Equities in the U.S. are some of the most liquid financial assets in the world because stocks are traded throughout the day, so at any given point there is a buyer. Stock exchanges like the New York Stock Exchange (NYSE) and NASDAQ facilitate liquidity by ensuring that there is always a buyer and seller for every stock.
Additionally, the larger the market cap of the company, the more shares available to trade and the more volume of trading activity means the easier it is to buy and sell the stock. Hence, that stock is more liquid.
The equity allocation within CI is comprised of highly liquid stocks that allow us to exit quickly if we feel that bad news is on the horizon. Now, we could find far more attractive income in smaller or less liquid stocks, but then we would run the risk of facing large losses if we had to get out quickly and sell more stock than the market is used to seeing. In essence, we are trading off potentially higher return in order to maintain less risk.
Bonds, on the other hand, are far less liquid than stocks because there is no major exchange for bonds. Most of the trading is conducted by matching a buyer and a seller together through major brokers like Goldman Sachs and Morgan Stanley. To make matters worse, recent regulation has made bond trading more difficult for these firms, which in turn, makes liquidity more of an issue for individual bondholders.
Since exchanges promote liquidity, we use ETFs that hold several hundred bonds for the fixed income allocation in CI. At any time, we can sell these ETFs if we feel that they no longer belong in the portfolio.
Simply put, we strictly monitor the liquidity of CI, and we only own securities that we feel can be exited smoothly if we deem necessary. High liquidity reduces overall risk.
High Quality at a Low Price
Finding income in equities is actually quite easy these days. Any investor can screen for stocks with a dividend yield higher than 10% and be presented with a myriad of investment options. However, most of these stocks would introduce far too much risk into CI.
High dividend yields are often a major red flag for two reasons:
1. Stock Price is Down: Dividend yields act like current yields for bonds in the sense that they are inversely related to their price, so if the price of a stock falls then the dividend yield rises. Often times a company paying a high yield is doing so because of a material decline in stock price.
2. Dividend is Unsustainable: Companies that pay a high yield run the risk of a dividend cut if their business were to suffer for an extended period of time. For example, if an energy company that paid a high dividend yield faced a period of low oil prices, they may be forced to cut their payout, which would result in significant downward pressure on the stock.
Companies that pay attractive dividends must be thoroughly inspected, particularly around cash flow generation, dividend payment history, and balance sheet strength. Stocks are only included in CI when
4. This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion or our investment managers
at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no
indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private
Capital is an SEC Registered Investment Adviser. All charts courtesy of Bloomberg.
they pass our rigid set of controls to ensure that the company’s financials and competitive positioning within their industry are top tier.
Furthermore, we only consider stocks that are trading at attractive valuations, and we will sell those holdings that become too expensive to own. For example, we sold many of our consumer staples holdings over the year because we felt that the sales and earnings growth did not warrant such lofty valuations.
Simply put, we only include those stocks that bring CI an attractive “risk-adjusted” yield, or the highest yield possible without sacrificing quality and/or valuation.
Income Generation Will Get Tougher
Recent insight into Fed policy points to an even longer period of low interest rates than we had anticipated. Janet Yellen has already implied that she has no intention of changing policy anytime soon, and there are many within the Fed that are now publicly stating that they would like to see the unemployment rate reach 5.5%, instead of their current target of 6.5%, before they begin raising rates.
The net result of such commentary is that finding income is going to get harder, and we will not likely see a return to normalized interest rates (approximately 4.5 - 5%) for several years.
The bottom line is that now more than ever has active management been critical to income seeking investors. Income is out there, but finding it in a conservative manner requires skill and patience (this explains our high cash balance as we wait for opportunity rather than chase performance).
The asset allocation within CI has changed dramatically over the last three years in order to respond to the changing investment environment. However, what hasn’t changed is our strategy – preserve capital as best as possible over the long-run, and only after that goal is achieved are we to attempt to deliver 4% to 6% income annually.
