Newsletter – 1st qtr 2020, From The Desk of Al Miller


Newsletter – 1st qtr 2020

April, 2020

In the last quarterly letter, I suggested that with interest rates near zero and inflation nowhere in sight, the Federal Reserve might fade into the background. I went on to suggest that fiscal policy would need to lead in setting out pro-growth policies to maintain the long economic expansion. Well, last January seems like ancient history. The Federal Reserve has taken up the role of savior to the economy, standing in the gap to supply whatever liquidity might be needed to keep markets functioning.

Given the massive uncertainty over when and how the economy will restart, rates will likely remain low for the foreseeable future. Historically low rates have been a fixture since the 2008-2009 recession, bouncing between 3.4% and 1.4%. But current rates on the safest bonds have collapsed, falling from 1.5% in January to .6% today. Without a doubt today’s rates are a blessing to all borrowers and a support to the economy whenever it’s restarted.

But ultra-low rates aren’t a panacea. Historically bonds have fulfilled two roles: as a portfolio diversifier and a source of income. Even though mid quality corporate bonds yield around two to three percent better than treasuries, that still presents a real challenge for portfolio income requirements. And at prevailing yields, bonds carry risks that aren’t fully appreciated. To explain, it’s helpful to understand the concept of duration. Though the math is a bit complicated, duration can be described as the weighted average of the cash flows produced by an investment. For a typical bond that means semiannual interest payments and principal repayment at maturity. Duration is usually expressed in years and will be between zero and the years remaining until maturity. For example, a 10-year Treasury bond has a duration of 9.15 years at today’s .6% yield.* If that IO year Treasury had a 3% yield, the duration falls to 8.95 years.* Conversely, a zero coupon bond would have a duration equal to its maturity.

So how is this important? Duration is also used to express a bonds sensitivity to changes in interest rates. In the above example, a 1% change in interest rates would result in the ten year bond value moving 9.15%. If rates fell, the bond gains value but if rates rise, the bond loses 9.15%. Note that the 3% bond is slightly less sensitive, with a price change of 8.95% for a 1% rate change. To generalize, for a given maturity, the lower the yield the higher the duration. Also, the shorter the maturity, the shorter the duration.

To illustrate, the duration on the popular iShares 20-year Treasury exchange traded fund is approximately 18 years. So a half a per cent increase in rates would cause a decline of 9% in the fund. Note the loss far exceeds the current yield of 1.19% for the etf. Though interest rates aren’t expected to increase, a modest half a percent rise wouldn’t be surprising. The message is pretty clear: you are not being adequately compensated to take risks in reaching for yield. Lower quality bonds with their higher interest rates do have lower durations for comparable maturities but lower rated bonds have credit risks, a subject for another day.

The combination of meager yield and duration risk raises real challenges for portfolio asset allocation and portfolio management. Consider VRS’s present allocation strategy. VRS or the Virginia Retirement System, is facing a 6.75% assumed rate of return. (Lowered from 7% in October 2019).** The current allocation includes 15.6% in traditional fixed income with another 14% in “credit strategies.”** Credit strategies include direct lending, convertible bonds and private debt. Given currently available yields, it isn’t too surprising. Allocations to traditional fixed income have been dropping for years. According to Federal Reserve data, pension funds allocated approximately 55% of their funds to fixed income in 1990. By 2000, the allocation had fallen to the low thirties and to 23% by 2019.***

So if you have a 6.75% targeted rate of return, how much can you afford to allocate to traditional fixed income? According to BlackRock, the worlds largest money manager, the mean expected rate of return for the broad domestic bond market over the next ten years is 1.8%. Continuing the VRS example, traditional bonds would be expected to contribute 27 basis points ( 1.8 X .15 ) towards the 6.75% (675 basis points) of the required return. That leaves 85% of the portfolio to seek more competitive returns. If VRS had a more traditional allocation from 2000, bonds would be expected to generate 58 basis points toward the 6.75% target. (1.8 X .32 ). That would leave only 68% of plan assets available for higher potential investments.

Now the VRS has a far longer investment time horizon than any client. It uses this to good advantage, allocating into illiquid private equity and debt, which have higher potential returns. Just for the record, public equity is the largest allocation at 38%. So the question now is, what is James River’s position on fixed income?

As we see it, at current yields you are not being compensated for taking on credit risk by moving down the quality scale or duration risk by extending maturities. We have concentrated our fixed income in investment grade, shorter term issues. We still capture much of the yield of longer dated bonds. And bonds still lower the volatility and risk of stocks within a portfolio.

Alvin H. Miller, Jr.

Footnotes & Disclosures
*As calculated by Bloomberg Terminal **VRS website
***National Bureau of Economic Research, Oct. 2010

James River Asset Management, LLC, is a Registered Investment Adviser. Securities offered through Valmark Securities, Member FINRA and SIPC.130 Springside Drive, Suite 300 Akron, OH 44333 1-800-765-5201. James River Asset Management, LLC is a separate entity from Valmark Securities Inc. Any opinions expressed here are solely those of James River Asset Management, LLC.

The information provided has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the material discussed nor does it constitute an offer or a solicitation of an offer to buy any securities, products or services mentioned. The examples given are hypothetical and are for illustrative purposes. Actual results may vary.


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