In my previous post I made the point that one should carefully consider any advice that suggests a particular market is about to move strongly in any direction, no matter the source. The underlying impetus for the post was an article on certain “geniuses” saying the sky was about to fall on Treasuries. While I think I made my point about market timing and geniuses, I avoided offering any opinion on Treasuries themselves. Nor did I offer any advice about how one might want to position their fixed income portfolios in this relatively bleak bond environment. Let me offer a few thoughts on those issues now.
First, let me start with how I think about fixed income investing in general. For most investors looking to grow their portfolios, bonds are there to offset the risk one takes in equities and to offer a little income along the way. They are not there for growth, as that is the job of the allocation to equities. Very simply, these investors should seek bond investments with three main attributes: (1) low risk, (2) a solid likelihood of beating inflation over a reasonable time period, and (3) low correlation to stocks, most specifically during difficult periods in the equity markets. Following this line of thinking, most fixed income sectors are off-limits because most areas of fixed income involve far too much risk and not enough equity-diversification benefit to be useful. Basically, we’re left with Treasuries and municipal bonds. So with Treasuries at their current levels, do we remove that option, too?
I do actually agree that long-term Treasuries are at extremely lofty levels, and that is very apparent when you look at today’s yields relative to history. There are numerous arguments that go far beyond looking at historical yields to support the view that Treasuries will come down dramatically at some point, but the trouble is always in figuring out when. This poses a dilemma for portfolio construction when we are already facing limited options for fixed income.
Luckily, however, there is an offsetting issue with the municipal bond market. Everyone is extremely worried about state and municipal budgets, leading to an underappreciated muni bond market. Just as one can make a clear case that Treasuries are overvalued, one can also make a case that municipal bonds are undervalued if you believe, as I do, that the fears of rapidly rising default rates are overblown. I am not saying that state budgets are remotely healthy or that municipalities are properly funded, what I am saying is that even with all the problems states are facing, they are highly unlikely to let their bonds go into default except in the most dire of circumstances, and those instances will be far less numerous than investors currently believe. A well-diversified portfolio of top-rated municipal bonds will offer adequate protection from the defaults the national market will eventually realize, all while giving investors a better pre- and post-tax return than Treasuries. When the Treasury bubble eventually bursts and people feel more comfortable with the muni market, it will be time to reevaluate our positioning in each of these sectors and it will likely be time to reorient fixed income portfolios along more traditional lines (Treasures in tax-free or tax-deferred accounts and municipal bonds in taxable accounts). And, in the case I am wrong, the risk to one’s portfolio of a muni-centric bond positioning is still fairly low since I do not believe that either market will implode on investors as long as one stays at the near-end of the yield curve, meaning short and intermediate durations.
What I must offer strong caution against in today’s environment is the temptation to “reach for yield.” People who are used to getting 4-5% from their bonds simply have to accept that it isn’t possible in today’s environment without taking on a rather extreme amount of additional risk. Once you begin to take on those additional risks in your bond portfolio (going out further on the yield curve, dipping into lower quality issues, buying exotic bond offerings, etc.), it ceases to do the job for which it is designed and you end up putting your overall portfolio at risk.