Do you remember the scene from It’s A Wonderful Life—only the best holiday movie ever—when George and Mary Bailey are cruising out of Bedford Falls on their well-earned honeymoon, only to notice a literal run on the banks (including the Bailey Savings and Loan, which George reluctantly operates)?
Well, as Mark Twain is attributed as having said, “History doesn’t repeat itself, but it does rhyme.” We saw, for example, a run on virtual cash in 2008 when the very first money market fund “broke the buck.” And while you might not have noticed it yet, because it just reached front-page status yesterday, there appears to be a liquidity crisis of smaller proportions playing out right now in the high-yield “junk” bond market.
It is not my aim to spread fear, but rather to spread knowledge in the hope that being informed about what is really happening in the bond markets will ultimately reduce your anxiety. As a friend recently reminded me, “Forewarned is forearmed.”
What happened?
Multiple hedge funds and mutual funds have shocked investors by limiting, or even eliminating, their ability to take withdrawals from their funds. Here are three good articles to bring you up to speed. (Please note that The Wall Street Journal articles may require a log-in to read the entire piece.):
Why did this happen?
You need not look further than the fictional Bailey Savings and Loan crisis to imagine what happened. People lost confidence in their ability to retrieve their investment—in this present case, in junk bonds—and asked for their money back. As more people got scared, the pace at which junk bonds were being sold started moving the price of those securities lower, faster. This created a cycle of fear between investors and fund managers that resulted in those managers halting liquidations. And in this case, unfortunately, the silver-tongued George Bailey wasn’t there to talk everyone off of the ledge.
What could happen now?
Over the weekend, my colleague, The BAM Alliance’s Director of Research, Larry Swedroe, said, “This could lead to the proverbial ‘run on the bank’ as any investors holding less liquid assets, like junk bonds, high-yield bonds, etc., could decide discretion is the better part of valor and all try to get out at the same time.”
That being said, hunkering down for another financial crisis certainly seems premature. Jared Kizer, the firm’s Chief Investment Officer, added, “We don’t see much spillover yet [into the broader markets and economy] because of the size of the high-yield market compared to the private mortgage-backed securities market in 2008, and it’s not apparent that there’s anywhere near the level of leverage in play now as compared to 2008.”
Could this contagion spread beyond the junk bond market?
Yes, Kizer suggests that the liquidity crisis in junk bonds could spread to corporate bonds. And Swedroe does add that because the energy sector is the high-yield market’s biggest buyer—and energy prices continue their precipitous drop—we could see: 1) below-estimate earnings for some big S&P 500 companies, 2) emerging market ripples, especially in resource-rich countries like Russia and Venezuela, 3) all credit spreads widening, and 4) margin calls in the leveraged loan market.
The confluence of all these factors, none of them good, could lead to a flight to securities that are deemed higher quality—like U.S. Treasuries. If the fear gets intense enough, it could even lead to the Fed forestalling its well-publicized plans to raise interest rates.
What should you do?
If, and only if, you have allocations to high-yield bonds, you may want to consider alternative arrangements. Situations like these are precisely why you might consider investing only in the highest quality bonds and staying away from junk bonds and even corporate bonds. These asset classes are regularly subjected to higher levels of risk without a satisfactorily proportionate opportunity for reward.
We all know that stocks are volatile—a fact proven nearly every year (including this one)—but we endure this volatility because the evidence shows that we can expect a higher rate of return (over time) in exchange for occasionally unsettled stomachs.
We invest in the stock market to make money, but we invest in bonds to stabilize portfolios and help us stay invested in stocks during those inevitable volatile times. Consider risking abject boredom in your fixed income allocations, precisely to avoid instances like these when seemingly safe bonds (and the funds that hold them) go rogue.
It is certainly possible that this somewhat isolated crisis will remain that way, although it seems to have already spooked the broader market a bit. But I don’t believe that a wise course of action is to try to time the market (guessing if and when the market will decline, and then subsequently attempting to determine its next rise).
I appreciated the honesty of Thomas Lapointe, lead portfolio manager of the recently halted Third Avenue’s Focused Credit junk bond fund, when he confessed that “the magnitude and scope of managing this fund over the past year has been a humbling experience.” Unfortunately, Lapointe is learning the hard way a lesson that virtually all investors are destined to experience—that we must be smart enough to know we can’t outsmart the market.
This commentary originally appeared December 15 on Forbes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE
It’s been said that diversification is the only free lunch in investing because, done properly, an investor can reduce risk without reducing their expected return. Yet despite this wisdom, many individuals hold concentrated positions in a single stock when they could easily diversify away that idiosyncratic, single-company risk. Which, then, begs a critical question: given the proven benefits of diversification, why do so many investors hold portfolios with heavily concentrated positions?
Over the next few weeks, we’ll provide some answers and insights to this question, as well as show why holding such positions is almost always imprudent speculation, unless you have a very high marginal utility of wealth, and are fully prepared to accept the possibility, if not likelihood, of a highly negative outcome.
While we’ll focus on the issue of concentrated positions in individual stocks, the very same issues apply to mutual funds. For example, while investors can own a total stock market fund, such as Vanguard’s Total Stock Market Fund (VTSMX), many will invest in funds that own as few as 20 or 30 stocks, such as the Ariel Focus Fund (ARFFX). The issue of failing to diversify extends to mutual fund investors who fail to diversify geographically and limit their holdings to domestic mutual funds, or maintain only a small allocation to international stocks. And the same issue of failing to efficiently diversify also extends to those who invest in sector mutual funds.
We’ll begin by discussing the concept of compensated vs. uncompensated risks.
Compensated vs. Uncompensated Risks
In investing, it’s important to distinguish between two different types of risk: good risk and bad risk. Good risk is the type you are compensated for taking. Investors get compensated for taking systematic risks, or risks that cannot be diversified away. The compensation comes in the form of greater expected returns (not guaranteed returns, or there would be no risk). Bad risk is the type for which there is no compensation. Thus, it’s called uncompensated, or unsystematic, risk.
Equity investors face several types of risk, which is true of any risky asset, be it a stock or bond. First, there is the idiosyncratic risk of investing in stocks. This risk cannot be diversified away, no matter how many stocks, sector funds, or different asset classes you own. That’s why the market provides an equity risk premium.
Second, various asset classes carry different risk levels. Large-cap stocks are less risky than small-cap stocks and glamour (growth) stocks are less risky than distressed (value) stocks, at least in terms of classical economic theory. These two risks, size and value, also cannot be diversified away. Thus, investors must be compensated for taking them. This is the reason that the small stock and value stock premiums exist.
Another type of equity risk is the risk associated with an individual company. The risks of individual stock ownership can easily be diversified away by owning a passive asset class or index fund that basically contains all the stocks in an entire asset class or index. Asset class risk can be addressed by the building of a globally diversified portfolio, allocating funds across various asset classes (domestic and international, large and small, value and growth, and even real estate and emerging markets).
Because the risk of single-stock ownership can be diversified away, the market doesn’t compensate investors for assuming this type of (unsystematic) risk. And because the risk can be diversified away without lowering expected returns, why so many investors hold concentrated portfolios remains a puzzle.
So Why Does This Happen?
I will provide several behavioral explanations for this phenomenon, as well as the reason for why the behavior is a mistake that can prove very costly. Among the behavioral errors that lead to concentrated positions are:
Another cause for the failure to diversify is one we can call “rearview mirror investing.” The study Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock found that strong past performance of an employer’s stock leads to overconfidence with respect to its future performance. Past performance was simply extrapolated into the future. However, great past performance usually results in high valuations. Thus, not surprisingly, participants who over-weighted their employer’s stock based on past performance earned below average returns.
The Bottom Line
That’s what happens when you fail to consider the price you pay for an equity investment relative to its expected returns. Great past returns typically lead to high valuations (high price-to-earnings, or P/E, ratios) which forecast low future returns.
Next week, we’ll continue our discussion about the perils of concentrated positions with a look at yet another cause for failing to diversify. It relates to what is often called the “endowment effect,” where an individual values something they already own more than something they don’t own yet.
This commentary originally appeared November 25 on MutualFunds.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE
With the recent spate of positive economic news, highlighted by the strong jobs numbers for both October and November, all signs point toward the Federal Reserve raising the federal funds target rate 25 basis points from 0–0.25 percent to 0.25–0.50 percent. Based on federal funds futures, the market is assigning a roughly 76 percent probability of a federal funds increase. Given that this would be the first interest rate hike by the Federal Reserve since 2006, many clients are beginning to ask, “Should we stay short and wait for the Fed to raise interest rates before investing?”
Investors need to remember that fixed income markets, just like equity markets, incorporate all known information into bond prices. If investors know the Fed is highly likely to raise the federal funds target rate at its December 16 meeting, then that information should already be priced into the market today. To see this at work, take a look at the federal funds futures market as well as the yield on the 2-year U.S. Treasury bond. At its meeting on October 28, the Federal Open Market Committee opened the door for a possible December rate hike with the following statement: “In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress — both realized and expected — toward its objectives of maximum employment and 2 percent inflation.” Before this announcement, federal funds futures were predicting a 35 percent chance of an interest rate move in December while the 2-year Treasury rate sat at 0.65 percent. After the announcement, federal funds futures jumped to a 57 percent probability of an interest rate move while the 2-year Treasury yield increased eight basis points to 0.73 percent. As you can see, the market was able to digest this information and price it in rapid succession.
Now that we know a likely rate hike has already been priced into the market, we can answer the question of whether we should stay short and wait for interest rates to rise. The answer is a resounding no. Because this information has already been priced into the market, the only way an investor could profit by staying short is to know that interest rates will either rise faster or higher than the market is currently anticipating.
To illustrate this concept, look at forward interest rates. Let’s say a 1-year Treasury currently yields
0.57 percent while a 2-year Treasury yields 0.94 percent. If you were to invest in both securities and hold them for one year, you would have to reinvest the money in the 1-year Treasury at a yield of 1.30 percent just to break even with the original 2-year Treasury. The market is telling investors that it anticipates the
1-year Treasury to yield 1.30 percent one year from now. Again, the only way it’s profitable for investors to stay short or to wait is if they know the 1-year Treasury yield will be higher than 1.30 percent next year.
Academic evidence shows that no manager can persistently time the fixed income markets. We continue to recommend constructing a high-quality fixed income ladder that will protect client assets in both a rising and falling interest rate environment.
Copyright © 2015, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.