Portfolio Management Overview:
Bonds have long been considered an essential part of well-balanced portfolios. A favorite of high-net-worth clients, they have a history of providing semi-annual coupon payments while dependably returning principal at maturity. In addition to the coupon income, bond investors have benefited from substantially lower overall portfolio volatility because bonds have far less price action and react differently than stocks to market events. As a result, returns of balanced portfolios often perform as well as stock-only portfolios with substantially less volatility over an entire market cycle.
Not long ago, investors bought high-grade bonds with substantial yields that provided earnings on which most retirees could live. Unfortunately, high-grade bond yields alone no longer provide sufficient income for most retires. Over the past several years bond yields have fallen to levels few thought possible, and these low levels remain with us today. Therefore, high-net-worth bond portfolios are now employed more as a way to dampen the price risk inherent in the overall portfolio and less as an income generator. This is an important investment management change because it pressures the stock portion of a portfolio to provide higher and more consistent dividend income and yet still grow enough to sustain retirement spending.
At Clearview, risk management is the key to our investor’s success. At a time when market volatility is low and investors have grown complacent, risk management takes on added importance. The trend toward lower volatility in markets is likely to reverse at some point and this could be damaging to those portfolios holding long maturity, illiquid, or poor quality bonds.
Exercising due diligence on bonds is very important to us. As it can be difficult to fully understand the risks inherent in bond issuers (especially municipal bonds) we buy and hold only higher quality bonds.
At Clearview, managing bond risk effectively is central to our success and includes:
Objective I: We strive to capture representative yields while limiting the potential for significant price declines across the bond portfolios. We use only short and intermediate term bonds. Our disciplined management process employs both active and passive management including:
Tranche I: 1-3 year – Active short maturity bond holdings
Tranche 2: 3-10 year – Core “buy and hold” bond portfolio
Tranche 3: 10-15 year – Active “opportunistic” bond holdings
Interest Rate Movement Risks
Interest rate risk is defined as the risk of significant and thus damaging interest rate changes in the market (usually higher rates). At Clearview we employ several models to anticipate rate change; however, we do not try to time the market with purchases or sales.
Time to maturity risk is greatest among longer maturity bonds as they experience greater price movement for a given change in interest rates. In order to avoid substantial maturity risk, we do not buy long dated bonds and always seek to align the portfolio’s maturities to client risk tolerance and income needs.
Reinvestment risk is the risk of interest rate change (typically lower rates) that negatively impacts a client’s future portfolio income. While we cannot avoid reinvestment risk with bond purchases, we seek to limit the damage through laddering the portfolio.
Income Replacement risk is the risk of purchasing securities that provide higher levels of income but do not typically act like bonds when markets are stressed, such as structured finance, REITs, MLPs, high yield bonds, alternative investments and bank loans, are avoided because they are not bonds. These investments can be illiquid and may decline in price far more than anticipated in a downturn.
Each client’s portfolio is uniquely designed through “Top Down Market Analysis” including:
- Understanding economic trends as they develop,
- Thoughtful use of yield curve expectations to better position the portfolio,
- Working with the level of real interest rates, and
- Defining current and future expectations of monetary policy.
Objective II: Managing Credit Risk across each bond within the portfolio by purchasing only high quality, “single A” or better credits.
Default risk is the risk that a bond issuer will default on its debt obligation to the bond-holder. We minimize this risk through rigorous credit analysis and by only buying high quality bonds rated “A” or better.
Specific risk is the risk taken through the purchase of one or a few credits. This lack of diversification in the portfolio, especially with the purchase of lesser quality bonds, can be devastating if the specific bond(s) chosen become challenged. Within the constraints of each client’s portfolio we therefore diversify holdings and use only high quality bonds.
Bottom-Up Detailed Bond Analysis
We monitor the credit cycle to better understand where liquidity and credit problems are most likely to develop. We analyze the relative attractiveness of tax-exempt sector as it compares to taxable bonds. Client specific circumstances such as AMT are also examined to provide the best possible after-tax outcome for each client.
Conclusion
At Clearview Wealth Solutions we manage bond portfolio risk through a combination of market analysis, extensive research on specific bonds and a deep understanding of our client’s overall risk tolerance. Risk cannot be eliminated, but it can be managed through thoughtful analysis, risk management and diversification.