In normal times you might own bonds for either of two reasons. You might enjoy the regular income from interest payments, or you might own them for the stability they add to an equity portfolio.
Neither of those reasons carry the usual appeal with today’s ultra-low interest rates. If you’re counting on bonds for income, you are going to need to own a lot more bonds. While bonds add stability, the total return will be reduced when interest rates eventually move to higher, normal levels. Neither reason is particularly compelling these days, although the stability factor is more compelling given stability in a quick equity correction.
The bond market is not uniform. Some parts of the bond market have less exposure to interest rate risk. Additionally, the proliferation of alternative strategies offers investors a wide array of tools for managing risk in today’s macro driven investment climate.
Much has been written about various types of risk, and that is not the focus of this essay. My purpose is to explain an approach to managing equity market risk in the current low-interest rate environment.
Liquidity is important. Let’s take the case of the Brexit induced market decline that began last Friday. Over two days the Dow lost about 900 points as stunned markets went into “sell first, ask questions later” mode. If you believed, as I did, that the world economy was not poised for mass suicide, and that cooler heads would prevail as hysteria faded, you might have been inclined to sell some of those bond positions to buy equities at distressed prices.
If those bond or alternative positions were in mutual funds, the cash would not be available for trading until the next day. Using margin is not a bad strategy, since you can execute a purchase locking the price before the bond fund sale is complete. If you wait until the next day, the price could be higher. It could have gone lower too, but that’s speculation. If you want to control the trade, you want to make timely buy and sell decisions.
Using hedge positions in ETF format eliminates the liquidity problem. Unfortunately, many of the better bond funds and hedge strategies are based on active management, and hence not available in ETF format. There is no perfect solution. If the main objective is performance relative to a benchmark, for a fixed/alternative portfolio component, then the mutual fund liquidity problem can be overcome with judicious use of margin. If the objective is to hedge a richly valued market in a world fraught with macro risk, then bond sector ETF’s can fit the bill.
Then again, in a rich market, cash is an attractive asset class. To paraphrase Charlie Munger, a good way to get rich is to put $5 million in a checking account and wait for a good crisis.