I am a “bond guy” from way back. I managed investments for insurance companies for about 30 years and most of my time was spent making sure that the risk/return profiles of the bond portfolios that we held were consistent with the needs of the liabilities that they were backing. This experience transfers nicely to helping me manage bond exposures for D&A clients.
I have written a lot of blog posts recently on bond characteristics and portfolio allocations. Back on June 8, I wrote a blog post titled “Smooth or Bumpy” highlighting the relative graphical path of the performance characteristics of short versus long corporate bonds. Following is a summary of the specific traits and market dynamics that are causing this relationship, an update on how they have performed since then, and a review of how this translates into specific investment management for D&A clients.
Since I made that blog post, the paths have continued to exhibit those smooth or bumpy traits mostly defined by their underlying fixed income characteristics. As I wrote back on April 24 in “Strategic Bond Math Explained”, bond returns are mostly a function of the effective duration of the bond portfolio and their inverse relationship to changes in interest rates.
In this case, both iShares Investment Grade Corporate Bond (LQD) and iShares 0-5 Year Investment Grade Corporate Bond (SLQD) hold true to their risk profiles. The LQD duration of 8.71 years is almost four times as high as SLQD at 2.34 years making its total return performance four times as sensitive to changes in interest rates. From the chart below, one can easily observe that LQD (the bumpy blue line) is more volatile than SLQD (the “smoothish” green line) with the paths closely following changes in interest rates over the time horizon.
So, the obvious question is, “How does this translate into investment strategy for a client portfolio?” Bond exposure is usually added to a diversified investment portfolio to smooth returns over a time horizon to help an investor achieve their investment goals. Most importantly, it is expected that bonds will exhibit a low or negative correlation to stocks when stock returns turn down (except, not this year!) thus reducing downside risk. Of course, investors who have a high tolerance for risk and a long time horizon (such as young professionals with high earning potential) do not necessarily need any bond exposure at all!
At D&A, we strive to understand our client’s risk profile and time horizon so that their bond allocations are appropriate to help them achieve the goals. In this case, due to the extreme risk differential between LQD and SLQD, all D&A clients with a bond allocation have a mix of both LQD and SLQD to help smooth their risk exposure.