The Bomb Shelter Portfolio: Maximum Income with the Least Risk

Conservative investors are faced with unappealing choices. They can reduce risk and accept low yields and high exposure to rising rates, or they can push the bounds of their risk tolerance to increase yield. My analysis shows a way out of this predicament: a “bomb shelter” portfolio of exchange-traded funds (ETFs), which offers attractive yield with minimal volatility and exposure to rising rates.

Equities are not cheap after a 25% gain in the last 12 months. A viable alternative for conservative, yield-seeking investors lies in asset allocations that are outside of the norm.

Conservative investors have three critical requirements. Total portfolio risk must be low. The portfolio should generate a reasonable level of income so that investors are not forced to sell a disproportionate fraction of their assets into a declining market to maintain necessary cash flow. And the portfolio needs to minimize exposure to rising interest rates.

These three objectives compete with one another. To increase bond yield, one must accept either higher interest rate risk or default risk. To increase dividend yield, one must accept higher market risk (beta). To increase correlation between return and rising interest rates, market risk will be greater.

The solution that I outline here is a low-risk all-ETF implementation of the methodology that I used to develop my ultimate income portfolio. The motivation for this article came from an advisor who read my previous article and asked whether the approach could be used to develop portfolios that could achieve the three objectives mentioned above.

In this article, I determine the maximum available yields and expected total returns for portfolios with risk levels (volatilities, as measured by standard deviation) between 33% and 45% of the S&P 500, which equates to between 64% and 89% of the risk level of an investment-grade corporate bond index (LQD). At these low-risk thresholds, the balance among income, interest-rate exposure and total risk is even more challenging.

Asset classes

I started by examining the range of yields and risk levels available from individual asset classes, along with their sensitivities to 10-year Treasury bond yields. The asset classes I considered are in the table below.

Most bonds have relatively low volatility, and their returns have strongly negative correlations to changes in Treasury bond yields. The exceptions are high-yield corporate bonds (HYG), which fall into the middle range of risk levels and have a modest positive correlation to Treasury bond yield. For my target risk range — between 33% and 45% of the risk of the S&P 500 — investment-grade corporate bonds (LQD) are the optimal asset class. Their yield is 3.9%, but they have a substantially negative correlation to Treasury bond yields (-52%).

Table 1: Asset class characteristics

Asset class characteristics

I included two preferred share ETFs because they exhibit different correlations to Treasury bond yields from one another, as well as different risk levels and yields.

Higher yield is obtained by assuming higher risk, and asset classes with moderate risk and meaningful yield provide poor returns in a rising-rate environment (evidenced by a negative correlation to 10-year Treasury bond yield). This is the core of our challenge in designing a portfolio that meets the stated criteria. I have calculated the correlations between these key variables across all of the asset classes above.

Equities have the highest positive response to rising bond yields because corporations can boost earnings by raising prices in higher-rate environments, which tend also to be those periods with rising inflation. Across all of these asset classes, there is a 62% correlation between yield and correlation to 10-year Treasury bond yield. Higher-yield assets in this group tend to response more positively to a rise in interest rates than lower-yield assets do.