I Thought The Safety Was On

For the past thirty years investors could allocate a portion of their portfolio to investment grade bonds and regard that money as “safe”. Wealth preservation was easy – buy a ladder of Treasuries or triple-A rated corporates and go back to bed. That perceived safety was a direct result of a continuing, if not steady, decline in interest rates.

This overwhelming trend, which we have experienced since KC & the Sunshine Band were relevant, has been a tremendous tailwind for bond investors. Most have never invested without such a tailwind so the possibility that “safety” may actually be perilous is a novel concept. Many investors will be caught complacent and, as behavioral finance teaches us, over confident because of their recent experiences.

Losses in these “safe” assets are not only possible, but likely. As Dr. Michael Hasenstab, manager of the Templeton Global Bond Fund, said a year ago, “The concept of a ‘risk-free’ asset no longer exists. To simply seek to preserve wealth one has to take risks.” The days when you can just build a ladder and forget about it are over. We are unlikely to have the same context going forward as we had the past 30 years. We now must adapt to a new context and realize safety may require being more nimble, more creative, and released from our 30 years of experience.

It Has Never Hurt Me Before

Reaching for yield by extending maturities is a recipe for disaster. Years of yield can be swept away in weeks by a small move in interest rates. We’re already seeing losses in investment grade bond portfolios as rates trickled up in the second quarter of 2013. Treasuries, the “risk-free” asset, had net losses for the year as of August 13.



YTD Return



iShares 1-3 Year Treasury Bond ETF




iShares 3-7 Year Treasury Bond ETF




iShares 7-10 Year Treasury Bond ETF




iShares 10-20 Year Treasury Bond ETF




iShares 20+ Year Treasury Bond ETF



Too many are ill-prepared and unwilling to adapt strategies to be more context dependent rather than historical experience dependent. There is almost no one who can remember what it was like before this long slide in rates. Junior investors weren’t around for it and most of the senior investors have forgotten what it was like (as well as forgetting where they put the remote and the car keys). Any experience from the 70’s might not help in our current era with a completely different set of financial tools, trading practices, and products. Back then, there was no such thing as a stripped treasury let alone the other tools created via financial engineering. Old guys, tell the kids what it was like back when our clients were named Oog and Grok and dreamed of getting that vacation cave over by the lava flow.

Always Cut the Red Wire

This doesn’t mean that that it’s all over and there’s no point to fixed income investing or no hope for wealth preservation. It just means that they can’t be done in a linear fashion anymore. There are opportunities for active managers to find and exploit inefficiencies as different types of income investments move in and out of favor, are oversold or bid up. The same sort of effort that we typically see in equity investing – focus on diversification, an opportunistic eye, attention to sectors and issues – will have to be applied to income investments as well. Fixed income will never be as sexy as equity, but bonds will get as challenging as stocks.

This is a critical time to be thoughtful about how a bond portfolio is built and managed. Sure, passive strategies have worked well in core fixed income for the last thirty years. Passive strategies always look good in favorable markets. Active management will be one tool investors will need. It’s counter-intuitive, but investors should also seek safety by looking into new practices and products that, by themselves, feel more risky than the “safe” bonds we have historically used. That’s a mental obstacle that must be overcome. What if the next trend is equally as powerful and enduring as the last – but in the opposite direction? As pricing mechanisms are restored, volatility will rise and those clinging to the past will suffer greatly. As we wrote in our February newsletter, risk isn’t flat, complacency makes us nervous, and decisions must be made in context. There is no answer that is always right. Reverting to habit and doing things as you have always done them can blow up in your face. It’s better to be on the other side of those trades.

Come on! I’ll Show You Where My Dad Keeps His Gun

The key here is the same as always: pay attention to what risks are being rewarded and which are being punished. Refer to the table above and see how the losses align with the maturities. Duration risk, which is the primary risk accepted with investment grade bonds, is going to cost investors in a rising rate environment. This is a risk to avoid, not accept. There are other risks which are being rewarded, such as credit quality, which are better choices to accept.

Look to income investments that are less sensitive to interest rates. There are opportunities in emerging market debt, short term high yield, bank loans, CMOs, and other types of income generating securities. There are tools like inverse Treasury funds that can hedge bond portfolios against principal loss. We also have access to alternative strategies that can absorb volatility. It’s not the 1970’s anymore and we have tools and products that will allow us to preserve wealth by taking smart risks rather than just riding it out with gritted teeth. Do not rely on the old safety, get a new gun.

As always, we are proud to be your partners and gun dealer while exercising stewardship without compromise.

Best Regards,

The Team

Galway Investment Strategy

[email protected]

© Galway Investment Strategy


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