“By failing to prepare, you are preparing to fail.” - Benjamin Franklin
Insurance is a funny thing. People loathingly seek it out, begrudgingly pay for it, typically complain about the high price, and frequently witness their contracts expire worthless. Excluding health care, which can be more predictable, this is generally true of most types of insurance including auto, home, product protection and much everything else under the sun. Managing risk within your portfolio is no exception, yet large numbers of investors inevitably find their investment assets overexposed to risks that can be minimized through thoughtful diversification.
The performance of the markets from late last summer onwards has been a breathtaking ride for many investors who found in retrospect that their risk exposure was much higher than anticipated. Although some investment portfolios appeared to be diversified across various asset classes – stocks, bonds, commodities, and real estate – in reality they were all exposed to the same factors. Namely, slowing corporate profits, lower global GDP growth rates, and a tightening Fed. As a result, many of their holdings went down by varying degrees.
Most of my career in the financial markets to date has been spent on the institutional side, where I worked as a government bond and interest rate derivatives trader managing a large book of portfolio risk on both proprietary trading and market making desks. It was truly an exciting experience, to be part of the machine moving large sums of money around the world, and I feel lucky to have been given the opportunity. Those days are past however, as I am firmly committed to growing my wealth management practice at Pacificus Capital Management. I can’t tell you the level of satisfaction I receive from working with, and investing for individuals, families and small institutions. In the past, I believe this client segment had been underserved, and so I see first hand the impact that can be made.
What I have noticed in my transition is that both clients and investment managers in the wealth management space generally view bonds only as a source of income, and do not fully understand that bond prices change just like stock prices. Understanding what the driving forces are that relate to each bonds value should be thought of in the framework of an overall portfolio context. In many instances, people are not differentiating between US Treasuries, corporates, or various other sovereign bond obligations and therefore do not understand their risk exposure. This can be dangerous in practice as corporate bonds and most sovereign bond obligations are exposed to credit risk, which is highly correlated to risk asset prices in general. This means that the value of these bonds are not only exposed to interest rate risk, but are also dependent on perceived credit risk, which in the case of corporate bonds is linked directly to both the stock of the underlying company and that of the equity markets as well. It is no wonder that investors recently witnessed mark to market losses on their credit allocation as global equity markets tanked.
By including US Treasury bonds, in an equity-oriented investment portfolio the investor not only receives periodic coupon payments, but also achieves a high level of diversification, akin to insurance protection. As global stock markets inevitably sell-off, commodity markets sink, and currency markets swing about, US Treasury prices tend to rise serving as a strong hedge. The aspect I find most interesting about this type of insurance is that an investor can actually get paid for implementing this strategy.
Thus far, the talk of the markets year to date has been the rally in gold prices. According to data provided by The Wall Street Journal, gold futures as of March 4, 2016 are up 19.8% from the end of last year. Many factors have been cited for this safe haven demand including the turmoil across global equity and currency markets, however the one idea that grabs my attention and makes the most sense to me is the prevalence of negative interest rates across a large segment of the sovereign debt markets (Figure 1). According to an early February article written in Bloomberg, $7 trillion of government bonds at that time were offered at yields below zero, which proportionally made up 29 percent of the Bloomberg Global Developed Sovereign Bond Index (Figure 2). A negative yield means investors who buy the debt now and hold the bonds to maturity will receive back less than they paid. Or said another way, investors that hold these bonds to maturity are making an investment today that locks in a certain loss.
In the past, investors who shied away from gold made the point that the asset had no implicit value as gold did not pay dividends nor make interest payments. But now that a number of developed countries have instituted NIRP (negative interest rate policy), the opportunity cost of holding gold in one’s portfolio has surely decreased and the market has caught on. Risk adverse investors who park cash in negative yielding short maturities along the front end of the yield curve are now locking in losses rather than making returns, why not take a portion of that allocation and put on a gold hedge as an insurance policy? The arguments against owning gold are crumbling, as global central banks experiment with unorthodox monetary policy that may increase the likelihood of a policy error, even if only by a small amount. As a result, gold should continue to benefit.
Lastly, I’d like to conclude this month’s letter on a more positive note. Some of us expected that the Presidential candidates would be dishing up loads of doom and gloom, which of course is always good for grabbing headlines. Many voters believe the economy has not been working for them and as a result, appear more willing to give alternative ideas or philosophies a shot. I get it, as does anyone who possesses the ability to empathize. Displacement through technological progress and global capitalism, not to mention incompetent politicians have affected us all to some extent and we have a right to feel dissatisfied or uncomfortable with the current state of affairs. With that said, Berkshire Hathaway recently released their2015 annual letter, written as usual by Warren Buffett. Mr. Buffett exuding optimism had this to say:
“It’s an election year, and candidates can’t stop speaking about our country’s problems (which, of course, only they can solve). As a result of this negative drumbeat, many Americans now believe that their children will not live as well as they themselves do. That view is dead wrong: The babies being born in America today are the luckiest crop in history. American GDP per capita is now about $56,000. As I mentioned last year that – in real terms – is a staggering six times the amount in 1930, the year I was born, a leap far beyond the wildest dreams of my parents or their contemporaries. U.S. citizens are not intrinsically more intelligent today, nor do they work harder than did Americans in 1930. Rather, they work far more efficiently and thereby produce far more. This all-powerful trend is certain to continue: America’s economic magic remains alive and well.”
“Indeed, most of today’s children are doing well. All families in my upper middle-class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth. His unparalleled fortune couldn’t buy what we now take for granted, whether the field is – to name just a few – transportation, entertainment, communication or medical services. Rockefeller certainly had power and fame; he could not, however, live as well as my neighbors now do.”
And finally, “For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs. America’s social security promises will be honored and perhaps made more generous. And, yes, America’s kids will live far better than their parents did.”
Justin Kobe, CFA Founder & Portfolio Manager
Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated.Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond marketis subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.