So far we’ve discussed the need to understand your risk tolerance before developing an asset allocation strategy and the four main assets classes we’ll consider. In this post and the next, we’ll look at asset subclasses and how to handle them.
In the last post we broke assets into four general categories of assets: Cash equivalents, Bonds, Stocks and Other.
Cash equivalents should not need any subclasses since the whole purpose of this category is to be ready cash. Whether you are holding $100 bills, have a checking or savings account, short-term CDs or money market accounts is of no matter.
I think of bond subclasses as having three dimensions.
One dimension is the time until maturity. I use three categories: short, medium and long.
Short: Up to 3 years.
Medium: 3-10 years
Long: Anything 10 or longer.
A second dimension is who is responsible for paying the bond.
Agencies of the US Government (for example Fannie Mae)
State or Local Government
- Investment Grade
- Junk Bond
- Mature Markets
- Emerging Markets
- Investment Grade
The third dimension is a catch-all that includes the other characteristics of the bonds:
Good heavens, we could have fifty or more subclasses of bonds! Yes, but you don’t need that many. It is important to avoid purchasing any security you do not fully understand. (How many people understood CMO’s—Collateralized Mortgage Obligations—for example. If they had, the banking system may have avoided its recent near collapse. But I digress…) So when you purchase an individual bond or a bond fund, you’ll want to understand all of its characteristics, but our main discussion point is your personal asset allocation policy, and for that we can combine categories.
I use six subclasses only:
I use the first three categories to loosely categorize my interest rate risk for those bonds where interest rate risk is the primary determinant of my overall return.
Properly speaking, the financial tool for understanding interest rate risk is a bond’s duration rather than its maturity. The idea behind duration is to reflect when you expect to receive payments for the bond. A zero-income bond with ten-year maturity, for example, pays nothing until the end of ten years. It is subject to higher interest-rate volatility than another bond with ten-year maturity that pays semi-annual interest and pays back one-tenth of its principal each year. The second bond has much less money at risk in future years. Consequently, the effect of interest rate changes is smaller on this bond than on the zero-coupon bond.
Unless I am dealing with a zero-coupon bond or mortgage-backed security (which pays principal back as the mortgagees make their monthly payments), I rely on maturity to classify it. For callable bonds (one the issuer can choose to “call in” – i.e. pay back – before maturity, which they are likely to do when the bond’s interest rate is higher than current rates) I use the call date if I think the bond might be called and otherwise I use the maturity date to classify whether it is a short, medium or long-term bond.
Inflation-protection bonds are a different cat with their own sets of risks and rewards. While I have loosely stated my main financial objective is to not run out of money before I die, what I really mean is I want to maintain at least a certain minimum standard of purchasing power until my demise. Because Treasury Inflation Protection Bonds (TIPs) directly reflect CPI-measured inflation in their investment returns, they are an important class for me—and I monitor them separately.
Corporations are the primary issuers of junk bonds, although some municipal bonds also have sufficiently low ratings to qualify them as junk. In recent years I have avoided junk bonds. Junk bonds have higher expected returns than bonds from quality issuers because the risk of default is much higher. In addition to the effect of interest rate movements, how the company is doing financially significantly influences the financial performance of the bond. [If the company starts doing better, the risk of default declines and the bond price increases; if the company’s performance worsens, the risk of default increases and the bond price declines.] Because of the significant effect company performance has on the bond price, when I do own them I keep them as a separate category.
Foreign bonds, whether corporate or government, have one additional risk that causes me to segregate them as a separate subclass: they are subject to currency fluctuations. If the dollar strengthens relative to a particular foreign currency, all other things equal, the bonds of that country lose value in terms of the US dollar. I buy things with US dollars—that’s the purchasing power I want to preserve.
Some funds holding foreign bonds hedge the currency risk. If the fund hedges most of the currency risk (say at least 2/3rds), I wouldn’t bother with a separate subcategory. Any less hedging, then I want to add a category to recognize the additional risk I have taken by allowing currency fluctuations to affect the value of my holdings.
I am lucky enough to have a corporate pension from one of my former jobs. I consider it a bond because its value to me closely resembles that of a bond paying monthly interest with no maturity date. My monthly payments are fixed and will continue as long as I do. Like a bond, this stream of payments loses value if inflation kicks in because I can buy less with my monthly payments. Should we experience deflation, the value of my monthly payments rises because I can buy more with them.
Since my pension came as the result of a qualified corporate pension plan (and is relatively modest), the Pension Benefit Guarantee Corporation guarantees all of my benefit payments (unless Congress retroactively changes the law.) Given these characteristics, my pension looks a lot like an insured bond and that is how I value it.
Social Security is also bond-like, but unlike my corporate pension, future payments (more or less) reflect inflation subsequent to the start of payments.
Later in this series of articles, I’ll discuss the specifics of how I recognize the value of my corporate pension and Social Security in my personal asset allocation policy and balance sheet.
Next up: Asset Subclasses in Your Portfolio (Stocks and Other Investments)