A worrisome buzz
Letter from the President
We’re hearing a worrisome buzz, which is that U.S. corporate junk bonds are facing a growing liquidity risk: investors could suddenly start trying to unload them en masse and fail to find willing buyers except at fire-sale prices.
Our client and model short-term portfolios hold large (nearly 50%) allocations to U.S. corporate credit and about half that to the junk bond segment. So far we have not made any adjustment to our strategy but we’re watching this risk closely.
Remember that, these days, we define “short-term” as 6–24 months. This means that our short-term portfolios are appropriate only for that portion of a client’s wealth that he might need in the next 24 months but not in the next six months.
Another way of saying this is “We see a large risk that our short-term portfolio will dip in value—perhaps sharply—in the next six months, but we think the portfolio would recover in six months or less.”
Why would we run this risk? To meet the portfolio’s mandate, which is to at least keep up with inflation over periods longer than six months. Remember that to earn an return one must always run some risk, and that “run risk” means “put up with volatility”. So we’re running what we think is six-month risk to maximize our chances of meeting our performance objective over 6–24 months.
Now I can explain I meant in my opening paragraph when I wrote “So far we have not made any adjustment to strategy but we’re watching this risk closely.” Let me break that sentence into two parts.
Part one: “So far we have not made any adjustment to strategy”. This means that, although I don’t rule out an episode of U.S. junk bond volatility in the short term and realize that such an episode would cause our short-term portfolio to dip, so far I judge that any portfolio losses from such an episode would be recouped in the six months subsequent to the dip.
Part two: “But we’re watching this risk closely”. This means that we’re watching the U.S. corporate bonds market like hawks, ready to spring into action should we lose confidence that our portfolios could bounce back from such an episode in six months or less.
What sort of actions might we take? We could shrink the portfolio’s allocation to corporate bonds generally. Also, within its corporate bond allocation, we could shift some of its holdings away from junk into investment grade bonds and away from the USA into other developed markets.
Previous Letters from the President
- Letter from the President (2014 07 18): Did you see that?
- Letter from the President (2014 07 11): Do you click? Are you braced?
- Letter from the President (2014 06 27): Very bearish on the euro
- Letter from the President (2014 06 20): A lovely market moment ending soon
- Letter from the President (2014 06 13): We hold to our strategies. Good one, Banxico.
- Letter from the President (2014 05 23): 2014–2016 Outlook: Loose
- Letter from the President (2014 05 16): Tiptoeing back into emerging markets
- Letter from the President (2014 04 16): Humility pays off
Read descriptions of these portfolios here. Clients receive details on their composition in addition to individualized strategies and portfolio management services. To request more information, please write to email@example.com.