Seizing on this moment and congratulating you

Genevieve Signoret

Letter from the President

Carpimus diem

We’re seizing on high U.S. Treasury valuations to make a strategy shift we think will boost our model and client portfolio performances in the next two years.

Good one!

Oh, and speaking of seizing the moment, I want to applaud those of you who heard our call last week to buy into the correction by putting more money into the risk portions of their portfolios. And congratulate the rest of you on your fortitude during this nerve-wracking downward segment of the market roller coaster. While some of you did call us this week to ask whether we ought not to be “doing something” about the correction (my answer: “Buy!”), but none of you demanded that we sell. Bravo! Because of course selling on dips is the way to lose money. We’re focused on making money.

Our strategy shift

We’re seizing on the wonderfully high valuations of the U.S. 7–10-year Treasury bond fund in our model and client portfolios with an average duration of 7.58 years and a dividend yield of 2.02% to sell them and switch into 5–10-year corporate investment grade bonds with an average duration of 6.51 years and a dividend yield of 3.58%. So we’re selling safety and duration to buy yield and protection against interest rate hikes.

Duration will matter again soon

It may sound crazy to be shifting into lower duration when bond yields are falling, but, as we wrote in today’s edition of Macro Views, although we do perceive risks to the U.S. expansion to have heightened, we still hold to our central scenario outlook: for 2015 we continue to project that the U.S. economy will accelerate and the Fed will start hiking rates. Hence, we see long-term bond rates moving up. And the longer a bond portfolio’s average duration, the harder is the blow it receives from the upward revision in market expectations for rates followed by the actual fact of the rate hike.

Yield is nice too

We like income too, of course. An investment grade corporate bond fund that’s well diversified (the only kind we ever buy) adds just a tiny bit more risk and pays higher yield.

It’s more about reducing insurance costs than producing returns

Now remember, our outlook for investment grade long-term bonds over the next few years is negative. Yet our policy is to always hold some, precisely to smooth out volatility episodes like the one rocking our portfolios today—as you can see in today’s edition of Our Performance, these securities spike in value during bouts of market panic. So, what we’re hoping to achieve with this strategy shift is not to push up the investment grade bond portion of our portfolios on trend but rather weaken the downward tug we expect its trend to exert, while holding on to the protection this allocation offers us during bouts of risk aversion and the hedge it gives us against the risk of error in our rate forecast.

In other words, this is about reducing our insurance costs: diminishing the drag we expect from a chunk of our portfolios the chief role of which over the next few years will be protection more than gains.

Why now?

I’ve explained why we’re making this shift but haven told you why we’re doing it now. In what way is our timing an instance of “seizing the moment”? Because, compared with a few weeks ago, the recent bout of risk aversion has rendered U.S. investment grade corporate bonds cheaper than comparable Treasury securities (the corporate bond fund we’re buying is up 2.38% in three months, whereas the Treasury fund we’re selling is up 3.49%). In other words, we’re taking profits on a transitory panic-generated premium on safety (Treasuries over corporates), which in today’s worrisome global economy includes duration (7.58 years over 6.51 years).

Hold on and take heart

Returning now to your feelings: I know! This is hard. I’m in the same boat. But we should all take heart: we’re seizing on a superb moment to shift our bond holdings down slightly in duration and investment grade. And we’re smartly and serenely watching but not joining the panicked herd as we resist the temptation to sell low. Some of us are even buying on the dip.


Previous Letters from the President

A buying opportunity (2014 10 16)

5 reasons not to participate in Alibaba’s IPO (2014 09 16)

2014–2016 Outlook: Low for long (2014 08 29)

Should you sell your business? (2014 08 15)

Update History:

  • 20 October 2014: “U.S. 7–10-year Treasury bond fund “; “And the longer is a bond portfolio’s average duration”; “We like income too”; “An well diversified investment grade corporate bond fund that’s well diversified“.
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