You may remember way back in time the words appearing in the theme song to the movie “Midnight Cowboy”, starring Jon Voigt and Dustin Hoffman:
“Everybody’s talkin’ at me….don’t hear a word they’re sayin’….only the echoes in my mind”
These are lyrics that echo investment advice we have given in our previous writings on Strategy and Style. They also echo advice from US investment guru William Bernstein about forgoing the daily Financial Press, “financial pornography“, as he terms it, and from Nick Murray’s quote about “the apocalypse du jour.”
Indeed, the Financial Press always has a “topic of the moment”, and recently it has been the “fiscal cliff”, low interest rates and the impact on retiree cash flow. Yields-to-maturity on bonds purchased in today’s world indeed are very low, and locked in at that rate far into the future.
Table of current annual yields–to-maturity:
But this, generally, is not the whole story.
One of the ultimate purposes of investment management is called “matching assets and liabilities.” This is what large pensions funds do, and the same principle applies for individually managed accounts. The “liabilities” are the retirement cash calls needed over life’s duration to support the (hopefully reasonable and realistic) lifestyle expectations of the investor. The “assets” are the investment “things” bought to meet those future cash calls.
An investment manager uses various tricks of the trade to meet the objective. These include strategies in financial planning, investment management and tax planning. On the investment side, a wise strategy is to ensure that a significant proportion of the portfolio is invested in safe, guaranteed things, and this brings us back to bonds. There are many ways to execute a bond strategy, and the core of our strategy is to buy bonds directly and in a laddered fashion, where the maturities of the bond holdings are equally spread out over, typically, ten years.
Therefore, each year approx 90% of the bonds carry on to their future maturity dates, while 10% turn over into cash, awaiting their next “duty”. That duty might be, for a retiree for instance, to fund life. However, if the investor doesn’t require the cash, that money will be available for redeployment in the portfolio. If the strategy calls the money back into bonds, a new bond may be purchased out at the end of the maturity ladder. In today’s world, that brings us to the “hurt” part, because that new bond will yield, say, 2.5%. The Press would have us panic at the paucity of that yield, but it only represents the yield on 10% of the bond portfolio, and, say, 5% of the entire portfolio.
If the present environment was one in which new yields were exceeding historical yields, the investor would be cheering “Yeah! I finally got rid of that old, lousy bond!” So, today’s reality happens to be the flip side of that…. Keynes line about “the duty of the serious investor to accept the depreciation (in this case, low reinvestment rate!) of his holdings with equanimity”.
The following table gives some real historical data from an actual bond portfolio to give some perspective on this issue. Each year, 10% of this bond portfolio turns over and is redeployed. Each year, we recalculate the average yield-to-maturity of the whole bond portfolio.
You will see that, indeed, the average yield has been falling, thanks to a falling interest rate environment over the duration of time, but overall the entire bond portfolio is still yielding 4.4%. The impact from 2010 to 2011 was a modest drop of 20 “basis points”, or .2 of 1%. You also see the maintenance of a relatively stable average term-to-maturity over time.
However, this isn’t a full story either. For whatever reason, you may not have in 2012 a pre existing laddered bond portfolio. So, starting one now would launch and seed your entire laddered bond portfolio at today’s low returns. This would lock your average bond portfolio yield in at, say, 1.8% for the next six years….returning us to the afore-mentioned story of the Financial Press.
At Trivest, we have been moderating our strategy response to the recent low reinvestment environment. To some extent, we are following the market sentiment by augmenting the laddered strategy with the addition of some structured bond vehicles which add some yield lift via higher-yielding corporate bonds in a diversified basket. We use vehicles like TD Canadian Bond Fund and corporate bond exchange-traded-funds (ETF) to achieve this, rather than ladder in new direct corporate bond purchases, in order to diversify risk. An example of a Canadian corporate Bond ETF is “DEX All Corporate Bond Index Fund”, symbol XCB, that holds 604 ‘investment grade’ corporate bond issues, a current weighted average yield to maturity of 2.8%, an average term-to-maturity of 8.6 years, and an annual management fee of 0.4%. These vehicles also are a solution for brand new bond portfolios that are born into the present low yield environment.