Investors Vulnerable to Fixed Income Behavioral Biases

Investors continue to view fixed income as the default “risk-off” slice of investors’ portfolios, even as they are faced with two distinct challenges: Yields are dismal and risks are high. Part of the problem is that solutions to the fixed income problem are foggy. In this commentary we discuss the risks, both asset based and behavioral, as well as viable solutions to address fixed income yield and risk concerns.

Over the past 15 months the annual return of the i-Shares AGG ETF was 3% (while its current SEC yield has dropped to less than 1.7%), compared with an inflation increase of 2.8%[1]. If we assume an advisory fee of 1% in client portfolios, investors have realized a real (annualized) loss of .8%. It’s not uncommon for bonds to have very low or negative real returns over short periods. What is abnormal is the amount of risk being taken to realize that negative real return.

Setting aside default risk for the moment, current bond risk is made up of two components: inflation and interest rates. Inflation tends to occur during the latter part of sovereign de-levering, and there are considerable differences of opinion about the likelihood of high inflation occurring. Most agree that interest rates, however, eventually will rise. The price impact from a rise in interest rates can be significant. We estimate that Aggregate bonds would experience a decline of roughly 5% for every 1% increase in interest rates[2]. Since 1962 the 5 Year Treasury (a duration that correlates roughly to the duration in aggregate bonds) has had an average yield of 6.3%[3]. That compares to a current yield of .76%. To return to average interest rates would mean an increase of over 5%. This would translate to a 26% principal loss in aggregate bonds (see charts below). Ouch!

So how does the risk of a likely 26% principal erosion look against a “reward” of a 1% real annual loss? Not great we’d all agree. Yet, how are your capital preservation and balanced income investors allocated? If the answer doesn’t match up well with current risk/return dynamics then you (and your investors) may be vulnerable fixed income behavioral biases.

Behavioral Investing Challenges – Inflation and Rising Interest Rates

In our last commentary we identified our “Five Biggest Behavioral Investing Challenges.” When advisors think of behavioral biases, they often think of client vulnerability. In the case of fixed income, the chief victims may be advisors themselves. This is caused in part by cognitive dissonance. When new information conflicts with previously held beliefs, people tend to ignore the new information and consider only what confirms existing views.

Our Recommendations to Address Risks of Rising Interest Rates and Inflation

The first step advisors need to take is to emotionally untether from past success in bonds, and acknowledge the poignant “new information” about fixed income risk.

Next, when extraordinary risks are present, as they are with fixed income portfolios, portfolio modifications should be considered to address them. We see four solutions: Laddering individual bond portfolios, unconstrained bond strategies or funds, shortening durations, and tactical strategies.

Bond Tactical Strategies Explained

Bond tactical strategies may be new to many advisors, but Toews has been deploying them for 17 years across its separate account platform. The objective of these strategies is to remain invested during benign or bull market periods for bonds, but to allocate to alternative positions in the early phase of declines in order to avoid losses. Our primary experience is with High Yield Bonds. High Yield Bonds are still relatively attractive, but risk is clearly higher than aggregate bonds. Other traits that make High Yield Bonds desirable for tactical models are their clear long term trends and low daily volatility. The main vulnerability of these tactical models is under performance due to short term exits and re-entries, or whipsaw trades. Low daily volatility helps reduce underperformance risk due to whip-saw trades.

With aggregate bond yields so low and risk of principal loss high, allocating a portion of bond portfolios to tactical High Yield Bond strategies may be a way to improve portfolio risk and return measures.

Markets Rally during the Quarter back to 2007 Highs

Equity markets[4] advanced during the quarter to finish at highs not seen since 2007. Toews completed its re-entry into assets in early January, and spent the majority of the quarter fully invested across equity and high yield bond assets. As the quarter begins, portfolios (with the exception of emerging markets equities) remain fully invested. Following the robust gains in 2012, there is a possibility that gains will extend further this year.

What Lies Ahead

The statement that “markets reach 2007 highs,” has both positive and negative connotations. Yes, stocks have increased over the past 15 months. However, it’s taken almost 6 years for prices to return to 2007 levels and recover from losses realized during the financial crisis[5]. Even worse, while the S&P 500 has surpassed its all-time high, the NASDAQ Composite index, which finished the quarter at 3,267, remains significantly below its all-time closing high of 5,049 reached in March of 2000, 13 years later! A market that moves up and down and goes nowhere over many years is referred to as a secular bear market. These markets can last for as long as 20 years, and may include both significant declines as well as huge market rallies.

Over the past few years we’ve highlighted global risk factors that could derail this bull market. Those risks remain relevant. Global debt continues to increase and populations in developed countries are aging. This confluence of events means that countries are forced pay increasing entitlement costs even though their budget deficits are high and their workforces are shrinking. These factors can lead to stock market declines and potentially to inflation. In other words, instead of entering into an extended rising market, it’s possible that stocks will continue in a secular bear market cycle for some time to come.

The Toews System during Secular Bear Markets

Although the outlook for the stock market can at times be dire, we remain cautiously optimistic. The crucial advantage of our methodology is its ability to attempt to avoid the bulk of market declines. If this is achieved successfully, it creates an opportunity to buy near market lows and participate in rebounds. As a result, it may be possible to produce positive returns even when the market is losing money or moving sideways.

Secular bear markets include not just large drops, but sizable stock market rallies. During the Great Depression, the stock market was in various stages of decline from 1929 through 1942. Despite the decidedly negative bias of the market, the Dow Jones Industrial Average experienced 7 bull markets with returns producing average gains of 54%. Systems that successfully avoid big declines can provide favorable returns for investors if they participate in even a portion of these robust market rallies.

The path to navigate these markets and address possible significant declines is straightforward but requires constant vigilance: 1) stay committed to equity markets, historically the best performing asset class to help protect against inflation; and 2) hedge your equity portfolios against losses. Both are pillars on which the Toews system is built.

[1] Source – Bureau of Labor Statistics
[2] Change in bond price is calculated using both duration and convexity according to the following formula: New Price = (Price + (Price * -Duration * Change in Interest Rates))+(0.5 * Price * Convexity * (Change in Interest Rates)^2).
[3] Source – Federal Reserve
[4] As represented by the Standard and Poor’s 500 Index
[5] This analysis of the return in price to 2007 excludes the effects of dividends paid by stocks held by stock market indices.

Disclosure

Prior performance is no guarantee of future results. There can be no assurance that Toews will achieve its performance objectives.

This commentary may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

This commentary is intended to provide general information only and should not be construed as an offer of specifically-tailored individualized advice. Please contact your investment adviser, accountant, and/or attorney for advice appropriate to your specific situation.

Inclusion of benchmark or index information is not intended to suggest that its performance is equivalent or similar to that of the historical investments whose returns are presented or that investment with our firm is an absolute alternative to investments in the benchmark or index (if such investment were possible). Investors should be aware that the referenced benchmark funds may have a different composition, volatility, risk, investment philosophy, holding times, and/or other investment-related factors that may affect the benchmark funds’ ultimate performance results. Therefore, an investor’s individual results may vary significantly from the benchmark’s performance. There is no guarantee that the Toews portfolio will outperform any benchmark in any given market environment. Toews portfolios are actively traded and thus are not tax efficient. Investors may incur additional tax liabilities as of a result of investing in Toews portfolios. Investors cannot invest directly in an index.

Toews’ advisor’s fees are disclosed in our Form ADV, Part 2A and will also be provided upon request.

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