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By Christine Benz | 11-14-2011 12:00 AM

Essential Ingredients for Income-Focused Portfolios

For more income in today's environment, Marta Norton of Morningstar Investment Services says her team has emphasized dividend payers and healthy high-yield issues over reaching out on the yield curve.

Christine Benz: Hi. I'm Christine Benz for Morningstar.com.

It's Better Bond Investing Week on the site, and here with me to discuss essential ingredients for income-focused portfolios is Marta Norton. She is an investment manager with Morningstar Investment Services.

Marta, thank you so much for being with me.

Marta Norton: Thanks for having me, Christine.

Benz: Marta, for folks who are putting together portfolios and they have a goal of income and stability for that portfolio, how should they think about setting the baseline; bond, stock, cash mix for their portfolio?

Norton: Well, in our lineup, we vary it based on investor need, because there's a lot of different investors out there with a lot of different risk tolerances. So, I think income can be essential for a lot of those different portfolios, but you have to vary it according to time horizon--a lot of the general rules of thumb that come to asset allocation; time horizon, risk ability I guess, ability to sustain risk.

So, in our portfolios, we can range our fixed-income allocation. In our diversified lineup, anywhere from 15% for someone who is more growthy, down to 55% for those more conservative investors who want fixed-income exposure as part of income driving for their portfolio and also for stability.

Benz: Right, so it's very personalized, very much driven by the investors own personal circumstances. I'd like to talk about that bond component because we are focusing on bonds this week. Say I have a bond portfolio and I'm trying to figure out, well, how much should I keep roughly in Treasuries versus corporates versus mortgage-backed bonds? Do you have any guidelines that you can share that you all use to manage your portfolios?

Norton: We do. So, we have strategic asset allocations across the board that we derive a lot from Ibbotson, our sister organization, from their estimates of risk, return, correlation of those different asset classes.

So for certain asset classes, we always have a core stake in fixed income, and that's very traditional. That's almost mimicking to a certain extent, the Barclays Agg in terms of a Treasury split, a split to mortgage-backed securities, asset backed.

Benz: So, very heavy on government bonds at that point.

Norton: It can. It can. Certainly we don't have as much as the Agg does today, but just that general idea of the investment-grade, intermediate-term bond universe.

Then on the margin, we slot in non-domestic bonds, we slot in TIPS, we slot in high yield. And when I say margin, for a more stock heavy portfolio that has less in bonds, that could be 3%. For a portfolio that has closer to 55% in bonds, your non-domestic allocation could be 10%. So, that's how we kind of think about it. We scale it up, but we keep those growthier sectors of the fixed-income market to the margin.

Benz: Okay. So, you hinted that you are not as heavy on the government bonds as is the Barclays Aggregate Bond Index. What's the thinking on being light on the government bond sectors?

Norton: When we make decisions in terms of specific sectors within the fixed-income market, it's usually yield and it's fundamentals. So, right now, the Treasury offers very, very little yield. We think that's a valuation call. It's just not attractive in our view. Yields can really only go one way at this point. They are getting so narrow. We're not getting much bang for our buck there.

On the other side, on the flipside, the fundamentals of the Treasury market just aren't that compelling in terms of supply-demand, in terms of questions you might have about the U.S. government’s financial health. So, that's really our thinking there, but we think there are other sectors of the fixed-income market that offer us a little more yield that's a little more attractive.

Benz: Okay. Let's talk about some of those because I know that our viewers are income starved and really looking at where they can safely maybe step out a little bit on the risk spectrum, pick up a little extra yield, but not take too much risk. So, what would you identify as being relatively attractive?

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