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?
Norton: We favor some of those marginal players. Now, TIPS, we kind of view very similarly to Treasuries, especially with some of those negative real yields you see there earlier on the curve. But in terms of high yield, in terms of non-U.S. bonds, we think those are pretty attractive.
They are not at the spread levels that you saw in 2008, early 2009, certainly not that kind of bargain, but they do offer far more than even you’d find in the investment-grade, corporate bond universe. Thinking of just the end-of-October data, you can see yield data for high yield and emerging. For high yield around 8%, for emerging between 5% and 6ish percent in terms of yield. So, way more attractive than what you're finding in other corners of the market.
And when you think about risk management in this space, when you're using mutual funds, it really comes down to the manager and their own kind of risk controls and research that they are doing. So, we're pretty careful about the kind of managers we're using in that space.
Benz: So, I guess a fear is, if someone has too large a positions in high yield, though, they are sort of making a tacit bet on an economic recovery, right, because the bonds could really get knocked down if growth doesn't continue to materialize.
Norton: I think broadly speaking that can be true. I think high yield, just like the stock market in some sense, is associated with economic growth and, just in our view, we see kind of a sputtering recovery. We don't really see the recession that everyone calls for. So we're not terrified that the high-yield market is going to tank the way some are.
But I think you can also think of the high-yield market in another way as similar to the stock market in the sense that it's security by security. There are some companies that are far more likely to pay their debts that are actually quite healthy. For whatever reason, they are classified as high-yield, but they are not risky bets. ...When you think of it security by security, and that's how our managers who manage that space think about it, I think you can find some pretty healthy bonds and not run the same risk that you would if you were just buying a high-yield bond index fund.
Benz: Marta, you mentioned the TIPS and mentioned that you don't feel that investors are getting adequately compensated necessarily for being in TIPS right now. So, if an investor is concerned about making sure that their fixed-income portfolio has inflation protection, where should they look? Are there any securities that you like better?
Norton: Specifically within the fixed-income market?
Norton: I think bank loans are a decent way to go for inflation protection--just the way they are made up with these short-duration coupons that actually get fatter as interest rates tick up. That's a very attractive characteristic within the fixed-income market.
When you look at correlation data, so when you run correlation data with the TIPS relative to the Consumer Price Index, a broad measure of inflation in the U.S., and then you run it against bank loans on that same measure, you find that bank loans have even higher correlation with the CPI than with TIPS. And it's partly because of that coupon ticking higher, and I think it's also partly this idea that a company that's issuing that kind of debt actually gets healthier in inflationary environments because their fixed level of debt is shrinking as a percentage of their capital structure, and that causes some fundamental improvement there. So, there are a few reasons why that asset class can be attractive during inflation.
Benz: Interesting. So, you also mentioned non-dollar, and I want to follow up on that. In terms of non-dollar exposure, investors have two choices: They can go hedged or unhedged. Which sort of portfolio would you favor for most investors, or does it depend?
Norton: We like non-U.S. dollar exposure. We think that the U.S. dollar has secular headwinds, and I think everyone is familiar with those. Those have been in place for a while and you could argue that they are getting more fierce.
So, when we use our global bonds and our non-U.S. bonds, we're fine with taking on that added currency risk. It can go against us, and we are not great at timing the market necessarily. We are more looking at the fundamentals, and when we look at the fundamentals, especially of emerging-market currencies, we see a lot more attractiveness there than we do for the U.S. dollar.
The currency is always a tricky issue because it's always a relative game. It's not an absolute game. It's this currency versus that currency. But in our view, when we look at the U.S. dollar versus emerging-market currencies, we see a lot of attractiveness for those currencies. If we were to look at the U.S. dollar versus the euro, I think that's a trickier call. And we leave that to our managers.
Benz: So, would you think about a dedicated emerging-markets bond fund or should someone go with a ... and of course you can't give one-size-fits-all prescriptions--but would your bias be toward that dedicated emerging-markets fund or one that is more globally diversified and could go in developed market as well as developing?
Norton: If we have a ... diversified portfolio and have just a little bit of allocation to fixed income, we're likely to use that global funds because we want him to be flexible. We want him to move where he sees the bets are. That's his expertise, and we don't have that expertise, he does.
If we had a broader based fixed-income portfolio that was almost all fixed income, far more diversified within the sectors of fixed income, I think there is a place for an emerging-market bond fund. I think there are some good ones out there from a lot of well-established shops that are worth considering.
Benz: I also wanted to ask about duration exposure currently. There's been a lot of concern about what rising rates could mean to fixed-income portfolios. Do you have a view about duration positioning? Are you keeping portfolios short at this point?
Norton: We are, and that hasn’t necessarily worked out to the benefit of our portfolios [recently]. But again, when we come back to the fundamentals and we look at interest rate levels, yield levels, that kind of thing, we really only can see two outcomes: one, they stay the way they are, and that would be more of a macro force that’s keeping them in check, and we are not in the business of analyzing a lot of those macro forces. And then, two, that they go back higher, and we can't time that. We don't want to try to time that. We see a lot of fixed income managers who've tried to do that unsuccessfully over the years.
So, we have remained short and tried to kind of bolster our portfolio through more credit exposure. So, getting some more of that yield and some of the income from maybe having a little bit more overweight to what we consider to be healthy, high-yield issues rather than reaching out on the yield curve.
Benz: Okay. Lastly, Marta, I wanted to cover with you non-bond components of an income portfolio. Out and about in my travels, I hear a lot from investors about MLPs, preferred stocks, certainly dividend-paying stocks, as components of their income portfolios. Do you have any take on those sectors, and do you think that they are good ingredients if you are focused on current income?
Norton: Of that subset, we think dividend-paying companies make a lot of sense. That’s within our wheelhouse to evaluate, and we think there's a lot of attractiveness to those companies, especially because when you just think of dividend payers, not only are they giving you that income, but they generally have a financial discipline in place that keeps them in check, more so than maybe other companies that aren’t paying a dividend. And we also think a lot of those companies, when you look at the valuations, are relatively attractive, just falling in that large-cap global franchise subset.
In terms of MLPs and preferreds, I think we just leave that up to the manager. We don’t have sleeves devoted to that, and that isn’t something that we are in the practice of analyzing specifically.
Benz: Okay. Well, Marta, it's always great to hear your insights. We very much appreciate it.
Norton: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
This video is meant for educational purposes only. The opinions are those of Morningstar Investment Services, and are subject to change without notice. Past performance does not guarantee future results. Morningstar Investment Services is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. and cannot guarantee its accuracy, completeness or reliability. Except as otherwise required by law.
International/Emerging Market Equities: Investing in international securities involve special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.
High-Yield Bonds: Portfolios that invest in lower-rated debt securities (commonly referred as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Bonds: Bonds are subject to interest rate risk. As the prevailing level of bond interest rates rise, the value of bonds already held in a portfolio decline. Portfolios that hold bonds are subject to declines and increases in value due to general changes in interest rates.
Credit: If an issuer or guarantor of a security held by the fund or a counterparty to a financial contract with the fund defaults or is downgraded, or if the value of the assets underlying a security declines, the value of your investment will decline. Junk bonds have a higher risk of default and are considered speculative. A default or downgrade will have a greater impact on subordinated securities.
Currency: When the fund invests in securities denominated in foreign currencies, the fund may incur currency conversion costs and may be affected favorably or unfavorably by changes in the rates of exchange between those currencies and the U.S. dollar. Currency exchange rates can be volatile and are affected by, among other factors, the general economics of a country, the actions of the U.S. and foreign governments or control banks, the imposition of currency controls, and speculation.
Interest Rate: Fixed-income securities have varying levels of sensitivity to changes in interest rates. In general, the price of a fixed-income security tends to fall when interest rates rise and can rise when interest rates fall. A change in interest rates will not have the same impact on all fixed-income securities. Generally, the longer the maturity or duration of a fixed-income security, the greater the impact of a rise in interest rates on the security’s value. In addition, different interest rate measures (such as short- and long-term interest rates and U.S. and foreign interest rates), or interest rates on different types of securities or securities of different issuers, may not necessarily change in the same amount or in the same direction. When interest rates go down, the income received by the fund, and the fund’s yield, may decline.
BarCap US Agg Bond TR USD: This index is composed of the BarCap Government/Credit Index, the Mortgage-Backed Securities Index, and the Asset-Backed Securities Index. The returns we publish for the index are total returns, which include reinvestment of dividends.