Fixed Income, Nov 2017

In this post I’ll go over my fixed income (FI) allocation as well as sharing the outlook and plan for navigating the next bear market. Currently, FI occupies 22.3% of the total portfolio, not counting 5.6% in cash equivalent (3.6% of the 5.6% is the emergency fund in a CD ladder, the rest actual cash). It has fluctuated between 22 and 24% over the past year and I may deploy some cash by year-end to get closer to 24% again. Detailed breakdown is shown in the table below.

My general philosophy is to treat FI as another source of return, contrary to the Boglehead/Bernstein teaching of taking risk in equities only, but consistent with modern portfolio construction methods such as risk parity, max diversification, min correlation, etc. What I ended up with is a “bar-bell” in risk profile where stable value funds in passive is counter-weighed by leveraged CEFs in active.

The stable value funds are in the 401K’s and have a combined yield around 2.5%. $PCI/$PDI/$PFN are Pimco taxable multi-strategy CEFs, and $BGB is a Blackstone bank loan CEF. The current yields are 8.65%, 8.76%, 8.96% and 7.98%, respectively. These four are in tax-advantaged accounts. Pimco has paid a year-end special in the past but I’m not too hopeful this year. $NAC and $PCQ are two CA muni CEFs in taxable accounts, currently yielding 5.12% and 5.38%, respectively, federal and CA tax free (though $NAC has some AMT). The Pimco taxable CEFs in particular have had good capital appreciation with total returns exceeding that of S&P in 2016/17. When comparing with benchmarks, I expect greater out-performance from my FI vs. $AGG than individual stocks vs. $SPY.

Above is a correlation matrix between the total stock market ($VTI) and the CEFs from My rule of thumb is to assume a 0.4 correlation between the Pimco taxable CEFs and stocks. The muni CEFs show near zero correlation to stocks but don’t quite provide the negative correlation during a crisis. Therein lies the rub: the CEFs provide excellent returns during bull markets but are likely to drop along with stocks in bear markets. This lends itself to market timing where CEFs are swapped with treasuries, which is my plan for the taxable CEFs. The Pimco CEFs are “unproven” in bear markets. Even if they navigate skillfully, investors may still punish them, leaving exploitable discounts. These are opportunities not available in open-ended mutual funds. As for the muni CEFs, trading may not be worthwhile if the bear market is as brief and shallow as I expect. The $TNX (10 year yield x 10) chart below was shown two weeks ago. I’d like to re-balance “into” treasuries rather than “out of” existing holdings. The yield won’t go up in a straight line, however I’m expecting 2.8% first and then above 3% during this bull market.

The PortfolioVisualizer table also shows the volatilities of the CEFs which are on par with that of $VTI. When correlations vanish risk parity degenerates into volatility parity; when the volatilities are equal it degenerates again into equal weight. So the data is suggestive of replacing the cash portion of a Permanent Portfolio with $PCQ. I’ll write about this in a future post.

Towards the end of The Next Bear Market, I painted a rather bleak picture of an investment landscape where the equity risk premium has either diminished or disappeared due to “over grazing” by investors enamored with stocks and the performance assurance from passive buy-and-hold. Fixed income, properly leveraged, may offer a ray of hope in this new world. After all, the FI universe is far greater than equities both in size and variety. It may be the last refuge of active managers.

None of the above is investment advice, the standard disclaimer applies.