A Great Defense
For those of you who watched the Super Bowl Sunday night, we were all reminded that while a great defense can keep you in the game, you need some offense to win. Both the Carolina Panthers and Denver Broncos played great defense. At times, it looked like no one was going to be able to score. In fact, the Broncos’ only touchdown until the fourth quarter, came from the defense! The stock market’s gyrations last week remind us that knowing how to play defense in an investment portfolio is equally as important.
A diversified portfolio, one that includes investments in many asset classes, provides defense if it holds investments that perform differently during times of market stress. Over the last several years, many investors have thought about eliminating the bond portion of their portfolio because interest rates are so low. In addition, they worry about what happens to the value of their bond portfolio when interest rates rise.
This argument for eliminating, or significantly reducing bonds from your portfolio, ignores the benefits of diversification. The much maligned benefits. Last week we were reminded of them.
The S&P 500 stock index was down 2.62% last week and is down almost 8% for the year through last Friday. For those same periods, an index of U.S. Treasury bonds was up .35% last week and is up 2.62% since the beginning of the year while an index of investment grade corporate bonds was up .03% last week and is up .76% year-to-date.
As the environment for corporate earnings has become more uncertain and investors are realizing that last year’s technology stock darlings like Facebook, Amazon, Google and Netflix can’t rise forever, the stock indexes have sold off in dramatic fashion. And, we probably haven’t seen the end of stock market weakness or volatility just yet.
Capital Account Order
As a result, investors have begun to move to safer investments like corporate and U.S. Treasury bonds causing yields to decline and prices to increase. This is one of the things that makes bonds defensive during periods of stock market turmoil. It also highlights the notion that bonds belong in a portfolio, not just to generate income but to provide some principal diversification in a portfolio.
One of the reasons investors may prefer bonds over stocks when markets are in turmoil has to do with the fact that bonds are further up in the order of companies’ capital accounts. Think about it this way. Companies raise capital in a number of different ways. They can borrow money from a bank, sell senior or subordinated bonds, and sell preferred or common stock. Each of these approaches to raising capital comes with a specific risk and rate of return.
The order I’ve listed them here is also similar to the order in which a company considers paying back those that have provided capital. In other words, a senior bond holder is taking a lot less principal risk than a preferred or common stock holder. The risk premium for stock holders is higher. Bond holders also receive a coupon or income cash flow while they wait to receive the money they’ve lent back. A stock holder may or may not receive a dividend but most of their return comes from the appreciation in stock price they hope to get based on the earnings growth of a company.
Just as companies want to diversify their sources of capital because they all have different costs, so too does an investor want to diversify the types of capital they provide companies, that means owning investments that sit at different levels in companies’ capital accounts. This diversifies risk.
The 10-year Treasury yield is below 1.80% as of this writing. The 2-year Treasury yield has sunk to a .67% yield from near 1% at the beginning of the year. Bond investors are becoming increasingly concerned about the Federal Reserve’s ability to raise interest rates in the face of weaker economic growth. Last week’s jobs report was weaker than some anticipated showing that only 151,000 jobs were created last month. This was more than 60,000 jobs per month below the three month moving average and wasn’t well received.
We are experiencing a time when weak economic data suggests to bond investors that there is less likelihood that interest rates will rise and as a result, bond prices rally. At the same time, weaker economic data cause stock investors more concern that their rosy view of future earnings may be too rosy!
While bonds can be a great defensive strategy in a portfolio, you also can’t be only invested in them. It is difficult to own stocks, especially when they exhibit the kind of volatility we’ve seen during the last several weeks. However, if you desire a return that is in excess of the increase in prices over time, taking the additional risk necessary in a stock portfolio provides the offense needed to offset the defensive nature of bonds. Over time, you need to play enough offense to win, and allow the defense to keep you in the game.