"Kee" Points with Jim Kee, Ph.D.

As an end of year note, or rather, before we get into 2014, I’d like to briefly discuss bonds. This is something that I know is on client minds, and the business press is hardly providing clarity. Here goes…


Our philosophy here at STMM has always been that bonds are a safe, transparent, reliable, and cost-efficient hedge to equities. Recently, however, headlines have increasingly been filled with warnings of a bond market bubble and the potential for loss (although I am sure that few of these writers, or any “bubble” writers for that matter, are acting on their beliefs by shorting the relevant asset class). But most of these gloomy scenarios revolve around longer maturity Treasury bonds, and these are not bonds that we have been buying for client portfolios. Our strategy of building a laddered portfolio of individual bonds is designed for a rising rate environment.


The easiest way to think about bonds is to recall that there are basically two types of risks to bond holders: default risk and interest rate risk. Default risk arises when a borrower (bond issuer) cannot make good on payments of interest or principal. The way to minimize default risk is to buy high quality bonds in categories with very low default rates. That’s what we do. Interest rate risk has to do with the fact that the prices or values of existing bonds fall when interest rates in the economy rise. That’s the only way for the buyer of a pre-existing bond to earn a “yield” equivalent to what a new, higher interest rate environment bond would earn. But remember that if you own individual bonds, their price can fall but you will still be repaid the full principle when the bond matures if you hold it to maturity. So it is important to have this “control,” that is, to hold individual bonds rather than bond funds. And some of these bond funds hold stocks. In fact, a Wall Street Journal article last May (“Bond Funds Running Low on….Bonds”) reported that the number of bond funds that own stocks “surged to its highest point in at least 18 years.” That means that investors could be exposed to risks they might not be aware of!


Finally, we have a very compelling offering for professionally managed fixed income portfolios. I have included a discussion from our fixed income team below (a version of this will also be included in your year-end books):  


Fixed Income Management at South Texas Money Management


(from Hutch Bryan, Director of Fixed Income)


At STMM our process of actively managing fixed income portfolios begins with analyzing the current rate environment to access the most advantageous position within our investment guidelines. We have a seasoned staff of experienced and knowledgeable fixed income professionals. Once the decision has been made regarding the duration of a portfolio, our team then sources bonds from our extensive network of over 40 dealers. This process allows us to properly diversify portfolios and to ensure competitive prices from our dealers.


Portfolio Construction


Portfolios are constructed primarily with new issues securities. This is an effective way to achieve competitive yields while avoiding hidden costs such as markups that are found in secondary issues of dealer inventories. Markups vary in amount based on size and maturity of bond offers but average two points, or $20 per $1000 face value. For example, if a retail investor purchased $1 million in face amount of a secondary issue, the potential markup could be as much as $20,000, which would significantly reduce the investor’s yield. Buying new issues mitigates the transaction costs because bonds are sold at competitive prices based on the current rate environment and what the market will accept. As an institutional investor, STMM accesses the new issue market by working with our dealer network and purchasing larger blocks of bonds than the typical retail investor.


Credit Quality


We believe that most of an investor’s acceptable level of “risk” should be taken in the equity portion of their portfolio. Therefore we focus on high quality for our fixed income strategy. This approach helps to dampen the effect of volatility in portfolios since equities and high grade fixed income typically act as a hedge to one another. The average credit rating of our fixed income portfolios is “AA” or higher, and STMM will only purchase bonds with a rating of “A” or higher.


Tax Exempt and Taxable Portfolios


Our tax-free municipal portfolios focus on general obligation bonds and essential service revenue bonds such as water and sewer bonds and utility bonds. Portfolios are constructed with geographical diversification while avoiding certain areas of the country that are experiencing large budget deficits, declining property values, and/or declining populations. The focus of our taxable fixed income portfolios is currently investment grade corporate bonds and taxable municipal bonds.


We take a team approach in actively managing fixed income. Portfolios are monitored for ratings changes and material events. We use research from our dealers as well as independent third party research and our own in-house analysis to weigh the risks of sectors and individual credits. Default risk is the greatest risk when investing in fixed income and we work diligently to provide our clients with a safe, sound, reliable source of income and capital preservation.


Separately Managed Accounts


With interest rates still at historically low levels, now is the time to hold individual bonds to weather an eventual rise in interest rates.  Holding individual bonds, as opposed to mutual fund shares, allows the bondholder to ride out the rise in interest rates, collect income, and wait until maturity to get back a bond’s principal.  For investors with sufficient investable assets, opening a separately managed fixed income account with an investment advisor is a prudent investment decision.  A separately managed fixed income account offers professional management, laddered individual bond portfolios, full transparency, and tax efficient management.  Conversely, in a rising rate environment, the net asset value (NAV) of fixed income mutual funds falls as interest rates rise.  Often, bond mutual fund portfolio managers are forced to sell into a falling market to meet fellow shareholder redemptions.  Since a bond fund shareholder owns shares in a mutual fund instead of individual bonds, the bond fund investor is stuck; the shareholder either has to exit the fund or take the medicine as the value of the fund declines.  In a fixed income mutual fund, there is no guaranteed repayment of principal.  In addition, owning individual bonds provides the investor full transparency as opposed to fixed income mutual funds, which may even hold stocks.


We are currently constructing fixed income portfolios with short average maturity and individual bond ladders – staggering maturity dates so as to not get locked in to a particular maturity for a long time period. In the meantime, the investor is receiving steady income.  In addition, we are buying short to intermediate individual bonds, which are less vulnerable to rising interest rates than longer bonds.