Follow a Foundation Investing

A five-minute read: Market observations, performance and portfolio notes from an equity hedged foundation strategy

Should Bond Exposures Be (At Least) As Tactical as Stock Holdings?

Bond investors worry about yield. How do you out-perform your index? You out-yield it, don’t get too adventurous on duration or credit, and keep your seat for another year. How do you compare similarly rated credits? How do you compare differently rated credits? How do you compare different parts of the fixed income opportunity set? Mostly by looking at yields and having an opinion about how that translates into value.

But what if current conditions were to suggest a need to pay much more attention to price swings than observable yield levels? Higher price swings obviously raise the risk that a few days of price action, or a mis-timed buy or sell, can wipe out months of carry.

Compare the state of volatility so far this year to 2024:

And you can now add to your list of volatility drivers a locked-in higher fiscal deficit with uncertain effects in terms of market impact timing and size, but a fairly certain directional component—towards negative outcomes.

So far this year the bond aggregate ETF AGG is up 3.24%. But that return includes in April both a 2.39% drawdown and a 2.04% rally. May featured a 1.94% drawdown and then the beginning of a rally that culminated at the start of July and encompassed a 2.7% price return.

Under current conditions it has—big picture—paid to look at such stock-like notions such as price moving average slopes, over and under-sold short term conditions, and trend change indicators—all the things that would matter far less, if at all, in a traditional low volatility bond market. A portfolio manager’s attention should be at least as focused on price as on yield if recent history is any guide.

There are two other implications of the impact of higher volatility. One is portfolios should be biased towards higher liquidity. Those sweet higher yielding, five year dodgy credits you hold can still be there, but in even more modest sizes since the yield advantage they offer is likely to be swamped by overall bond market price movements. And in terms of the attention span of yourself and your team, spending long hours unearthing less liquid credit gems is going to pay off less and less for overall portfolio returns.

Holdings might need to include highly liquid ETFs rather than just individual bonds, allowing the portfolio to respond with more alacrity to news that initiates or concludes trend changes.

The second is that overall duration needs a re-think. Whatever your analysis of value at the long end of the curve in any fixed income instrument, the reality is that volatile price action is going to impact your returns more dramatically the more duration you hold. A higher volatility regime means a shorter duration portfolio is the most prudent move.

Obviously a complete focus on market timing will likely lead to less positive outcomes since humans tend to be bad at that. However, a slight change in mindset towards being a stock jock instead of a yield hog will result in more soundly constructed portfolios, lower volatility than the overall market, and a higher probability of avoiding sudden trend shifts that can potentially cripple total return in our brave new bond world.

Portfolio Notes

After holding a far-too conservative portfolio since April and performing abysmally, our recent focus on more bond holding alacrity, as described above, is paying performance dividends for a blended portfolio WITHOUT rolling the dice on increasing equity holdings overall after a long rally.

A second factor has been reducing international developed stocks while retaining emerging market holdings. This portfolio change was originally sparked by a re-tracement of the dollar after its steady fall. But it has also benefited the portfolio as EM has gone on a tear since June:

We conclude that dollar movements have become much more determinative of developed market returns than EM. The second factor of course is the tariff situation, with broadly more exposure to negative outcomes for developed markets than EM (with individual country exceptions, of course).

Cairo, Egypt