Diversify When the Upside Is Limited

While having lunch with a client recently, I asked about his attitude towards risk.  His half-joking response was that he would like high returns with no risk. I’ve heard similar sentiments echoed many times down the years. We all want the magic pill, weight loss without dieting or exercise, gain without pain.

Because we all want that, we fall prey to the idea that there are ways to engineer returns without having to endure volatility. It’s why investing with Bernie Madoff was so attractive. He proffered a long term record of over 10% per annum with few down months and no down years. It didn’t end well.

In most non-fraudulent circumstances the gains are not so lofty, nor the outcome so stark, but the script is similar. You invest in something based upon perceived stability. It pays well for a while, perhaps years, and then it implodes. Corporate bonds, high yield bonds and bank loans all reside in this asymmetrical neighborhood.

Everyone reaches for yield. I get that. The problem is that the risks taken in reaching for yield can be disproportionate to the available returns. These are not stocks. Most of the time you collect your coupon and your principal at maturity. Sometimes they go down hard.

That happens more often than you know or would like in both high yield and investment grade bond investing. The slow steady gains disappear when volatility spikes. Sometimes it’s triggered by macro events like equity market selloffs. Other times it may result from the decline of an individual firm. One 20% loss in a ten bond portfolio translates to a 2% loss for the whole portfolio, not a great result when corporate bonds yield 3.97% overall.¹

Minimizing blow ups is everything when you own bonds or other debt. There is rarely upside.² When I managed institutional bond portfolios, we selected individual bonds in order to add incremental performance, not to shoot the lights out. It was important to avoid blow ups; very few individual bonds contributed materially to performance unless I bought them at distressed levels. That’s a game that individual investors are not equipped to play.

I am not a proponent of most individuals holding bonds directly.  Since there is so little upside to individual bonds, it is most effective to diversify broadly by investing through funds or ETFs. Why? 1) You need a very large portfolio to diversify adequately using individual bonds. 2) The vast majority of advisors don’t have the capacity to analyze or monitor a broad range of bonds. 3) Execution costs for non-institutional order sizes are very high.

¹ ICE BofAML US Corporate Master Effective Yield as of 2/11/2019

² After a crash, there can be equity-like upside in some bonds and bank loans.

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