October 2010: Quarterly Letter

Dear Clients and Friends,

Since our last quarterly letter, the U.S. stock market returned 11.3% (as measured by the S&P 500 total return: this includes the impact of dividends on returns) and developed international markets returned 16.5% (as measured by the MSCI EAFE).  A solid performance that certainly surpasses last quarter's -12% US return by a significant margin.  During the Q2 earnings season that ended in August, 78% of the companies in the S&P 500 exceeded earnings expectations.  Despite this strong performance, the market continues to be volatile.  Markets continue to be driven by global economic indicators and  governmental interventions in fiscal and monetary policies - as opposed to the underlying business fundamentals.  Investors are struggling to read the tea leaves and determine if the weak US and global growth will take hold or perhaps relapse into recession.

Bonds are the New Black

One of the impacts of continued uncertainty in the markets has been the increasing popularity of bonds and bond funds.  Consider this data from Morningstar: through August, taxable bond funds have taken in $168.5 billion.  Meanwhile U.S. equity funds have seen outflows of $42.2 billion. The charts below show the outflow and influx of funds for equity and bond funds through 2009.  The maroon bars represent the flow of new money into or out of funds.

Equity Fund Flows

1 Net new cash flow to equity funds is plotted as a six-month moving average.

2 The total return on equities is measured as the year-over-year change in the MSCI All Country World Total Return Stock Index.

Sources: Investment Company Institute and Morgan Stanley Capital International



Bond Fund Flows

1Net new cash flow to bond funds is plotted as three-month moving average of net new cash flow as a percentage of previous month-end assets. The data exclude flows to high-yield bond funds.

2The total return on bonds is measured as the year-over-year change in the Citigroup Broad Investment Grade Bond Index.

Sources: Investment Company Institute and Citigroup

Keep in mind, the U.S. domestic equity market is $2.9 trillion in assets, so these shifts represent small percentage changes - but we can still see where investors preferences lie.

It's easy to see why people are attracted to bonds.  The total return of the S&P 500 over the last 10 years was -0.43% per year.  Meanwhile the bond market has returned 6.41% per year (as measured by the Barclays Capital Aggregate Bond Index).  With money market and CD rates near zero, who can blame investors for shifting into bond funds?  Although the motivations are understandable, I wonder if investors have really thought out the implications of heavy investments in bonds during such a low interest rate environment.

First, a quick bond lesson (I can hear the cheers of "Oh, goodie!" from all my readers).  Bonds are subject to several types of risk: interest rate risk, default risk, call risk, prepayment risk, re-investment risk, to name just a few.  For the purposes of this discussion, we're going to talk about interest rate risk.  One of the key metrics for bonds or bond funds is the bond's duration.  The calculation is a little complicated, but luckily it is an industry standard metric and widely quoted for bond funds.  Duration is quoted in years and is a measure of a bond funds sensitivity to interest rate risk.  If a bond fund has a duration of 5 years, it means that for every 1% rise in interest rate, the bond fund will lose 5% of its value (conversely, for a 1% decrease in interest rates the fund will gain 5%).  Higher duration bonds are more susceptible to losses from increasing interest rates than short duration bonds.  Duration is different from maturity although the two are related.  Maturity references the term on the bond and represents when an investor will get her principal back.  Longer maturity bonds often have longer durations as well.  This concept can be illustrated with the Interest - Price "see-saw" as shown below.

Given bond funds' sensitivity to interest rates, I am recommending clients keep the duration of their bond allocation short.  I currently recommend bond funds with a duration of 2 years or less.  This ensures that investors will be protected in the event that interest rates spike.  The tradeoff is the current yield on these funds is lower that one with a longer duration.  I think that the 1-2% in yield we are sacrificing will be worth the protection in principal that this strategy supports.  Consider that during the recovery from the last recession the Federal Reserve raised interest rates 17 times from June 2004 through July 2006 increasing the rate from 1.0% to 5.25%.  A bond fund with a duration of 4.5 years would be expected to decrease in value by 19% (although a portion of this return would be made up by the increased yield paid by the fund).  Given our starting point of near zero rates, I think caution is warranted when considering the impact of interest rates going forward.

In Closing

Deciding the appropriate strategy for bonds in your portfolio can be a tricky decision, as discussed above.  If you have any questions on how this relates to your investment strategy, please give me a call.  Also, if you have any friends or family with questions about bonds or any other financial issues, please don't hesitate to make an introduction or forward this letter.  We provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances.  We will treat your friends and family with the same care and diligence that we treat you.

Thanks,

Brian McCann