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Note from the CIO: Our New Higher Quality and More Sustainable Bond Mix

Post Series: Investment Committee Commentary Q4 2018

One of the major objectives that the Investment Committee (IC) at Abacus had for 2018 was a review of the mix of bond investments used in our portfolios. The comprehensive review took more than the first half of the year and is now complete. It resulted in some notable changes to the list of bond mutual funds we use, and those changes have now been implemented across client portfolios. Here is a summary of the changes to the bond mix in our general Rainbow portfolios:

The process the IC followed for arriving at the result began with setting the desired target strategy for each of the many factors that drive bond returns. For example, the length of a bond, or its “duration”, is a risk factor that influences how much the value of the bond will drop when interest rates rise. But, as a competing force, the duration is also positively related to the overall yield of the bond. IC members analyzed in detail the historical tradeoff between risk and return for different duration choices, and after that analysis we voted to target 4.9 years as our overall duration of bonds. This is slightly longer than the previous target of 3.6 years, because we believe that the extra yield would more than compensate for the slightly larger temporary dips the bonds will experience when interest rates rise.

Similarly, we re-evaluated the ideal credit exposure we want in our bond portfolios. The tradeoff here is between bonds with higher credit, such as U.S. government bonds, but which correspondingly yield the least, or corporate bonds that have slightly more credit risk but have a somewhat higher yield. After reviewing the historical analysis, we decided to increase the average credit target in our portfolios to the second highest credit rating, known as AA (the top credit rating is AAA) because we are no longer comfortable with the potential for outsized drops that lower credit ratings can have.

In addition to these two important factors, many other factors were reviewed including the degree of inflation protection desired, the use of mortgage backed securities, the degree of international versus U.S. bonds, etc. And although setting a target for each factor is a valuable exercise, the factors should not be viewed in isolation. For example, one might be willing to take more interest rate risk (duration) if the credit quality is increased, and vice versa. So most of the factors were discussed collectively rather than in isolation. Here is a summary of the more quantitative strategy metrics of the new bond mix:

This table (which shows the old bond mix as having a higher yield yet lower duration or interest rate risk) does not tell the entire story. In particular, we believe that the risk in the old bond mix is understated compared to what the metrics above suggest because of its growing exposure to mortgage backed securities that are not issued by government agencies (which now play a much smaller role in the overall bond market than they did in the past) and due to the unpredictability and lack of transparency in the actively managed Doubleline and PIMCO funds.

This highlights an important qualitative factor we also re-evaluated: active versus passive bond management. We took a clear stand between managers that attempt to time and beat the markets through subjective judgements (“active management”) and those that use evidence and objective criteria for decision making and do not attempt to time or beat the markets (“passive management”). We are decisively in favor of passive management, which resulted in dropping the Doubleline and PIMCO funds. When we started using those funds, their active management was not material and importantly they tracked the overall bond market like passive funds while providing an advantage to our clients due to their size and reputation in the market. But overtime, it became more difficult to estimate what their risk and return would be, and their allocation to non-agency mortgage backed securities became unacceptable. We voted to maintain roughly the same mortgage backed securities allocation, although only those issued by government agencies, and through Vanguard, one of the pioneers in passive management.

Finally, with our involvement and encouragement, Dimensional Funds will soon be releasing their first sustainable bond fund (listed in Table 1). In keeping with the Abacus mission of sustainable investing, the fund is an excellent addition to the new mix. The fund is designed to be a core holding of bonds across the globe, issued by major governments as well as high quality corporations with much better environmental performance than their peers, and as such it deserves the largest allocation in the new mix. The fund is expected to be launched this Fall, so as a temporary substitute we are using the Dimensional Investment Grade fund from the old mix, which has similar financial characteristics.

The new mix of funds in Table 1 reflect the best fit to all our strategy targets. And speaking of better environmental performance, our IC has recently revamped our other major offering, the Environmental, Social and Governance (ESG) Portfolio. We will share that change in a future newsletter, but if you have questions about how it compares to the Rainbow portfolio, please ask your Abacus advisor.

We believe we have a solid grasp on how best to utilize financial markets to reach the goals of our clients. But we have to respect what can go wrong in the markets. As Francis Bacon said, “Nature, to be commanded, must be obeyed”. While most of us don’t wake up in the morning hoping to command nature, we are each striving to reach our life and financial goals with a high degree of certainty in a world that has a high degree of uncertainty, especially in the short-term. This is why our advisors help their clients decide on a judicious mix of stocks, real estate and bonds that suits the needs and goals of each client.


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