Portfolio Update: Toward a Better Bond Balance

Portfolio Update: Toward a Better Bond Balance

Translucent Globe on Euros and DollarsAs you may recall, at the end of 2013 we decided to reel in the average maturity of the bonds in our portfolios because we were concerned about the prospect of rising interest rates (Investment Update: Going Short (Really Short!)).  When rates rise, all other things being equal, the price of bonds will fall.  The size of the reaction is a function of a bond’s (or portfolio of bonds’) maturity, with longer maturities suffering bigger declines than those with short maturities.  Thus, our decision to radically shorten those maturities, pulling the average maturity down to less than one year.  Of course, the other side of the equation is that the yield on a bond, all other things being equal, is higher on longer maturities and lower on shorter maturities, so those ultra-short bonds haven’t been producing a lot of interest income.

Which brings us to the present moment.

A little over a year later, the outlook for rising rates is pretty modest.  A week and a half ago, Fed Chairman Janet Yellen, speaking in San Francisco, made it pretty clear that the Fed is going to continue taking an extremely cautious approach to raising rates. Based on guidance from the Fed, it looks like the first rise in the Federal Funds Rate from its current near-zero level will come “sometime” (“probably”) between June and September and isn’t expected to be more than 0.25% (one-quarter of one percent or 25 “basis points” in bond market jargon). Over the past year, nearly every projection by the Fed for when they would start raising rates has ultimately been pushed back.

Now combine that with the fact that the Bureau of Labor Statistics has just reported the trailing 12-month change in the Consumer Price Index (CPI) to be zero, the initiation of a trillion euro round of “quantitative easing” (QE) by the European Central Bank, near deflationary conditions across the Eurozone, and similar conditions in Japan, and we’re feeling that the interest rate outlook will continue to be rather modest for some time to come, probably through 2016 and possibly even beyond.

All of which led us back to the drawing board to analyze the upside yield potential of slightly extended maturities against the downside price risk of rising rates. We concluded that swapping half of the one-year portfolio now in place (DFA One-Year Fixed Income Portfolio, DFIHX) for a slightly longer-maturity bond portfolio (DFA Five Year Global Fixed Income, DFGBX) represented a good risk-reward tradeoff. We should note that the fund’s name refers to its maximum maturity of five years while the current average is below four years (and for you bond geeks, the “duration” is 3.82).  We should also note that the credit quality of the bonds in this portfolio is very high.

As always, we’ll continue to monitor monetary conditions and inflation outlook here and abroad with an eye to capturing as much “rational yield” as possible from a global portfolio of high quality bonds.

The Yeske Buie Team