Portfolio Construction

With the crescendo of all US Treasury yields to trading below 1% in early March marking the high-water mark for bond prices, the need to revisit how portfolios are constructed has emerged. Is the traditional 60% stocks/40% bond model dead?

This may indeed be a worthwhile question to explore but it is the underlying assumption or the underlying narrative of a stock/bond mix that warrants examination. For decades scholars of portfolio management theory ran studies after studies showing how a mix of assets, even as simple as stocks and bonds, can lower the risk and improve returns of non-diversified portfolios.

With the advent of computers in investing and something as relatively simple as a pie chart, investors could “see” how they were invested. When stocks swooned in 2000 and 2007, yes, diversification worked as advertised…just look at the results!

Back in the 1990’s, I taught a class in the evenings down the street at SMU for several years. I did not teach portfolio theory or diversification; I taught bond math. Realize in the late 1990’s the focus in investments was on growth, particularly NASDAQ stocks, led by DELL as a favorite poster child. The message of my class was how bonds perform, specifically that from the earliest days of stock markets bull market in the 1980’s bonds had performed, in lock step with stocks.

Double digit returns from bonds? Absolutely! Stock-like performance numbers, to the upside? Yes! How? Selection was key. This is The Select Approach^TM after all. My focus was on structure, the terms of the bond, not on quality issues. I focused on government bonds, not corporates or junk bonds to show how bonds perform.

Rather than diversifying between stocks and bonds for a narrative reason such as bonds perform better in a downturn versus stocks (do they?), bonds have, over the years of the bull market, preformed in lock step with stocks.

With US Treasury yields at their lows in March and their prices at record highs, across all maturities of bonds, all bond investors become winners. It didn’t matter which bond maturities you owned; your prices were now similar to the high-water mark prices of March 6th.

Investors examining their portfolio mix between stocks and bonds may correctly infer that such high prices mean that bonds in their portfolio should be largely forsaken. When I said to sell bond mutual funds and ETF’s in my March 6th letter, I wanted to make this point clear.

However, do not miss the larger implication. The idea that stock and bond portfolio diversification has worked for decades may also just happen to be for other reasons we may not have examined.

Stocks may have performed because bonds performed. This is not a radical statement, but if it is correct then investors worrying about their bond allocation missed the larger issue. Your stock allocation should be your focus.

As stock and bond prices continue to hover around their all-time highs this is not the time to do nothing. Selection of bonds has always been key to performance, and this will continue to be the case in the weeks and years to come. Change is coming and you need to be ready.

Navasota, TX

Certificates of Obligation, Series 2020

A S&P Underlying

Due 11/15   Dated 12/1/20 Maturity 11/15/40

$9,865,000 Sold

Years   Maturity     Coupon      Yield*

 1            2021           4.00%          0.35%

 2            2022          2.875%         0.40%

 3            2023          2.125%         0.45%

 4            2024          1.75%           0.50%

 5            2025          1.50%           0.60%

 6            2026          1.50%           0.75%

 7            2027          1.50%           0.90%

 8            2028          1.625%         1.05%

 9            2029          4.00%           1.25%

 10          2030**     2.00%           1.45%

 11          2031**      2.00%           1.55%

 12          2032**      2.00%           1.70%

 13          2033**      2.00%           1.80%

 14          2034**      2.00%           2.00%

 15          2035**      2.00%           2.05%

 16          2036**      2.125%         2.10%

 17          2037**      2.25%           2.15%

 18          2038**      2.25%           2.20%

 19          2039**      2.25%           2.23%

 20          2040**      2.375%         2.27%

*Yield to Worst (Call or Maturity) ** Call 11/15/29

Source: Bloomberg

This is an example of a new issue priced the week of 11/9/20

Prices, yields and availability subject to change