Fixed Income/Bonds

Arbor Capital Management, Inc. takes a refreshing approach to fixed income management that is neither new, nor particularly innovative but is largely forgotten. Most investors recognize risk in terms of price volatility. This makes sense as most attention by individual investors and to a large extent even institutional investors is focused on equities. By default then they tend to use the same filters to evaluate and allocate monies to fixed income.

In other words the question asked is “which will do better over the next (period in question) stocks, bonds, cash, or something else”? The question is asked because people think they can predict which asset class will outperform others over a specific time period. That is a dangerous game. This approach to fixed income has arisen over the past 25 years or so as a result of modern portfolio theory suggesting that the relationship between stocks, bonds, et. al is known, relatively stable, and thus can be used to create diversified portfolios that are less volatile and return as much or more than those portfolios that ignore these characteristics and relationships.

ACM has no argument with this in principle. Diversification is important and has very real effects on both return and volatility. However, ACM does differ in its application. Most make the assumption that stocks return more than bonds and that bonds are “safer” than stocks. Both of these statements are true or false but are entirely dependent on the time period in question. Stocks have underperformed bonds for the past 44 years and counting; yes, it’s true and you can look it up. However, we have had significant periods of equity outperformance during that time period. Over both shorter and longer time periods equities begin to get an upper hand. Despite this, bond allocations are sold as being both lower in return relative to equities and “safer” in that they tend to be less volatile and experience fewer negative returns. This approach might be acceptable if we are making a purely allocation, diversifier, decision on a pool of money that is intended to have a long or perpetual time horizon. However, far too often monies are placed in bond investments for short time periods under the premise that they are safe with very short time horizons and this is where the trouble begins. Bonds prices are inversely related to interest rates. Interest rate predictions are no more reliable than stock market predictions. So, therefore, the direction of the bond market is no more knowable than the direction of the stock market; Period. This is important because it has much to say about HOW your bonds should be held. The one very significant advantage that bonds have over stocks is a maturity date: the point in the future that everyone agrees the money should be returned. However, once bonds are commingled, or managed collectively in any fashion in an ongoing basis; i.e. mutual funds, closed end funds, or etfs, they lose the maturity date benefit.

ACMs approach to fixed income is to focus on issuer risk and place a significant premium on who we are lending your money to and on what basis they think they can keep their promise of returning it at the agreed upon time. This emphasis is intended to be efficient in terms of risk/reward decision making but is in no way attempting to put return ON capital in front of return OF capital. This is the forgotten approach that was used in fixed income investing until the late 1980. This current period of declining and ultra low interest rates (peak in 1983) has significantly skewed investor perceptions of how bond portfolios really behave in more normal environments.

Therefore, ACM is committed to owning and managing the maturity date. ACM is committed to knowing the underlying issuer and its ability to repay the funds. If prices move against us along the way we can largely cast a blind eye to it as long as we remain confident in the promise to pay. This is the real value that the fixed income allocation can bring to the client both in terms of diversification from the academic sense and the real world true piece of mind sense.

We can have a discussion about duration, VaR, yield curve fluctuations, barbell vs. ladder strategies, determinant factors affecting interest rates, and anything else that goes into what will ultimately affect bond prices between now and maturity. All of these are valid. However, allocations to bonds under these assumptions, and educated guesses towards the future belong the in the “at risk” portion of the portfolio not the “I need my money” portion of the portfolio. This portion of asset management is largely forgotten and underappreciated by our industry but certainly not by most investors.

You may fire us for underperformance to some relative index or expectation but it won’t be because we blew up your safe money pile.

ACM’s Approach to Fixed Income Securities

  • The Hippocratic oath is valid here
  • Keep the safe money safe; then try to earn a return on it
  • We will not re-learn prior lessons with your money
  • ACM recognizes that sometimes the best way to live is to not die