Our UConn Huskies scored three tremendous victories last month. As just about everyone in the state knows, the lady’s and men’s basketball teams each took home another national championship. That’s the ninth for the women and the fourth for the men — but who’s counting?
Another important event also occurred last month with much less fanfare. UConn sold $168 million in tax free bonds to the public. Given where interest rates currently are and where they may be headed, this may prove to be another tremendous win for the school.
Bond owners have been on a heck of a ride for a long time. The Barclay’s Capital U. S. Aggregate Bond Index, a broad measure of bond investments, generated an average gain of 8.42 percent from 1980-2013. Amazingly, bond investors only experienced three losing years during that time period — 1994 being the worst at a loss of only 2.92 percent.
Because of the complacency these stable returns have created in investors, last year proved to be a wake-up call of sorts. Bond performance in 2013 was anything but stellar when bonds were down by 2.02 percent versus stocks, which were up by 32 percent. At face value, the sticker shock would appear to be minimal. That is, until it is taken in the context of bond investor’s long-term investment experience. One other losing year for bonds was 1999, when investors were selling everything and anything to buy Internet stocks.
So what to do now?
With interest rates still relatively close to all-time lows, the first step that makes sense is to manage the interest rate risk in your portfolio. As interest rates change, the value of bonds typically will move in an inverse direction. All things being equal, long-term bonds will experience more significant price volatility than comparable short-term bonds as interest rates change. With an improving economy and a Federal Reserve Bank that has stated it is slowing down its open market bond purchases, bond yields may be nearing the beginning of a cycle of moving higher. Therefore, Morgan Stanley is recommending investors shorten the average maturity of the bonds they are holding to help reduce interest rate risk.
Historically, bonds have served as an anchor in investors’ portfolios. For all but the most aggressive investors, bonds offered a shelter during times stocks weren’t faring well. Bonds were positive — averaging an 8.46 percent gain in each of the 6 years that the Standard & Poor’s 500 index was negative since 1980. This inverse correlation to stocks during difficult times surely kept many investors on track to achieve their long-term goals by helping them stay invested.
Unfortunately, that may not be the case as we move forward. The basis for owning bonds in a diversified portfolio may be changing before our eyes. A solution to this potential dilemma is to find other investments that have exhibited characteristics bond holders seek: attractive risk adjusted returns with low variability and low correlation to stocks.
So where to go during times stocks weren’t faring well?
Consider alternative investments. When used in the context of a well-diversified portfolio, alternatives have helped investors optimize their portfolios. This process helps create portfolios that are efficient — or ones that attempt to generate the lowest level of risk for a given level of expected return.
Examples of alternative investments include: real estate investment trusts, master limited partnerships, commodity trading advisors, managed futures and hedge funds. Please note that these investments may come with their own unique set of risks, potentially less liquidity and likely different tax consequences than stocks. With over 90 percent of the variability in a portfolio’s returns attributable to asset allocation, now might be the time to seriously ponder owning asset classes that are not correlated to your other holdings.
Joseph Matthews is the Fairfield office manager and senior investment management consultant with the Global Wealth Management Division of Morgan Stanley Wealth Management.
