Investment committee thoughts from friday 4/20/18

Introduction

People from all across the world look forward to Friday.  Friday marks the end of a (usually long) work week and the start of what is supposed to be a relaxing weekend.  At Rockbridge, we look forward to Friday’s, particularly Friday mornings, for a different reason.

Friday mornings have become a tradition, some say a “tradition unlike any other” (not the masters), where great minds (some) sit around our conference room table and discuss the core principles of our investment philosophy and what, if any, changes should be made to our portfolios.  These meeting are led by Bob Ryan, Rockbridge’s Chief Investment Officer, and topics include anything and everything investment management related.

The purpose of these weekly articles is to inform clients what we are discussing each week and how it relates to their wealth at Rockbridge.  Our investment philosophy is proven in academia and the ideas we implement in our portfolios have been around for several years.  It’s important to us to not have a “whimsical” approach to managing wealth; something we see all too often in the investment management world.  Although we are seen as a financial planning/wealth management firm in the eyes of our clients, investment management and portfolio construction is the backbone of this process.

We hope to provide valuable insight on our Friday meetings; what some have coined “Bob’s Investment Class.”  This marks the beginning of a series of weekly posts sharing some of these ideas with you.

Thoughts from Friday 4/20/18

Mike, Ethan, and Claire, attended the Dimensional Fund Advisors (DFA) conference in New York City this week and came away with some interesting ideas for our Friday discussion.

Topic: Corporate Bond Credit Risk Premium

There are risks to consider when investing in the bond market, one being credit risk.  Credit risk is the risk of a bond “defaulting”, and in a normal market riskier bonds will have to entice investors by providing higher coupon payments.  We ran across data suggesting that bonds with lower credit quality have similar default rates to similar bonds with higher credit quality.  This begged the question of “why not invest in riskier bonds and pocket the higher coupon payment if said bonds have the same default rate as  similar higher quality bonds?”

One of our core rules is to be suspicious of any “free lunches” when it comes to investing; achieving a higher return without enduring additional risk, which is what we see here.    This situation is no exception to our core beliefs.

We discussed that although increasing credit risk in the bond portfolio might not result in a higher default rate, it would actually increase the correlation to the equity portfolio.  Bonds should be inversely correlated with equities, and increasing credit quality too much creates positive correlation to equities; meaning equities and fixed income would behave similarly, something we don’t want to happen.  Bonds provide a “buffer” in the portfolio, helping to “smooth out the ride.”  For example, in 2008 the Barclay’s Aggregate Bond Index finished the year earning 5.24% while the S&P 500 Index finished losing nearly 37%.

In summary, the role of bonds is much more than the eye sees.  Sure, we could increase expected bond returns by exposing portfolios to more credit risk, but we would increase the correlation between the stock and bond components of the portfolio as well.