May 7, 2012: Bonds As Deflation Hedges

05/08/2012 Share 0 comments

Re-balance Cycle Reminder

Based on our monthly re-balance calendar, the next re-balance time will be on Monday, May 28, 2012. You can also find the re-balance calendar of 2012 on 'My Portfolios' page.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Also please note that we now list the next re-balance date on every portfolio page.

Fund Ratings

We are working hard to simplify our website and usages. You might have noticed that we recently changed our plan and portfolio pages. We would like to alert you that you can use fund ratings shown on a plan page more effectively.

When you visit a plan page, you will notice that there are rating stars associated with each fund on the Investment Options table. You can click on 'Show All Funds & Details' at the bottom of the table to see the complete list of funds. You can further click on 'Show More Fund Parameters & Ratings' and that will give you the actual fund rating scores. For example, the following is a snapshot of high yield bonds in the fund table of Schwab OneSource Select List Funds (click on any column such as the first column will sort the rows of the table based on the keys of that column. For the first column, that means sort based on asset classes):

In fact, recently, a user asked for alternative funds for ABHYX. In this case, one can see that you can use MWHYX (Metropolitan West High Yield Bond M) to replace it as it has 47% rating score, higher than ABHYX's 20%.

We hope users can fully take advantage of this feature more often to study funds in a plan. These ratings can be used as reference for your further studies in case you would like to do more due diligence on finding other alternative funds in the same category/asset class.

Bonds As Deflation Hedges

We continue our coverage on the four corner concept for building an all weather portfolio. See our pervious newsletters April 23, 2012: All Weather Portfolio Construction and April 30, 2012: Inflation Hedges if you missed them.

In this article, we will discuss the deflation corner.

Deflation is a phenomenon where prices of goods and services decline due to oversupply (and/or less demand). Notice that deflation is not necessarily directly linked to the decline of Consumer Price Index (CPI). In other deflation scenarios, CPI can still increase slightly but other assets such as residential houses can have large price decline. Deflation can be linked to the decline of interest rates.

In a severe financial crisis in a deflationary environment such as the 2008-2009 financial crisis, prices of stocks and commodities can drop substantially. Even risky bonds that are often linked to equities (think high yield bonds and convertible bonds) can see large price decline.

Perhaps the most negatively correlated assets with deflation are the long term Treasury bonds (and long term investment grade corporate bonds). US Treasury bonds are often considered to be the safest bonds in the world. Long term bonds will benefit from deflation as their prices are more sensitive to the inflation (or deflation) interest rates.

In general, in a deflation environment, the longer the duration or maturity of a bond is, the better. Same also true for credit quality: the higher the credit rating, the better. In the credit spectrum, one can see the US government has the highest credit rating. Even though one might say this might not be true anymore as the government has been downgraded from the highest ratings but from the safety point of view, the US Treasury bonds not only benefit from the US government credit rating, but also from the US dollar's world reserve status. Second to the US Treasuries, investment grade corporate bonds are often considered to be safer (albeit less effective in a severe crash).

It is thus no wonder that in Harry Browne's original proposal, he used US Treasury bonds to cover the deflation corner. It is also evident that Yale's endowment manager David Swensen also uses (long term) Treasury bonds as insurance to hedge against a financial catastrophe.

In many portfolio management tools, bonds are all lumped into one bucket. In reality, one should clearly distinguish them into three or four buckets:

• Hybrid or equity like: high yield bonds, convertible bonds
• Inflation hedge: inflation protected bonds such as TIPS.
• Deflation hedge: high quality bonds such as Treasury bonds and investment grade corporate bonds.
• Currency or global bonds: international bonds (unhedged)

The last category is trickier and deserves more discussion.

Finally, we would like to bring your attention to our ETFs in Asset Classes listed on Advanced Users page. From there, you can find US Long Term Treasusry Bond table that lists several major ETFs.

Portfolio Reviews

The Goldman Sachs Global Tactical Asset Allocation is the basis of our Tactical Asset Allocation(TAA). The portfolio P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds ETFs listed on our Advanced Users page (all these portfolios are accessible by expert subscribers), hasn't done that well compared with S&P 500 index or even a moderate risk buy and hold portfolio for the past 1 year or so. However, the portfolio still has stellar long term performance as can be seen by the following chart (you can see that on the portfolio's page too):

Annualized Return(as of 5/7/2012)

We would claim that the portfolio lags but not out. In fact, we are very pleased with its recent positions that hold REITs and long term Treasury bonds, both of them are showing considerable strengths amid recent events. We have confidence that the strategy as well as the portfolio will still deliver its good long term performance in the years to come.

For more year by year performance, click on More Performance Analytics button on top of the performance table on the portfolio P Goldman Sachs Global Tactical Include Emerging Market Diversified Bonds ETFs.

Market Overview

This weekend's European elections further revealed how serious the situations in Europe are, both politically and economically. US REITs (VNQ) is the last one standing (see article Asset Class Trends: Only U.S. REITs Are Standing Strong). US stocks (VTI) are now just a hair the total bond index (BND) in the major asset class ranking table. The other three major risk assets (commodities, international equities and emerging market equities) are all ranked at the bottom again.

We again urge users to review their portfolios' risk levels. We don't know where the markets are going but it is prudent to be risk conscious at the moment.

See MyPlanIQ 360 Degree Market View for more details.

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