Fixed Income-Core Strategy –Taxable Accounts

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Core Fixed Income Portfolio Recommendation for U.S. Taxpayers

In determining our fixed income portfolios, we document an investor’s need for fixed income exposure as part of a diversified portfolio (asset class).

We develop and manage fixed income accounts based each client’s specific circumstances within the context of our “macro- economic” and interest rate viewpoint,”- which we use as a guideline to providing management services to clients

In managing our client accounts, we move/transition assets or current holdings to our fixed income core (if applicable). We focus not only on credit quality but primarily on the components of a bond that we think are most critical:

  • Duration
  • Average Life, and
  • Yield

We also believe maturity structure and credit quality are important, just less so.

We are long term investors: as a result we do not modify or make frequent changes in this core fixed-income portfolio. If our interest rate expectations change substantially or we experience large shifts in relative value across sectors of the fixed income markets, we may make or implement changes in the composition of the core portfolio. For example, if our interest rate outlook were to turn long-term bearish, we would recommend shortening the core portfolio duration or average life slightly. Or, if yields in the mortgage-backed securities market were to rise substantially relative to other bond yields, we might recommend shifting some assets into that sector.

This is not to say that the core portfolio is intended as a “buy and hold” investment. At the very least, some trading will be necessary to maintain portfolio duration or average life, which, naturally, drifts downward as time goes by. In addition, we are prepared to take advantage of trading opportunities or to avoid pitfalls within the broad guidelines we use.

For example, an investor in a small and high-tax state might look for opportunities to swap out of bonds in their home state and replace those bonds with more attractive issues that become available.

Our Fixed Income Core represents our stable, long-term commitment to the fixed income asset class. It is not intended to place an upper limit on investments in the bond market. From time to time, various fixed-income market sectors offer investment opportunities that emerge and fade over various time periods that range from a few weeks to a few years.

For example, the high-yield corporate bond market has offered such opportunities at times in the past. In emerging debt markets may offer another opportunity. Such opportunistic forays into specific fixed income markets should not be seen as a substitute for the core fixed income portfolio. Investors should not raise funds to buy, for example, emerging market debt solely by selling bonds out of their core fixed-income portfolio. Rather, these purchases should be financed, for the most part, by shifting funds from other relatively volatile or “opportunistic” asset classes.

Core Portfolio: High-Tax State Resident

To illustrate how we would think about a client in this situation, we would adjust the client’s account to include 80% double-or triple-tax-exempt bonds/20% state tax-exempt U.S. government issues.

Core Portfolio: Low-Tax State Resident

For this client (illustration only) we think the clients bond allocation should be about 65% tax-exempt bonds
/35% selected among: Corporate bonds, Western European bonds (preferably currency hedged) and/or U.S. government issues.

Portfolio Maturity Structure

We recommend portfolio duration of about four years, with most maturities concentrated around 2015-16. This is because of our beliefs:

We believe investors seek exposure to the fixed income market as an asset class in a diversified investment portfolio. We also believe that the average or market duration of most of the worlds fixed income markets is a bit less than five years and that the average or “market” duration of most of the world’s major fixed income markets is a bit less than five years. With about 3.5-year duration over the course of a year, the portfolios sensitivity to interest rate changes will be more conservative than that of the asset class as a whole (i.e., the portfolio will begin the year longer than the market and end the year slightly shorter.)

We adjust the target portfolio duration in either direction to reflect our expectations regarding interest rates over about a one-year horizon. Because we expect rates to begin to rise over the next year, we have made and will continue to make substantial changes to the portfolio’s duration and shortened maturities: of course this can change.

Because we believe that it is somewhat more likely that the curve will steepen rather than flatten over the next year, we recommend shortening duration to protect principle.

Sectorial Diversification

Among investment-grade fixed income markets, municipal bonds provide, by far, the highest after-tax yield to U.S. taxpayers. Nonetheless, we recommend some diversification beyond the municipal market. Each bond market sector is exposed to its own “sectorial risk.” In the case of the municipal market, this risk is the threat that major tax reform legislation might reduce or eliminate the tax advantage of these bonds. We do not anticipate any action on a major reform this year, but we recommend diversification – even at the expense of after-tax yield – as a standard precaution.