Figure 1 shows the average monthly yields on Treasury securities of different maturities, for August 2008 (prior to the rapid drawdown in stock prices) and February 2009.

Figure 1

It’s interesting to note that except for December 2008 and January 2009, the last time the 10 Year Treasury Constant Maturity Yield was lower than 2.87 percent was in February 1956!

The price of a bond moves inversely to interest rates, so as rates fall, bond prices rise – and vice versa. Longer-term bonds are more sensitive than short-term bonds to changes in interest rates.

Some observers have been saying that current Treasury prices represent a “bubble” that is likely to burst when interest rates rise. Some portfolio managers are advocating selling Treasuries and buying other fixed-income products such as corporate bonds or mortgage backed bonds.

We have been asked how our recommended bond portfolio is positioned for the current (and future) environments and whether or not we plan any changes to our recommended bond allocations.

Our philosophy

Before answering these questions, let’s first discuss Merriman’s philosophy regarding bonds in a diversified portfolio and then review our current recommendations.

Our buy and hold equity allocations are overweighted in value and small cap stocks, relative to the overall market. We expect this to increase long-term returns, although with additional risk. Because we rely on fixed-income funds to reduce the portfolio’s risk, we want to minimize the risk of this part of the portfolio.

Fixed-income risks

Bond investors face several kinds of risk. These include credit risk, interest-rate risk, inflation risk and prepayment risk.

By investing only in government bonds (Treasuries, Agency bonds and municipal bonds where appropriate), we eliminate most credit risk. While municipal bonds have some credit risk, their default rates are lower than those of similarly rated corporate bonds.

By avoiding longer maturities, we reduce interest-rate risk.

Inflation is the nemesis of bond investors, because inflation reduces the real worth of future payments. In order to minimize this risk, we recommend an allocation to Treasury Inflation Protected Securities (TIPs) in tax-sheltered accounts. The principal amount of these Treasury securities is indexed to the Consumer Price Index (CPI). As inflation increases, so do the principal amount and interest payments.

We do not recommend TIPs in taxable accounts since the increase in principal, which will not be received until maturity, is taxed each period, meaning that investors are taxed on income before they receive it.

We also recommend shorter maturity bonds to help guard against inflation. As these bonds mature, they are replaced with other bonds with presumably higher interest rates, to reflect the higher inflation rates.

Prepayment risk is when some of the principal is paid back unexpectedly before maturity. We seek to avoid prepayment risk by avoiding mortgage bonds. Non-callable bonds cannot pay back any principal before maturity. With non-callable Treasury or Agency bonds, when interest rates come down, the prices of the bonds increase. With mortgage bonds, however, as interest rates decline, some of the underlying mortgages will prepay, as borrowers seek to refinance at lower interest rates. This prepayment will lead to less of a price increase for mortgage bonds, relative to non-callable Treasury and Agency bonds, as interest rates decline. It also means that the investor has to reinvest the prepaid principal at a lower interest rate, relative to what they were receiving.

In what environments will interest rates decline? Interest rates may decline during recessions, economic crises, deflationary environments and times of decreasing inflation. In the first three types of environments, equities may perform poorly. In such periods, we believe that non-callable bonds offer better diversification than mortgage bonds.

So, while mortgage backed bond funds (especially those which invest in GNMA securities) have relatively attractive yields, we do not include them in our standard bond allocations. (We do include GNMAs in our optional bond allocation for tax-deferred portfolios with low equity exposure, discussed at the end of this article.)

Although we sacrifice some yield by not buying corporate bonds and mortgage bonds, we view this as a reasonable trade-off for maintaining a very safe bond portfolio which minimizes credit risk and prepayment risk.

Recommended bond allocations

Figures 2, 3 and 4 show our recommended bond allocations for three types of portfolios: tax-deferred accounts, taxable accounts without a state income tax and taxable accounts with a state income tax.

Figure 2

Figure 3

Figure 4

Each of these portfolios conforms with our fixed-income allocation philosophy.
-    No corporate bonds, to control credit risk.
-    Low exposure to longer maturity bonds, to control interest rate risk.
-    No mortgage bonds, to minimize prepayment risk.

The tax-deferred accounts include TIPs to help guard against inflation. The taxable accounts include munis, which have some credit risk but are tax-free. While that tax benefit is valuable, we also include an allocation to taxable Treasuries and Agencies to control credit risk.

To evaluate how these recommendations are positioned for the current and future environments, let’s use the tax-deferred bond portfolio. As mentioned, we have no corporate credit risk in the portfolio, which certainly helped this past year as investors fled to Treasuries.

With 30 percent of the bonds in one- to three-year Treasuries and with 50 percent of the portfolio in bonds with a maturity of five to 15 years, we are also limiting our interest-rate risk. Any increase in interest rates caused by an increase in the supply of Treasury debt or by an increase in inflation will be felt much more by 20- and 30-year bonds than by three- and six-year bonds.

With 20 percent of the portfolio in TIPs, which are indexed to inflation and 30 percent of the portfolio in short-term Treasuries, we believe the bond portfolio should hold up well during any future increase in inflation.

Finally, much has been written recently about the very low yields in the Treasury market, which have led to the closure of some Treasury money market funds to new investors. The DFA Intermediate Government Fixed income fund invests in both Treasury and Agency securities. As of 10/31/08, the latest date for which we have publicly available information, this fund was invested 65 percent in Agency securities and 35 percent in Treasury securities, allowing shareholders to benefit from the higher yield on Agency securities. At the same time, we maintain a 30 percent allocation to super safe short-term Treasury securities.

Tax-deferred portfolios that emphasize fixed income

Our general approach is to concentrate investment risk on the equity side of investing, because that is where the highest return potential is. Our bond portfolio is designed to mitigate the volatility of equities, and we believe it should emphasize high quality and low risk.

For portfolios with equity allocations of 30 percent or less, the fixed-income portion has some additional burden to produce return. In these cases, we may choose to use short-term Agency securities instead of short-term Treasuries and also to include GNMA securities. This gains some incremental expected return and incurs some additional risk. We recommend making this choice only after consultation with a financial advisor.

We are often asked if we are about to change our recommendations. In creating our fixed-income portfolios, we have invested a great deal of thought in choosing bond funds which will provide the right combination of safety and return for a given level of equity exposure. We believe we have found the right combinations, and no changes are planned.


Larry Katz is director of research at Merriman.