Fixed Income, Inflation And Deflation – Fire And Ice by David Merkel, CFA of Aleph Blog
This is a hard time to be managing fixed income. Yes, if you are at a big shop with access to deal flow, not so bad — but when you are small like me and have limited tools for a small client base (less than 10% of my assets are fixed income… smart people, because I am better at equity investing) it is really difficult.
Everyone knows interest rates have to rise. That is why I own long Treasuries. If the certainty level were truly that high, we would have sold off a lot more by now. As it is, oldsters, their intermediaries, and pension plans are investing in longer fixed income to provide long-term income. The need for income, at least for now, holds rates down. If price inflation kicks up, my view will change, and so might the view of millions of others.
I call that position “ice.” What will do well if the global economy goes cold? That’s 20% of the portfolio.
Then there is “fire,” credit risk in mild and stronger forms. 40% of assets in short investment grade bonds. 20% in bank loans. 20% in short-dated junk. What will do well if the economy expands? “Fire” will do well.
What I did wrong last year
My big mistake last year was owning emerging market bonds, both dollar-denominated, and local currency. That market fell apart after Bernanke uttered the word “taper.” I held, thinking there might be some recovery, only to sell in November, ahead of the first real taper.
I forgot what I knew, that immature/emerging financial markets are disproportionately sensitive to changes in monetary policy from developed markets. Michael Pettis’ book, The Volatility Machine, makes that point ably.
On the bright side, maybe I missed the second half of the losses. As for now, Fire and Ice is working, and providing returns to the small number of clients that use me for fixed income.