Bonds have more fun

Fort Pitt Capital Group has been managing asset-allocation portfolios of mutual funds since our founding in 1995.  We own fund portfolios for many of the same reasons we own individual stocks, including diversity of style, manager and company exposure. We also manage portfolios of funds in order to capture overseas growth and, in the case of bond funds, to reduce risk.

We recognized 17 years ago that the U.S. stock market was not the only game in town. So for clients with a longer investment horizon and/or a greater tolerance for volatility, we chose to participate in both mature and developing equity markets outside the United States. We wanted to go where the growth was. We sought the same qualities in overseas money managers that we’d found in domestic ones: a documented history of outperformance, and the ability to steadily grow principal over time. We built a stable of talented managers not only investing in, but often living and working in, foreign countries.  These efforts brought not only incremental growth to the portfolios, but greater diversification as well.

On the risk reduction side, we knew that leavening stock portfolios with (generally more stable) fixed income investments helps soften the bumps in the equity road. Voluminous academic research (plus years of experience!) shows that asset mix is the primary driver of investment returns. Over time, we have seen stocks generate the best returns, and should therefore account for the lion’s share of your portfolio. Equity returns don’t happen in a neat, linear fashion, however. Instead they come in a way that frustrates the greatest number of market participants.  Inevitably they prod investors to do exactly the wrong thing at exactly the wrong time. By diversifying into bonds and dampening the overall volatility of your portfolio, you reduce the odds of a rash decision, making it easier to hold on for the long run.

To absorb the bumps, Fort Pitt Capital currently utilizes four main “buckets” within the fixed-income class.  The first bucket is the foundation of the fixed income portfolio, with an allocation to an intermediate- term core manager investing mainly in investment grade corporate bonds. The second bucket seeks to add additional yield by allocating to an intermediate- term government manager that invests in mortgage-backed securities guaranteed by the U.S. taxpayer. The third bucket is a high yield manager that invests in corporate bonds below investment grade. The fourth bucket, and the focus of the remainder of this article, is a global bond category that looks for opportunities all around the world.

Fort Pitt Capital has included a slice of the global bond market in our asset allocation portfolios for well over a decade.  Simply put, international bonds are a good source of diversification away from U.S. fixed income. They provided higher risk-adjusted returns, as well as additional currency exposure. This began to change in 2009, however, as fears of a debt crisis emerged across Europe. Investors became concerned that countries in Europe’s southern tier would be unable to repay the money they’d borrowed since the Eurocurrency was instituted in 1999. Numerous rescue packages forestalled default, but the prodigious debts issued to finance these bailouts, along with slower growth, are likely to burden the region for years to come. Meanwhile, Japan was suffering debt and recession issues of its own, with the largest debt to GDP ratio of any major nation. One of the obvious concerns of a fixed income investor is the ability and/or willingness of a borrower to pay back what is owed.

In short, the European debt crisis and ongoing developments in Japan led us to consider dropping the world bond category as a viable alternative. The problem with the category is that so much of it is comprised of nations with serious fiscal problems. Japan, which has a debt/GDP ratio in excess of 200%, makes up more than 32.7% of the Citigroup World Government Bond Index, for example. The Eurozone makes up another 27.2%, and the United States comes in at roughly 28.2%. (through 9/30/12) source: Franklin Templeton.

Our dilemma: If we wanted investment returns that looked at all like the index we were measuring ourselves against, we were forced to own large amounts of weak Eurozone and Japanese debt. The large majority of world bond managers either choose (or are required by prospectus) to track the weightings of their index. This is because they’re compensated based on how they perform against the index, not absolute performance. Put differently, there’s far greater career risk in deviating from the benchmark and losing money, than sticking with the crowd and doing the same.

At Fort Pitt Capital, we’ve never been slaves to an index. Our history with the world bond category told us that it provided good diversification as long as we weren’t taking too much credit risk. So instead of dropping the category, we looked for experienced managers with strong long-term performance. The depth of the analyst team was also a key consideration, given the vast number of opportunities in developed and emerging markets. It was also important to pick a manager with the conviction to invest their own money alongside shareholders. Our analysis also included a look at expense ratios. Funds with high expenses have a high hurdle to overcome, which can be a detriment to long-term performance. In the end, we invested in a fund that looked for value anywhere in the world, with no restraints on country, currency, credit or duration.

The fund we chose, the Templeton Global Bond Fund, looks very different from its capitalization-weighted brethren.  This fund looks for value anywhere in the world, and has no restraints on country, currency, credit or duration. We believe this fund will serve our clients well.

by Denny Baish


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