Simple analogies can go a long way in helping clients understand complex investment strategies. For example, advisers looking to explain corporate bond portfolio construction to their clients can liken it to the anatomy of a sailboat. A well-constructed corporate bond portfolio has anchors that will keep it safe in a storm, a sturdy hull that will keep it afloat, and the correct sails for the conditions.
The anchors are bonds that are expected to hold their value in volatile markets.
In a typical retail corporate bond portfolio the anchors should be rated Weak-Double-A (i.e., AA- by Standard & Poor’s or Aa3 by Moody’s) or better with stable or improving outlooks, issued by large corporations (e.g., Fortune 500 companies), secured or fully guaranteed by an operating company with real assets, and have at least $500 million of principal outstanding. They should be the lowest risk bonds in the portfolio and be expected to generate the lowest total returns. They should account for at least 10%, but not more than 25% of a retail corporate bond portfolio – depending on the client’s risk tolerance and the portfolio’s ability to absorb losses.
The hull represents the core of the client’s portfolio and should be able to withstand small leaks, sturdy enough to survive rough seas, sleek enough to push through waves, and fast enough to get clients to where they want to go. The hull should typically account for at least 50%, but not more than 80% of a retail corporate bond portfolio.
The risk relationships between anchors, hulls, and sails are relative, so compared to the anchor example above, the bonds that make up the hull should be expected to generate higher returns and thereby carry higher risk.
Bonds that make up a hull should be issued by companies that are leaders in their industry, with businesses that are easily understood, have at least $500 million outstanding, be rated Strong-Triple-B (i.e., BBB+ by Standard & Poor’s or Baa1 by Moody’s) or better with stable or improving outlooks.
The sails have to safely propel the portfolio forward. These notes should have the highest potential returns in a corporate bond portfolio and are therefore riskier than the bonds that make up the anchor and hull. Clients may want to resist the temptation to reach for yield or aggressively take on credit risk -- or they could end up on the rocks and lose their principal.
When your client takes on too much risk and the sailboat (portfolio) is moving faster than is safe for the conditions, it takes only a tiny unforeseen wave to cause them to capsize. In general, individual investors should never own notes rated below Weak-Double-B (i.e., BB- by Standard & Poor’s or Ba3 by Moody’s). Let the institutional investors buy the riskier stuff; they can own dozens or even hundreds of different junk bond issues so a single default shouldn’t hurt them the way it could hurt your client’s account. Build the sails with mid-grade notes rated between Mid-Triple-B (i.e., BBB by Standard & Poor’s or Baa2 by Moody’s) and Mid-Double-B (i.e., BB by Standard & Poor’s or Ba2 by Moody’s or higher) with positive long-term outlooks, avoid buying issues with less than $200 million outstanding, and keep the sails between 10% and 25% of the corporate bond portfolio.
When the wind is at your back and the economy is strong, the sails can be a little riskier at purchase than they would be if we are headed into a storm. And, right now, there may be a storm "a brewin’." Looking at the U.S. corporate bond market it is difficult not to be concerned that the market might sell off when the Federal Reserve raises its target interest rate, when global interest rates rebound, or if commodity prices retreat.
When you’re facing headwinds and sailing into a storm that you can’t avoid, the smart move is to batten down the hatches, tie everything down that you can, lower the sails and head into the storm. Clients may not want to take down the sails completely, because the next few market disruptions may turn out to be relatively short in duration and portfolios will need some sail to continue to move forward. Before heading into the storm clients may want to have the right sails for the conditions, review the sails and not be shy about swapping higher risk notes for lower risk issues. Consider shortening the sails by swapping longer dated paper for notes with shorter maturities. In this environment, risk-adverse clients may want to avoid owning double B notes all together and stick to investment-grade notes (i.e., BBB- by Standard & Poor’s or Baa3 by Moody’s or better).
Today’s corporate bond portfolio should reflect the risk clients are willing to take on, and not just the returns they hope to generate. A well-constructed corporate bond portfolio can provide the stability and flexibility to help clients navigate both smooth and choppy waters, and bring them home safe.