Conveniently for most, wealth tends to correlate with age. And with age comes a more conservative, pre-retirement portfolio.
Safety has always been a staple in a pre-retirement portfolio. The common balancing act is in the simple shift between equities (stocks) to fixed-income products (bonds and annuities). But what about savers who reach their goals earlier than average? Should conservatism always be tied to retirement dates, or is wealth a factor too?
Pricing Absolute Safety
If there’s anything good to come of financial crises, it’s that we have the opportunity to test ideas that have never before been tested. Japan’s lost decade(s) made it possible to test the idea of negative nominal overnight rates – the central bank effectively charged banks to keep funds at the central bank.
In the American Financial Crisis, it was possible to test the idea of negative nominal rates at the institutional level. In 2011, Bank of New York Mellon began charging .13% annual fees on cash accounts with balances in excess of $50 million.
Anyone storing their cash hordes of more than $50 million essentially paid for the privilege of keeping their cash safe and secure.
Going Negative with Returns?
It can be argued that investors in fixed-income assets – those seeking the safety of cash flows from debt securities – have accepted negative interest rates for most of the past four years. Inflation rates have varied, though 2% is roughly the average, while yields on debt securities on the short-end of the curve are yielding just over 1%.
The real question today is whether or not the wealthy, people who have sufficient wealth to retire, can afford to go negative with their savings for any meaningful period of time.
Is the value of safety truly a negative return?
Ben Graham always argued that wealthy investors had a problem misunderstood by many. Wealthy investors should never chase low-probability investments with incredible payoffs, but instead high-probability investments with much lower payoffs. The lesson: wealth does not give you opportunity to throw out a margin of safety on individual investments just because a larger portfolio gives you the opportunity for more diversification.
Swapping Stocks for Riskier Bonds
The best opportunity for those with sufficient wealth just might be in the high-yield bond space. Rather than simply move investment capital from blue chip stocks to investment grade debt like traditional advice might recommend, investors can swap stocks for junk debt. Arguably, junk debt is safer than a stock index but higher-yielding than AAA bond securities.
The net effect is a much lower price-risk portfolio in exchange for much more certain reward only a few percentage points lower than the historical return of the stock market.
The PowerShares High Yield Corporate Bond ETF (PHB), for example, yields an incredible return of 4.7% per year with the bulk (94% of assets) of the fund invested in bonds maturing in 3-10 years. Thus, investors encounter very little rate risk, and very high yields relative to other bond portfolios.
The real rate of return for investors is positive – inflation isn’t 4.7% per year – and swapping this fund in for stocks provides much more certainty insofar as volatility. The portfolio is very weakly correlated to the stock market, and it has, since the bottom in 2009, traded within a very thin trading range.
Accepting more credit-risk makes sense in this market where everyone is fleeing to safer assets, and stocks are anything but safe. Lower credit-quality bonds look like a much better bet than stocks for people who want to protect their asset from the two biggest threats: falling stock prices, or rising inflation rates.