The Safety of Safe

Market Notebook Image - Treasury squareFinancial markets have been particularly volatile in the last several weeks, with both stocks and bonds declining. This turmoil was largely triggered by Federal Reserve Chief Ben Bernanke’s comments regarding the eventual end of quantitative easing, as investors questioned the Fed’s credibility. As evidenced in 1994, a change in the Fed’s course can significantly disrupt markets.

Although U.S. stocks are still solidly positive as of late June, bonds have been hit very hard and are now negative for the year. May was particularly horrendous for fixed income investors, as rising interest rates prompted a -1.8% decline in the Barclays U.S. Aggregate Bond Index. So far in June, yields have continued to rise, pushing bond prices lower. These sharply falling bond prices brought the question to investors’ minds, “how safe is Safe?”

At Balentine, the purpose of the Safe building block is to protect capital by minimizing potential losses, to provide liquidity, and secondarily to generate yield. We are focused on controlling the risk of a sharp fall in price, and our Safe block is designed to limit negative volatility to 5% annually. Safe assets will not deliver positive returns in every environment, but remain a critical source of diversification and capital protection in an overall portfolio, especially for portfolios sustaining distributions.

The market’s newfound concern that stocks and bonds will decline together is a development we have expected. In a decision that turned out well, over the past three years we have significantly diversified our Safe building block. We intentionally moved away from traditional bond allocations, introducing diversification through inflation-protected securities, corporate credit, and foreign currency exposure. These steps also increased diversification relative to U.S. Treasury Bonds, whose market size has been driven by large increases in the federal debt.

Significant and potentially risk-enhancing changes in the core benchmarks were an important motivator for these steps. The Barclays Aggregate Bond Index, the most prominent bond index, now has near-record duration and lower credit quality. The Index is also less diverse, comprised of 37% U.S. Treasuries compared to 21% a decade ago. Given these changes and the potentially seismic shifts following a thirty-year bull market for bonds, we think now is the time for an even more creative approach that is less concerned with arguably flawed benchmarks.

Earlier this month, Balentine restructured Safe to reduce clients’ exposure to interest rate and credit risks. We did this by selling global bonds, TIPS, and intermediate-term corporate bonds. These exposures have been replaced with a core and satellite approach that limits risk and empowers managers to differ from the major bond benchmarks, yet under parameters Balentine has set for overall volatility.

As investors think about their own allocation to Safe, we urge them to ask three questions:

1. What is your duration risk? In other words, how sensitive will your bond holdings be to changes in interest rates?

2. Are you diversified across credit, inflation and currency risk? What percentage of your holdings are U.S. Treasury Securities?

3. What role is fixed income playing in your portfolio (yield or shock-absorbing)? As yields have gone lower, many have taken undue risk to reach for yield, truly calling into question the safety of safe assets. Care must be taken to ensure portfolio stock and bond positions remain uncorrelated, lest the shock-absorbing role of Safe becomes eroded.

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