Allocation Risk Budgeting for Income Overview
By Jeffrey Dunham, Financial Advisor | Volume 2, Issue 2 (February 2014)
As The End of the Great Migration into BondsSM continues, fixed income investors may experience detrimental consequences to their bond investments as interest rates rise. For investors who depend on the distributions from their bond funds, the challenge will be maintaining a proper level of income while providing relative protection of their principal.
In last month’s issue of The Ultimate Estate Planner’s newsletter, we introduced you to a turnkey marketing campaign designed to allow financial advisors to focus on the vast assets currently held in bonds and investors with bond portfolios. We unveiled a program that provides FINRA-reviewed sales and marketing tools designed to help advisors possibly convert those prospects with bond holdings to clients. In this month’s issue, we will examine ways to show your bond prospects how you might manage the risk they are taking within their fixed income portfolios.
When investing in today’s market, it is important to set the proper expectation with investors. They should understand that it is extremely difficult to eliminate the risk from a fixed income portfolio and the more income the investor requires, the more risk they will generally face.
If you invest in short-term instruments such as money markets, certificates of deposit (CDs), or short-term treasuries, you may be running the risk of not keeping pace with inflation. When you stretch for additional yield, you are likely increasing either duration or credit risk. If you “lock-in” a yield from an investment like an annuity, you run the risk of future inflation surpassing the locked-in yield.
If it is difficult to eliminate risk, then you must manage the risk in a manner to maximize the overall distributions of the portfolio. This is the concept we refer to as Allocation Risk Budgeting for Income.
Allocation Risk Budgeting for Income recognizes that certain types of fixed income risks have low historical correlation to each other. A simple example of this is comparing duration risk with credit risk.
Over the past 20 years ended September 30, 2013, there have been eight periods where the 10-year Treasury yield has increased by 1% or more.
In those periods, the 10-year Treasury (duration risk) lost -7.66%, on average, while Floating Rate Bonds saw an average 11.57% return.
Therefore, Allocation Risk Budgeting for Income is the process by which a financial advisor determines the investment cycle that they believe we are in. Based on that, they decide which risks may be the most damaging to a fixed income portfolio (underweight) as well as the risks that have the potential to provide the best balance of lower risk and proper levels of income (overweight).
The three risks we suggest to consider are:
- Duration Risk: Interest rate risk found in investments like government bonds, international bonds and investment grade corporate bonds.
- Credit Risk: the possibility of default found in investments like high-yield bonds and floating rate bonds.
- Event Risk: Income dependent on specific events, do not occur. This is the risk typically found in event-driven investments.
Allocating portfolios based on the perceived risk in the current market environment allows you to diversify:
- Credit Ratings
- Global Regions
Most importantly, it allows an advisor to diversify where they are generating income for their clients. By diversifying these specific risks, advisors may generate income from investment grade bonds, high-yield bonds, emerging economies, international developed economies, bank loans, and event-driven events like mergers.
When experiencing markets similar to the one we are in now, if you underweight investment grade corporates and Treasuries in favor of high-yield and floating rate bonds, you have the added benefit of possibly increasing the amount of income the portfolio might generate.
To review this concept further, click on the link below to download a 2-page guide for financial advisors.
The End of the Great Migration into BondsSM is a Dunham & Associates FINRA-reviewed marketing campaign. Dunham & Associates is not responsible for its approval or use with clients. All materials that comprised this campaign must be reviewed by a financial advisor’s compliance department prior to custom branding or use.
This document is provided for informational purposes only by Dunham & Associates Investment Counsel, Inc. solely in its capacity as a Registered Investment Adviser and should not be construed as individual investment advice.
All examples are hypothetical and are for illustrative purposes. We encourage investors to seek personalized advice from qualified professionals regarding all personal finance issues. The solution for an investor depends on their and their family’s unique circumstances and objectives.
Asset allocation, which is driven by complex mathematical models, should not be confused with the much simpler concept of diversification. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Rebalancing may be a taxable event.
For Financial Professional and Broker/Dealer use only. Not for use with the General Public.
Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA/SIPC.
RELATED PRODUCTS & EDUCATIONAL MATERIALS
ABOUT THE AUTHOR
Jeffrey A. Dunham is Founder, President and CEO of Dunham & Associates Investment Counsel, Inc., a wealth management firm based in San Diego, California. Mr. Dunham is also Chairman and CEO of Dunham Trust Company based in Reno, Nevada, and serves as a Trustee, Chairman, President, and Principal Executive Officer for the Dunham Funds. Mr. Dunham’s investment expertise spans over 30 years, including building a private client book of business with High Net Worth and Ultra High Net Worth clients.
As an industry visionary, Mr. Dunham started what he believes is one of the only mutual fund families where 100% of its Sub-Advisers are paid based on their ability to outperform their stated benchmark. In Mr. Dunham’s view, performance-based Sub-Adviser compensation provides investors with a level of accountability that is as important today as when he founded the firm in 1985.
Wanting to expand the concept of asset management accountability nationally, Mr. Dunham altered his business model to one that allows financial advisors to invest in Dunham Funds on behalf of their clients.
Other innovations include creating a performance-fee based advisory wrap platform and a Nevada-based trust company that is designed specifically to work with financial advisors and their clients. In addition, Mr. Dunham has extensive experience in real estate investing and has managed private placement funds for investors.
Mr. Dunham earned a B.S. degree in Business Administration with an emphasis in Finance from San Diego State University. He holds FINRA Series 3, 4, 7, 24, 53, and 63 registrations.