Building debt portfolios used to be easy. But it’s much harder now. These days, the debt side of portfolios should be absolutely secure and designed as three buckets. Tim Farrelly explains.
The debt part of a portfolio can have many, often competing, objectives. Security, regular income, liquidity, cash flow, high returns and volatility reduction are some of the more common.
We believe the primary role of the debt part of portfolios is to reduce the range of long-term investment outcomes of the overall portfolio to an acceptable level.
After we have set the appropriate level of secure assets in a portfolio, we can start thinking about meeting cash flow needs. Will we have the funds we need when we need them?
What might we need funds for? We should set aside funds sufficient to meet these cash flow needs.
Then, we can start thinking about returns. What debt assets give us the best returns (after first meeting security and cash flow requirements)?
Finally, we can turn to issues such as volatility, liquidity and income production. These are second order criteria. If we have managed the risk of long-term poor returns, volatility reduction can assume lesser importance in portfolio design.
Similarly, if we have set the portfolio to allow for cash flow requirements (both planned and unplanned), liquidity and income become of lesser importance.
Step 1 – Determine the split between risky and secure assets
Typically, this decision will depend upon an investor’s psychological tolerance for risk and their financial capacity to accept risk.
The end result should be a suggested allocation to secure or defensive assets.
For the purpose of this discussion, we will assume that the investor has a long-term allocation of around 60 per cent risky assets, 40 per cent secure assets.
Step 2 – Determine which fixed interest assets are secure and which are risky
It is important to be absolutely sure that the secure assets are just that – secure.
The role of the secure part of the portfolio is to ensure that the investor’s minimum objectives are met, even in the event that risky markets produce poor long-term returns.
We divide debt investments into secure debt – called tier 1 debt – and risky debt, described as tier 2 debt. Only secure debt securities should be allocated to the secure part of the portfolio.
Tier 2 Debt – an entirely valid and useful asset class – should form part of the risky allocation.
Step 3 – Three buckets
The cash flow reserve
Put aside sufficient funds to meet two years of living expenses.
For example, if an investor was in retirement and needed to draw 5 per cent of his/her capital base each year for living expenses, s/he would put 10 per cent of the overall portfolio aside in cash and short-term term deposits so that, at the very least, the next two years of living expenses were covered.
Given our hypothetical investor started with 40 per cent in secure assets, we now have 30 per cent left to allocate.
The asset allocation reserve
This ensures sufficient liquid funds are available to take advantage of opportunities that arise from time to time to buy assets.
If a dynamic asset allocation approach is used, the weighting to the asset allocation reserve will be very high when a bearish market outlook means large holdings in defensive assets, versus a near zero holding when at maximum weight risky assets.
If a strategic asset allocation approach is used, then just enough has to be put aside to ensure that there is sufficient cash to rebalance in the event that markets fall and buying needs to be done to re-establish the strategic weights.
Assume our hypothetical investor is at neutral weight risky assets right now, and is prepared to go 5 per cent overweight in the event markets appear very cheap.
They could hold about 10 per cent in the asset allocation reserve – around 5 per cent to re-establish neutral weights in the event of a market fall of 20 per cent and a further 5 per cent to go overweight should they wish.
The long-term debt portfolio
Whatever is left goes into the long-term debt portfolio. It is long term in the sense that we should expect it to remain invested for the long term, therefore the duration of the securities can also be very long term, depending on market conditions.
Furthermore, this part of the portfolio can be invested in illiquid assets if desired.
For our hypothetical investor, 20 per cent of their overall portfolio can be allocated to the long-term debt portfolio – being the 40 per cent overall weight to secure assets, less the 10 per cent allocations to each of the cash flow reserve and asset allocation reserve.
What securities?
For the cash flow reserve, assets must first and foremost be secure. After that, they must be liquid at the time the investor needs the cash.
At its simplest, this bucket could be invested entirely in cash.
Or, if it was invested 25 per cent in cash, 25 per cent in 180-day term deposits, 25 per cent in one-year term deposits and 25 per cent in 18-month term deposits, there would be sufficient cash coming due every six months to meet the next half year's living expenses.
The asset allocation reserve is a little trickier. Here again, assets must be absolutely secure and they must also be liquid so that when an opportunity presents, cash is available.
That said, if purchases are to be staggered over time, having a reserve invested in term deposits with maturity dates matching the times assets are planned to be purchased could be sensible.
The role of government bonds in the asset allocation reserve is interesting. They have been negatively correlated with equities for the past five years.
What better than having a reserve that increases in value and thus provides more dollars to spend when the assets we are buying have fallen in price?
The long-term debt portfolio has one major role – to provide long-term certainty to the overall portfolio. So again, it must be secure.
Where this bucket differs from the other two is that it does not have to be liquid. This is the ideal place for a range of securities that don't easily fit elsewhere in the portfolio.
Amongst assets that can be considered are cash, term deposits, long-dated term deposits, government bonds and CPI-linked government bonds.
All are eligible on the proviso that the assets are absolutely secure from a credit perspective.
We shouldn't mind short-term volatility in these assets if we are absolutely satisfied that we will get our capital back at the end of the term – because then, the volatility is essentially harmless.
Tim Farrelly is principal of specialist asset allocation research house, farrelly’s, available exclusively through PortfolioConstruction Forum.
