Philip Baker has been a bond investor for five years. His returns on bonds through his SMSF have been better than expected. He has a unique approach to investing that may help you with your own portfolio allocation.

Philip Baker, shown here with wife Mary, has been a bond investor for five years. Here he tells his story to Elizabeth Moran

Elizabeth – Philip I understand you are a published author, although not the Philip Baker that is a journalist for the Australian Financial Review.  

Philip – Yes, I write for a few electronic financial publications including: “Fair Value Online” and US publication “Seeking Alpha”.  I wouldn’t call myself a journalist though. [See the end of the note for a copy of Philip’s most recent article]

Elizabeth - I’m interested in hearing your bond story; can you tell how you first started?

Philip - In early 2011, I set up a self managed superannuation fund. I wanted to invest in assets that were stable and secure but paid a reasonable return. At that time you could get 8 to 9% in investment grade bonds. Term deposits were paying about 6 to 6.5% and for what I thought was a little higher risk I could get the extra return.

I attended a FIIG Seminar and was really impressed by a graph that showed in the ten years since 2000, bonds yielded the same as equities but with 28% of the volatility.

I had thought that bonds were less volatile and had lower returns but was surprised that they showed close to equity returns without the volatility.

At that point I invested 100% of my portfolio in bonds. I then left full time employment and I continued to put more money into bonds.

Elizabeth – Has your bond portfolio lived up to your expectations?

Philip - I think of bonds as ‘unsung heroes’. They’ve been ‘unloved’ and not talked about in the press but the returns on my bonds have pretty much lived up to my expectations.

The income provides comfortably for me and my family with something to spare. My net worth has grown since I started investing in bonds.  

The bull market over the last five years has helped and I have to say, I’m very, very happy, although I’ve reduced my bond holdings to 80% as I’ve found a small allocation to shares has improved my returns.

On the back of an envelope, and with the limited resources available to me, I had a look at hypothetical portfolios of bonds (proxied by the S&P ASX Corporate Bond Index) and equities (proxied by the ASX 200 index, with 4% dividend yield added - I couldn't get my hands on an Accumulation Index). I calculated the 5-year annualised compound return and volatilities (based on daily data) with the results shown in the table below.

The 10% equity portfolio is the one that maximizes the return/volatility ratio.

One the biggest benefits of bonds is that they are low maintenance and I haven’t had to worry. There hasn’t been any massive swings in the valuations. Pretty much each month, the value of my holdings has gone up.

Elizabeth – Have you traded your bonds or been a hold to maturity investor? 

Philip – I’ve mostly been a hold to maturity investor. I have traded my Sydney Airport bonds and some Royal Women’s Hospital bonds that I had picked up at good prices. 

I would call myself a ‘value investor’, so I look for where I think there’s value. My theory is to look at the yields and if they seem too high for the credit, buy them at the time. Theoretically the yields should compress and deliver higher bond prices.

Portfolio Allocation: Combining Equities, Corporate Bonds And Leverage To Maximize Risk-Adjusted Returns

Mar. 1, 2015 7:52 AM ET  |  1 comment

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Summary

• Frequently investors and advisors use the portfolio split between bonds and equities as the primary means of varying portfolio risk.
• A more efficient outcome may be achieved by leveraging the portfolio (depending on the investor’s borrowing cost) or reducing the long run allocation to cash.
• For portfolios with 100% corporate bond allocations, a higher return and lower volatility may be achieved by making a small (10-20%) allocation to equities.

The last five years have seen a bull market in both US equities and corporate bonds. Over that period, the compound annual total return (capital growth plus dividends) from the S&P 500 was 16.25% with volatility of 15.92%. For investment grade corporate bonds, the return was 6.25% with volatility of 4.56%.

Because of the way bond returns correlate with equity returns, the lowest risk allocation was not 100% to bonds (as the above might at first glance suggest), but 15% to equity and 85% to bonds. That portfolio had a volatility of 3.62%, 20% less volatility than the 100% bond portfolio. The equity weighting allowed a higher return, at 7.93%, 26% more than the 100% bond portfolio.

The portfolio having the highest return per unit of volatility had an allocation of 20% to equity and 80% to bonds. Return/volatility for that portfolio was 2.27 times, compared to 1.02 times (100% equities) and 1.37 times (100% bonds).

The possibility of leverage adds further potential to improve the return/risk tradeoff, subject to the borrowing cost.

If we can assume an institutional investor with access to funds at around the investment grade corporate bond rate, we have a borrowing rate of 6.25% for the five-year period. (This is also probably not too far away from the cost of borrowing against equity in real estate over that period).

At 6.25% borrowing cost, it would have paid to lever the portfolio with some debt, rather than increase the allocation to equities, if you wanted to take more risk. At 70/30 equities/bonds without leverage, the return would have been 13.54% with 10.65% volatility. If you were happy to accept 10.65% volatility, you could have achieved a return on your equity in a leveraged portfolio of 13.91%, or 37 basis points higher than without leverage and with the same risk. The portfolio would have had 42% equities, 58% bonds and leverage (borrowings to total capital) of 43%.

This analysis is pre-investor taxes so does not take account of individual tax rates on dividends, interest income and capital gains or tax deductibility of borrowing costs.

Asset allocation today

Given the strong upswing in US equity markets over the last five years, we should look to long run returns, to which returns over the coming years could be considered likely to revert, when framing allocation and leverage strategy going forward from today. The real return to US equities has been around 6% over the last 100 years - we would add 2% inflation to give an estimated nominal return of 8.15%.

For bonds, we are inclined to use the current 20-year A-rated bond rate of 3.77% as an estimate of the long run corporate bond return going forward.

For borrowing costs, we have 3.8%, being the A-rated 20-year borrowing rate and also the 20-year mortgage fixed rate.

We have used the volatilities and correlations found in the last five-year analysis period.

The left hand panel in the table below shows the portfolio returns and volatilities of a range of allocations between 0% equities and 100% equities. The right hand panel (under "Optimized") shows the returns when the allocations to equities, bonds and leverage are optimized so as to give the highest return for the volatilities shown in the left hand panel.

The table confirms the findings from the analysis of the last five years. A small allocation to equities will both lower the risk and increase the return of a portfolio comprising 100% bonds. At higher desired levels of risk, a higher level of return can be achieved by leveraging the portfolio than by increasing the allocation to equities.

The benefits of leverage are sensitive to the assumed borrowing rate. Indicative quotes for margin loans for $1 million+ portfolios are at the time of writing around 6.25% - at that level there would be no gains from leverage given the equity and bond returns assumed in the table above.

Conversely, an investor can achieve the effect of leverage analyzed in this article by decreasing the allocation to cash. In that case, the "borrowing cost" would be the interest rate on cash forgone, which would be well below the borrowing rate assumed in the above table. The "Optimized" returns in the above table would be correspondingly higher.

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