pure
adjective \ˈpyu̇r\
- without any discordant quality; clear and true
- free from what vitiates, or pollutes
- containing nothing that does not properly belong
Pure Financial was founded to deliver clean, objective advice based on sound research and data. This philosophy permeates through all facets of our financial planning. Our strategies are not based on the latest fads, media opinions or forecasting hunches. Changes in our strategies must be rooted in logic and evidence. Our new fixed income models are a perfect reflection of this definition.
The entire basis of our investment philosophy is centered around 50+ years of time tested research. Forget about Morningstar ratings. We look to the world’s leading financial scientists to drive our investment strategy. However, as with any field of academic study, evolution in new research allows us to continuously improve and update our strategies. To that end, we are implementing a few upgrades to our fixed income allocations. Before we get into the details, I want to be clear that our investment philosophy remains unchanged. We use equities to pursue higher expected returns and our fixed income to mitigate total portfolio risk. Our fixed income allocations will continue to remain short-term and high credit quality.
In order to explain the change, here is a short primer on bond market basics. When investing in bonds, there are essentially two dimensions of risk exposure that allow investors to pursue returns. 1)Term Risk 2) Credit Risk. On the term dimension, there is a difference or spread in returns between shorter term bonds and longer term bonds. Essentially you are being paid for your exposure to the effects of interest rate movements (interest rates and bond prices are inversely related). The credit dimension pays investors for the risk of default. There is often a spread between the return associated with higher credit quality bonds and lower credit quality bonds. In other words, riskier companies have to offer higher returns to attract investors.
Our belief is that markets efficiently integrate news and expectations into prices. Therefore, current market pricing contains information to guide decisions regarding the allocations to term and credit and how it should vary through time. In the academic circle, this is known as a variable maturity and variable credit strategy. Research has shown that current yield curves contain reliable information about expected returns on fixed income securities. Most notably, Professor Eugene Fama’s 1984 paper, The Information in the Term Structure, illustrates the reliability in the time-varying nature of term premiums. This information can be used to dynamically vary the duration of a fixed income portfolio to target optimal term premiums.
Due to recent advancements in trade reporting, transparency and data collection, we can now offer a similar variable approach along the credit spectrum. Credit spreads vary through time based on investor risk appetite and changes in expected default probabilities. As a result, our portfolios can vary exposure to the credit risk factor in order to capture higher expected returns or to dynamically reduce risk when credit spreads are narrow.
So what exactly does this mean and why should you care? Our portfolios have always implemented the variable maturity approach. However with the latest research in credit markets, we can now offer a similar strategy along this dimension of risk. Rather than maintaining a constant allocation to credit risk (or term risk), our portfolios budget slightly more risk only when spreads warrant the investment. Remember however, we are still only investing in shorter term bonds with investment grade credit ratings. In a nutshell, we take incremental units of risk when we are paid to do so and reduce risk when we are not.
If you are anything like me, I like to skip to the conclusion… the following are benefits you can expect from changes in the fixed income portfolio.
- Broader diversification to government and investment grade corporate bonds
- Additional exposure and diversification benefits from global yield curves
- Advanced focus on risk control in client portfolios
- Continued exposure to short-term high quality bonds
- Enhanced portfolio design will reduce trading and rebalancing costs for our clients
