Philosophy and Strategy
There are many different types of fixed income instruments available: corporate investment grade, high-yield corporates, federal government, municipals, and mortgage-backed securities, to name the most common. Additionally, bonds can be issued with different maturities, some returning principal to investors within a few years, and some extending to 30 years or even longer.
Our bond portfolio will seek to invest in those instruments that provide an attractive return, but do so without taking on higher levels of risk. Higher levels of risk are generally associated with longer-term bonds when interest rates are currently low and deemed likely to go up in the future, as well as low credit quality bonds.
The portfolio will rely heavily, and at times exclusively, on corporate bonds (particularly investment-grade corporate bonds) when we deem them to be a superior risk-reward equation compared with bonds issued by the federal government. We intend to use government bonds, municipals, mortgage-backed securities, and other fixed-rate instruments in a tactical manner when they offer rates that are sufficiently attractive. High-yield corporate bonds may also be used to gain modest exposure to higher-yielding maturities, though the portfolio is unlikely to hold a large percentage of high-yield bonds, especially those of longer duration.
We’ll be widely diversified in terms of the total number of bonds the portfolio is invested in. The best way for us to achieve this is to use widely diversified ETFs issued from well-capitalized providers.
The philosophy of this portfolio is not oriented around taxes, which might be a concern in particular for higher-net-worth individuals and for some investors at or near retirement (municipal bonds can be used effectively by investors to get tax-free income). That said, we expect to manage the purchase and sale of ETFs along general long-term Foolish investing norms, and for there to be limited capital gains incurred within the strategy.
Portfolio Management Process
The overall portfolio is constructed based on top-down, rather than bottom-up, selection, with the primary considerations being current interest rates, the shape of the yield curve, spreads between corporates and government bonds, and spreads between investment-grade and high-yield corporates.
The portfolio will be constructed with a ladder of individual-year-targeted ("bullet"), low-cost, highly diversified ETFs, each of which holds positions in hundreds of individual bonds.
Corporate bonds will typically be held in a ladder of corporate bond ETFs, each of which is designed to correspond to the performance of investment-grade corporate bond indices. The indices themselves are designed to represent the performance of a held-to-maturity portfolio of investment-grade corporate bonds with effective maturities in one specific year (e.g. an index of bonds maturing in 2016).
High-yield bonds will typically be held in a similar ladder, though with fewer individual ETF positions, as the total exposure to high-yield bonds is likely to be more modest.
The portfolio is not restricted to holding fixed income instruments through ETFs but given the strategy of the portfolio, is unlikely at the present time to use other instruments.
No individual ETF is likely to make up more than 15% of the portfolio. As each ETF is composed of hundreds of individual bonds, no individual bond will be a meaningful position in the overall portfolio.
Exposure to any one publicly traded company’s bonds is unlikely to be very high. Exposure to a particular sector, such as financials, is likely to be significant.
Individual ETFs are monitored on a consistent basis to ensure that they are fully invested, and that the ETF is managed consistently with the description of the ETF in its individual prospectus.
Every month, typically at the beginning of the month, each ETF will make a cash distribution of the coupon payments made by the individual bonds into the ETF. These monthly payments are fairly small as a percentage of the portfolio. The distributions will be invested in existing ETF positions or to open an ETF position on an extended rung of the ladder.
Significant changes, such as selling out completely of an ETF position within the existing ladder, or significantly restructuring the ladder, will occur infrequently — though active portfolio management includes the responsibility to act on significant opportunities when interest rates move dramatically.
The value of investments in the Fixed Income Strategy may increase or decrease, which will cause the value of the investor's portfolio to increase or decrease. Investors may lose money on their investment and there can be no assurance that the strategy will achieve its investment objective and goals.
The principal risks inherent in this strategy are:
Fixed Income Risk in General
While often considered to be safer investments, fixed income securities do carry risks. Changes in interest rate levels generally cause fluctuations in the prices of fixed-income securities. So, if interest rates rise, the prices of these securities usually fall. The ratings or credit quality of such security (and that of its issuer) may deteriorate, which could negatively affect the market price. Depending on the features of the fixed income investment, other risks such as inflation and lack of liquidity, may affect its market value.
Unlike a conventional bond, whose issuer makes regular fixed interest payments and repays the face value of the bond at maturity, an inflation-indexed bond provides principal and interest payments that are adjusted over time to reflect a rise (inflation) or a drop (deflation) in the general price level for goods and services. Although inflation-indexed bonds seek to provide inflation protection, their prices may decline when interest rates rise and vice versa. If an inflation-indexed bond is purchased at a premium, deflation could result in a loss.
Municipal bonds can be significantly affected by political or economic changes as well as uncertainties in the municipal market related to taxation, legislative changes or the rights of municipal security holders, including in connection with an issuer insolvency. Municipal securities backed by current or anticipated revenues from a specific project or specific assets can be negatively affected by the inability to collect revenues for the project or from the assets.
Exchange Traded Fund Risk
When MFWM utilizes ETFs, clients will incur their pro rata share of the expenses of the ETF, such as investment advisory and other management expenses. In addition, clients will be subject to those risks affecting the ETF, including the effects of business and regulatory developments that affect ETFs or the investment company industry generally, as well as the possibility that the value of the underlying securities held by the ETF could decrease or the portfolio becomes illiquid. Also, ETFs may engage in investment strategies or invest in specific investments in which MFWM would not engage or invest directly.
ETF shares are listed for trading on a national securities exchange and are bought and sold on the secondary market at market prices. Although it is expected that the market price of an ETF share typically will approximate its net asset value (NAV), there may be times when the market price and the NAV differ significantly. Trading of ETF shares may be halted by the activation of individual or market-wide trading halts.
Please see Appendix B to our Investment Advisory Agreement for a discussion of additional risk associated with this strategy. A link to the Investment Advisory Agreement is provided at the bottom of this page.
Each Personal Portfolio is subject to an account minimum, which varies based on the strategies included in the portfolio. Motley Fool Wealth Management retains the right to revise or modify portfolios and strategies if it believes such modifications would be in the best interests of its clients, and we may modify allocations within a client's account subject to the constraints of each client's current risk score and objective. Clients should be aware that their individual account results may not exactly match the performance of the Model Portfolios.