Market Matters for September 16, 2014

Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts an audio segment entitled “Market Matters.” In this week's show, Scott discusses market neutral investments. He explains what they are, how they are expected to perform, and why they have had disappointing results. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.

Episode Transcript:

Daphne: Welcome to Market Matters, a weekly discussion about investing in today’s capital markets. I’m Daphne Feng and, as always, I’m joined by the Chief Investment Officer of Savant Investment Group, Dr. Scott Lummer. Scott, I was browsing the web, and I found an old column by you about bond investing. The quote I took from the column is “bonds are boring.” Do you still believe that?

Scott: That column is 15 years old. Let this be a lesson to all of you out there – what goes on the web, stays on the web. To answer your question, no I do not believe that bonds are boring.

Daphne: What has changed?

Scott: For one thing, 1999 was the height of the dot com boom. So any investment that didn’t have a potential of doubling in six months was boring. But more importantly, the reason bonds were boring is it didn’t really matter what type of bond fund you invested in. All types of bonds moved up and down together.

Daphne: Was that because of the internet boom?

Scott: No. Until the past few years, high quality bond asset classes, such as government bonds, mortgage backed bonds, and investment grade corporate bonds, had very high correlations with each other. For bond funds that didn’t invest much in high yield or foreign bonds, the only real variation between them was based on the average maturity of the bonds.

Daphne: And you’re suggesting that is no longer the case today?

Scott: No. Let me give you an example. Let’s look at all intermediate-term bond funds that existed in 2005– they’re about 200 of them. Let’s look at the range of returns in 2005 and 2013. I’m going to focus on the 10th and 90th percentiles of that range (to remove the extreme outliers). The difference between the 10th and 90th percentiles in 2005 was 1.4%. That difference last year was 3.4% -- more than double. That’s because the choice of what type of

bonds now makes a huge difference in returns.

Daphne: What happened to make the bonds diverge?

Scott: Two things. First the financial crisis caused all bonds to move in unpredictable ways. Then, as part of the recovery, the Federal Reserve started buying Treasury bonds, causing the yields to become very low compared to corporate bonds. So the spread between corporate bonds and Treasury bonds, which used to be relatively low and predictable, is now more volatile.

Daphne: How does this affect investors?

Scott: For one thing, it’s much more difficult now to choose the right bond fund, because fund

returns can vary by so much. Also, it means it’s now very important to diversify across types of bonds, to take advantage of the low correlation between bond asset classes.

Daphne: Has this affected the way Savant gives advice to clients?

Scott: Yes. Over the past couple of years, we have focused a lot on our bond research. We more broadly diversify our clients’ bond holdings, thereby bringing down the risk of their portfolios.

Daphne: Do you think this low correlation between bonds will be permanent?

Scott: No. The Federal Reserve has been tapering the buying of bonds. Over the next few years, I believe Treasury bond rates will slowly rise, and then stabilize. The spread between corporates and Treasuries should stabilize as well.

Daphne: That’s Market Matters for this week. Thanks to all of you for listening. Please join us next week Scott and I will talk more about the structure of bond funds.

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