Most people understand they should create a diversified portfolio by splitting their investments among various asset classes.   But what does that really mean, what are the different asset classes and how do they differ from one another?  Over our next couple of posts, were going to  provide an overview of the major asset classes, some of their fundamental properties and how they differ.

At the highest level, assets are typically broken into 4 categories: cash, fixed income, equities and alternatives.  Well cover each of these in turn.

Cash

Cash is the simplest and least volatile asset class.  Cash is typically held in checking accounts, savings accounts, money markets, CDs or T-Bills.  The key features of cash as an asset class are:

• Easy liquidity
• Low, but positive expected returns
• Poor protection versus inflation

Cash is great for very short-term goals or an emergency fund where you cant afford the loss of principal.  Since 1926, it has averaged a 3.5% annual return, slightly outpacing inflation.  However, for longer-term goals, particularly in todays low interest rate environment, we are not fans of holding cash in your investment portfolio.

Fixed Income

When people talk about fixed income, they are primarily referring to bonds or other debt instruments.  For an overview of how bonds work. check out our 3 part series on the topic.

The primary role bonds play in an investment portfolio is stabilization.   Over the long-term, bonds have returned about 5.3%, more than cash but less than stocks, and the bulk of that return has been in the form of the interest payments made on the bonds.  On the flip side, bonds are far less volatile than stocks but more volatile than cash.

Within the overall universe of bonds, there is a wide variance both in the risk and the expected return one can get depending on the type of bond purchased.  Well cover each of the major types of bonds in more detail, but first, heres a quick overview chart of the major risks each type of bond is exposed to.

Treasuries

The safest and most secure bonds are those issued by the federal government.  Backed by the full faith and credit of the United States, Treasury securities have very little credit or default risk.  As such, this is often the asset class investors flee to in times of trouble.  In the bear market of 2008-2009 for example, Treasuries were the best performing asset class.

The main risk an investor takes when buying a Treasury bond is interest rate risk.  As with all bonds, when interest rates rise, existing bonds decrease in price.  Given todays historically low interest rate environment, many experts are leery of buying Treasury bonds, particularly those with longer durations .

On the flip side, one of the primary goals of diversification is to buy assets that zig when another one zags.  The technical term for this is assets that have a low correlation.  The reason for doing this is to reduce the overall volatility in a portfolio.  No one likes to see their portfolio drop like a rock and extreme volatility often leads investors to make poor, emotionally-charged decisions that hurt their long-term returns.  Treasuries are a great counter-balance to stocks because of their historically low correlation .

TIPs (Treasury Inflation-Protected Securities)

TIPs are a special type of government bond.  They have all the same properties, good and bad, as regular treasuries with one important difference.  The effective interest rate you are paid is not fixed, but varies with the rate of inflation.  In an environment where inflation ends up higher than anticipated, TIPs will outperform a corresponding Treasury.  When inflation ends up being lower than anticipated, TIPs will fair poorly.  Since the odds of guessing right on inflation being higher or lower than anticipated is basically a coin flip, owning some TIPs in your portfolio is a good hedge against unexpected inflation.  Commodities and stocks, both of which we will discuss later, also tend to do well in inflationary environments.  To see what the market is anticipating for inflation in the coming year, simply compare the yield spread between a 10 year Treasury and a 10 year TIP.

The important thing to take away about TIPs is they are the only type of bond not exposed to inflation risk.

Municipal Bonds (aka Munis)

Municipal bonds are those issued by state and local governments.  The most interesting property of muni bonds is they are free from federal taxes in almost all cases.  This makes their effective interest rate higher than it might otherwise seem.  If you buy muni bonds from your home state, they are also free from state taxes.

On the risk side of the equation, in addition to interest rate risk, munis are exposed to a small amount of default risk.  Cities have gone bankrupt, with Detroit being the most recent example.  That being said, the historical default rate on municipal bonds is extremely low.  Moodys did a study covering all bonds issued from 1970-2011. and of the thousands of bonds that were issued, only 71 defaulted.  More broadly, munis are exposed to credit risk.  If you plan to hold a bond to maturity, this risk is irrelevant, but if your bond is downgraded, its value on the resale market will suffer.

The other risk many munis are exposed to is call risk.  Call risk is important because it affects your expected returns.  By giving the issuer the right to return your money earlier than you expected, you may be forced into cash at exactly the wrong moment, when interest rates are low.

To compare munis with other types of taxable bonds, you need to calculate the tax-equivalent yield.  Doing this is simple.  Take the yield on the bond and divide it by 1 minus your tax rate.  For example, say a bond is yielding 3.5% and you are in the 28% tax bracket.  You divide 3.5% by 1 minus 0.28 or 3.5/0.72 for a tax-equivalent yield of 4.86%.

Investment Grade Corporate

These are bonds issued by US corporations which are rated investment grade by the various bond rating agencies.  Interest from these bonds is fully taxable at your personal income tax rate, and the risks associated with these bonds are similar to those found in munis, just in greater quantities.  As a result, corporate bonds typically pay a higher rate of interest as compensation.

To reiterate, the primary risks in this asset class are:

• Interest Rate Risk. When interest rates rise, existing bonds will fall in price.  The longer the duration of the bond, the more it will fall.
• Credit Risk. A corporate bond could get downgraded, lowering its resale value if not held to maturity.
• Default Risk. Investment grade corporate bonds have a default rate of under 1%, but this is still much higher than the default rate on munis
• Call Risk. Many corporate bonds are issued with call provisions, which allows the company to pay you off early if interest rates fall.

To compensate investors for these risks, investment grade corporate bonds have historically yielded about 1.3% more than a comparable treasury.

Next Time

To hopefully keep these posts engaging and digestible, were going to pause here and continue our overview of different asset classes, starting with high yield (or junk) bonds, next time.