In our last post, The ABCs of Asset Classes. we started to provide an overview of the different classes of assets an investor might want to hold in their portfolio.  As a quick refresher, we discussed the role of cash and some of the major types of bonds.  Today, were going to complete our coverage of bonds and then move on to the different classes of equities.

Fixed Income (aka Bonds)

High Yield (aka Junk) Bonds

Junk bonds are those issued by corporations with less than stellar credit, and like an individual with bad credit, there is an increased risk of further credit downgrades and ultimately default.  In addition, junk bonds can be more difficult to sell, especially in times of economic stress.   To compensate investors for the increased risks they are taking, junk bonds typically yield about 5% more than a comparable treasury bond.  However, the risk premium can vary dramatically in junk bonds over time.  At the height of the last economic cycle, the spread got down to 2.4%, and during the worst of the recent financial crisis, the spread approached 20%.

To simplify, high yield bonds are at the very riskiest end of the bond risk spectrum.  In times when the economy is going well, there will be fewer defaults and these bonds will provide good returns, but when the economy goes south, defaults will increase and these bonds will perform quite poorly.  Finally, because they offer a higher coupon rate than other bonds, high yield bonds are less sensitive to a rise in interest rates than other types of bonds.

MBS (Mortgage Backed Securities)

Mortgage Backed Securities (MBS) are a special type of asset backed bond created by pooling a series of residential or commercial mortgages.  They can be created by government agencies, like Fannie Mae, or by private institutions.  MBSs gained a lot of notoriety during the 2008 financial crisis as certain types of sub-prime MBSs were major contributing factors to the mess that was created.

MBSs are different from other types of bonds in one very important way.  Because  the payments are based on the underlying mortgages that have been securitized, you are getting both principal and interest back, with more of the money shifting to principal repayments as time goes on.  Mortgage owners can also prepay their mortgages.  The result of this is the cash flows on an MBS are more irregular and the ultimate duration of the security is not fixed.  Based on historical data, there is an assumed life expectancy for an MBS, but prepayments could affect the actual result.

The easiest way to think about this extra risk is as follows.  If interest rates go down, people are more likely to repay their loans early, which means you will make less money and have to reinvest the proceeds at lower rates.  Conversely, if interest rates rise, few people will prepay their mortgage and youll be stuck getting a below market interest rate.  As a result, investors need to be compensated with above average rates to take on this risk.

MBSs are very complicated (they could be a whole post of their own), so if you want more details, heres a good article that provides additional depth on MBSs .

International Bonds

International bonds are a newer asset class from a US investor perspective.  Simply put, they represent government and corporate bonds issued by other developed countries.  In many respects, they possess similar properties  to their US bond counterparts with a couple of significant differences.  The first is currency risk.  Because most foreign bonds are denominated in the local currency, as currency rates fluctuate, your ultimate return on the bond in US dollars is impacted.

The second difference is credit risk.  While many foreign governments have very low credit risk, the US is still considered the gold standard.  Look at activities in Europe over the past few years as an example of where major foreign governments have had debt issues.

The primary argument for including international bonds in a diversified portfolio is the same as the argument for international equities.

• Countries outside of the US now account for over 50% of the total market
• Different parts of the world do better at different times.
• You should hedge your bets by owning assets in different parts of the world

Emerging Market Bonds

Emerging market bonds are a subset of the international bond market.  As is obvious from the name, these are bonds issued by governments and corporations in emerging market economies, like China, Brazil and Turkey.  Like other international bonds, emerging market bonds are often exposed to currency and credit risk.  However, because these economies tend to be smaller and less stable, these risks are magnified.   The result is investors demand more yield than they would from a treasury bond.  The spreads have ranged from 2%-14% over the past 20 years with an average around 5%.  One other nice property of emerging market bonds is they tend to have a relatively low correlation with many of the other asset classes.  This makes them an effective diversifier for many portfolios.

Equities (aka Stocks)

Now that weve covered the major types of bonds, lets turn our attention to stocks.  Although most investors are more familiar with equities, there are still many worthwhile concepts to explore.  When breaking down the broader class of stocks, we usually do this in a couple of dimensions: market capitalization, geography and growth vs value.  In addition, most experts view real estate as a separate class.  We will cover each of these in turn.

Market Capitalization

Stocks are often broken down into 2 or 3 buckets based on the size of the company.  When broken down in to 2 classes, they are referred to as small cap and large cap stocks.  If a third class is added, it is referred to as mid cap.  A couple important things to note.  First, the size of the company is determined by its stock market value, not its revenue or profits.  Thats how a company like Twitter can be a large cap stock even though its revenues are tiny.  Second, while there is no rigid agreement on the exact cut-off that defines small, mid and large cap, the rough boundaries are as follows.  When broken into 3 classes, small caps are those under $2 billion, mid caps from $2 billion to $10 billion and large caps are those over $10 billion.  When just 2 sub-classes are used, small caps are those under $5 billion and large caps are those over $5 billion.

Why do people bother to break stocks down by market cap?  The primary reason is stocks with different capitalizations have been shown to exhibit different behaviors over time.  Specifically, small cap stocks have provided about 2% higher returns than large caps over the long run.    The most famous research study on this topic was done by 2 professors, Eugene Fama and Kenneth French.  Their 3 factor model   explores how size and style selection (growth vs value) impacts returns.

If you buy a typical total stock market index, say the Russell 3000, your performance will be heavily driven by the large cap stocks in the index.  This is because the index is weighted by market capitalization and huge companies like Apple, Exxon and Walmart dominate the index.  When people talk about devoting part of their portfolio to small caps, they are trying to capture the small cap premium by over-weighting the amount of money they have in small caps compared to what they would get if they just bought a total stock market index.

Next Time

In our third segment on asset classes, we will pick up the discussion with why one would consider adding international stocks and value stocks to their portfolio.