I had a chance to read David Swenson’s “Unconventional Success, A Fundamental Approach to Personal Investment” recently. Swenson is the head of investing for Yale’s endowment.
This book was published in 2005 and does a good job of presenting Swenson’s thinking about investing before the market meltdown of 2008-2009. Before ’08-’09 he and his team created an enviable investment track record at Yale by investing in a variety of asset classes—many that had different performance attributes than U.S. stocks, but that also offered higher returns over long periods of time.
Although Swenson and his team invested in asset classes like timberland and commodities, the performance of Yale’s endowment during the melt down, however, was more like stocks than was expected. Yale’s endowment declined 24.6% ($5.6 billion) in fiscal year 2009 (7/01/08 through 6/30/09). Over the same time, the broad U.S. stock market – as measured by the Russell 3000 Index—lost 26.58%.
Swenson did lead the endowment to a solid recovery. The University’s longer term results remain in the top tier of institutional investors. Yale’s endowment posted average annual returns of 10.1% over the 10 years ending June 30, 2011, surpassing results for stocks, which returned 3.9% annually, and for bonds, which returned 5.1% annually.
Although somewhat out of date, the book gives Swenson’s insights about all aspects of the investment markets. One section that feels most relevant now highlights his thoughts about including corporate bonds in an individual’s investment portfolio.
Swenson doesn’t like corporate bonds because they have asymmetrical risks built into them. If a corporate bond is held to maturity, all that the investor can get for this investment is the coupon payments due and the principal returned. If interest rates decline, most corporate bonds will be called which will pay the investor a slight premium. Then the bondholder will have to go out and invest in another (lower paying) bond. Finally, the company could experience financial problems and the bond could become worthless. These characteristics give Swenson little reason to own corporate bonds. He sees very little upside and potentially a large downside.
Here is a little more information about the specific risks he sees with corporate bonds:
Credit Risk—Although the cash flow to debt ratios of most large U.S. companies have improved over the past two decades, the credit ratings of many of these companies have decreased. He thinks this is likely because two kinds of companies don’t take advantage of the debt market often–those companies that are relatively new and are fast growing, and those very large and successful (often highly rated) companies that have enough cash flow and other assets to internally finance their debt. That leaves the “middle-market” companies that need the financing but that may have higher levels of debt to their equity than these other firms.
Callability/Interest Rate Risk—Corporations frequently issue bonds with a call provision. This allows the issuer to redeem the bond if interest rates decline. If rates increase, the firm has locked in favorable funding for the bond until it matures. Swenson calls this a “heads I win, tails you lose” proposition because it favors the bond-issuing company regardless of the direction of interest rates—an asymmetrical result.
Liquidity—Compared to U.S. Treasury bonds, investment-grade (highly rated) corporate bonds offer yields that are slightly higher because of their less liquid nature. Swenson contends that these higher rates don’t necessarily pay for all of the additional risk that corporate bond holders take on compared to Treasury bonds.
Alignment of Interests—Shareholders of the stock in a company are helped when the value of the company’s debt obligations are reduced. Therefore, many corporate executives, whose compensation is likely tied to the share price, may make decisions which focus on the needs of the stock holders, and not the bond holders.
Swenson’s concept of the bond holder “having the deck stacked against them” seems all too important—especially in today’s very low interest rate environment.
This is reflected in Yale’s current asset allocation targets for the fiscal 2012 year:
- Private Equity: 34%
- Real Estate: 20%
- Absolute Return: 17%
- Natural Resources: 9%
- Foreign Equity: 9%
- Domestic Equity: 7%
- Bonds and Cash: 4%
Traditional publicly-traded stocks and bonds make up 20% or less of the Yale portfolio. It’s not that Swenson doesn’t like corporate bonds, he doesn’t much care for Treasuries or foreign bonds either. Unfortunately, individual investors don’t have the same access to certain investment opportunities that multi-billion dollar endowments do.
~ Allyn Hughes, CFP®, ChFC®, CLU® — Brooks, Hughes & Jones, Partners in Wealth Management — Tacoma, Washington