Diversification Strategies for Better Bond Upside

by Darwin on February 5, 2012

Fixed-income investments like bonds may have beaten equities (stocks) over the past 30 years, but there are few analysts who would expect the same performance over the next 30 years. Fixed-income investors benefited from perennially falling interest rates, which send bond values higher as interest rates drop (read more on bond strategies and how they work)

Anyone buying fixed-income today knows they may very well be buying into a bubble. There are a few specific risks with bond investments in the current market climate:

    1. Rising interest rates – Rising interest rates would send bond values lower. Thus, investors would have to wait years or even decades before selling an individual bond or bond mutual fund to avoid locking in the losses in a climate where interest rates are rising year after year.
    2. Inflation risk – It is safe to say that the current rate environment creates a considerable amount of risk to inflation. Corporate bond yields are only slightly higher than the official inflation rate figures released by the BLS. Of course, the CPI as reported is not always consistent with our own inflationary concerns. Medical care, food, energy, and education costs all rise consistently faster than the average rate of inflation for all goods.

A New Diversification Strategy

Investors have to take on risk to avoid watching their investments lose to inflation. While the certainty of certificates of deposit, AAA-rated corporate bonds, and US Treasuries is very alluring in an uncertain economic climate, these investments are certain only to barely exceed the rate of inflation, if not generate returns below the current inflation rate.

Investors know also that modern asset allocation theory suggests to investors that fixed-income investments are a necessity in a retirement portfolio. Fixed-income vehicles have traditionally been an investment for safety and certainty, making up more of a portfolio as an investor reaches their preferred retirement date.

My strategy provides for investors to lock in the safety of fixed-income vehicles while allowing for upside in excess of the stated rate of interest. Investors should go one step deeper in buying fixed-income investments. Investors should consider very seriously displacing their fixed-income holdings with insurance stocks.

The Beauty of Insurance Stocks

Insurance companies, especially property and casualty insurance companies, retain much of the premiums paid into the firm in a favorable bond/stock split usually of 90/10. That is, an insurance company with $10 billion in assets would hold roughly $9 billion of their assets in bonds, and $1 billion in stocks. This provides for the best yield with the least amount of risk.

In buying a share of an insurance company, you have ownership to their pool of investments. Thus, you have exposure to bonds, but with the upside on top. If the market softens and the insurance business dwindles, then at least you have the revenue stream from the fixed-income portfolio. If the insurance business becomes stronger, you allow for upside in underwriting profits and potentially rising yields.

Insurance companies usually have an average portfolio maturity date of 5-7 years in their fixed-income portfolio.

An Insurance Company Example

We’ll use Chubb (CB) as an example in this portfolio. The company trades for 1.2 times book value, which includes mostly the cash on hand as well as the portfolio of stocks and bonds that back any insurance claims. For every $12 of CB stock one purchases, they have claim to $10 of assets held by the firm. These assets are mostly fixed income investments.

However, because we get an insurance company on top of the investment pool, the company generates a rather significant return for investors. First, investors enjoy the 2.27% dividend yield, which is pretty good given the low interest rate environment. Secondly, investors gain from the underwriting business, which generates even more profits for the insurance firm without capital gains from the investment portfolio. The company trades for only 11.6 times forward earnings, an earnings yield of 8.62%.  If you don’t have a trading account now, here’s an optionsxpress promo.

Hedged Risk

Imagine for a moment that the economy grows, interest rates rise, and all is well again. A portfolio of bonds would drop considerably in value, but not in cash flow. Rates you locked in today would significantly lag the inflation rate, as well as the current market rate of interest.

With insurance holdings, however, you have upside to protect from falling bond prices. If the economy recovers, you own part of a business that enjoys much higher margins in underwriting and increased profits. So, while you do lose on the bond/equity portfolio backing the firm, the company generates more money from underwriting new insurance policies to displace and exceed market losses.

If the economy weakens further or continues to stagnate, then you own shares of own of the oldest businesses in the world that pays 2.27% per year on your investment, not all different from holding short-term corporate bonds or government securities.

There’s a reason that insurance companies make up the bulk of Warren Buffett’s success. Insurance companies are given, for free, the time value of the money that customers pay in through premiums. Investors who own the insurance company lay claim to this cash flow, while taking on only a very small amount of risk. Insurance is undoubtedly one of the best business models on earth – it’s a numbers game to pay out less than you take in.

I think insurance equities are a great substitute for bonds given the current low interest rate environment. Insurance equities are relatively inexpensive, under the radar, and yet still the source of some of the best returns over the past decade.

Written by JT from MoneyMamba.

Disclosure: The author does not have a position in any of the above firms at the time of writing.

{ 4 comments… read them below or add one }

Darwin February 5, 2012 at 6:40 pm

JT, love the philosophy and the strategy. I hadn’t really contemplated the reasoning behind certain investors’ love of insurance stocks other than the “value” when they buy on dips. Nice sector to consider I haven’t given much though to!

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JT February 5, 2012 at 7:26 pm

I think it’s one of the best “hands-off” sectors, especially if investors opt for P&C insurance companies, which have mostly known risks. I’m not such a fan of life insurance and pension companies, because predicting the future returns of the market is far more important for these firms than P&C. Buffett would seemingly agree with me, given that his insurance portfolio is mostly property and casualty (GEICO) or the reinsurance of property and casualty companies.

A single small cap insurance company makes up the bulk of my “fixed-income” exposure. This is a strategy for people who are mostly younger and who are not drawing down on their accounts, and can thus not care in the slightest about beta. I don’t care about beta, so I’m happy to displace fixed income with insurance equities.

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AverageJoe February 7, 2012 at 12:46 am

While I don’t agree that any stock is a “good substitute” for a bond, I will agree that in this climate I’m much more likely to add insurance company stock to my holdings than I am most bonds. Much better upside potential. I like the idea of insurance company stocks. Hadn’t ever considered this argument before. Nice post, JT.

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AAAMP Blog February 7, 2012 at 11:32 am

I haven’t owned a financial services stock in the Arbor Asset Allocation Model Portoflio (AAAMP) for years. Lately I have been looking at an insurance company to add to the portfolio. You have added several concepts I had not thought of and confirmed my inclination to continue my research. Thanks for another great article!
I have included this article in the “Best of Personal Finance Investing Blog Posts # 8″ for anyone interested at:
http://blog.arborinvestmentplanner.com/2012/02/best-of-personal-finance-investing-blog-posts-8

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