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Changes to Our Fixed Income Strategy

Winter 2018

In late-December and early January, we made changes to the asset allocation of all bond-oriented client portfolios. Brief descriptions of our two new bond funds are below, followed by some history and background on our strategy:

DFA Five-Year Global Fixed Income Portfolio

The strategy seeks to cost-effectively target term premiums amongst higher quality, intermediate term bonds in developed countries and currencies. This fund invests in both U.S. and international bonds. As of 9/30/2017, exposure to U.S. bonds was 30% of the fund; the fund may shift a maximum of 100% of its allocation into U.S. bonds if that yield curve is the most attractive. The fund has constraints on exposure to non-U.S. bonds based on the country’s market cap weight (total debt outstanding) and 12 different currency curves. The allocation to any one country outside of the U.S. is also limited. This fund is hedged to the U.S. dollar.

This global bond fund is unique in its duration and its constraints on holding non-U.S. bonds. We like it for its exposure to 12 different currency yield curves, the variety of central bank policies, and its long track record.

Finally, this fund takes less risk than many intermediate term bond funds and will satisfy important diversification goals. From the first full month since inception in December 1990 to December 2017, the fund has outperformed its benchmark, the Citi World Government Bond Index 1-5 Years (hedged USD), by 0.65%.

DFA Investment Grade Portfolio

The portfolio offers a broadly diversified solution that seeks to maximize total returns through flexible, transparent, and measured exposure to government and investment-grade rated corporate securities. The portfolio may be considered a core bond solution managed within a systematic and well-defined process that is designed to capture term and credit premiums. As our fixed income objective is to outperform the Bloomberg Barclays Aggregate, this fund provides a systematic and reliable way to achieve this goal without taking additional risk. The fund’s maximum allocation to non-U.S. developed market bonds is 20%; as of September 30, 2017, the non-U.S. bond allocation was 12%. This fund will hold bonds with ratings as low as BBB (but not BB or B), and it holds no high yield bonds or long-term bonds (those with maturities of 15+ years). This is a broadly diversified fixed income fund.

Since its inception on March 7, 2011, through December 31, 2017, the portfolio has outperformed its benchmark, the Barclays US Aggregate Bond index by 0.28%.

History

We constructed our fixed income portfolios in 2010 to withstand a rise in interest rates, which could result in an expected drop in bond prices. Short-term bonds were added to our fixed income portfolios after the financial crisis ended, in anticipation of rising interest rates. Rates did not start to rise until the end of 2015. While there will likely be more interest rate increases, we are confident that our intermediate-term bond fund managers can effectively navigate the current environment. Therefore, we have added global bonds to all fixed income portfolios for diversification. This addition gives us access to 12 different currency yield curves and a variety of central bank policies. We believe in the diversification benefits of international investing to broaden our opportunity set.

The new global bond position in DFA Five-Year Global Fixed Income has replaced the short-term bond position. In fixed income portfolios, 20% of the bond allocation is in global bonds; the remaining 80% is allocated to intermediate-term bonds. We expect this change will increase the risk/return profile of our bond allocation, while maintaining our goals of volatility reduction and capital preservation.

During our review of the bond allocation, we also examined the funds we use to satisfy our intermediate term bond exposure. Our bond benchmark index is Bloomberg Barclays U.S. Aggregate Bond Index, and we seek to outperform it without taking on additional risk. Our new fund, DFA Investment Grade Bond Portfolio, is expected to help us achieve these dual goals.

Tax Considerations

The two new funds are not designed to manage around taxes. Getting the highest expected return is their first priority. Therefore, we hold these funds in tax-deferred accounts, if possible. We will continue to hold muni bonds in taxable portfolios to satisfy the intermediate term bond position, when appropriate.

Additional Considerations

For clients who are constrained by outside holdings via active retirement plans such as 401(k) accounts, we are using alternate funds. When muni bonds are appropriate to satisfy the intermediate term bond position, a second bond fund will be used so that a slice of the allocation will provide exposure to non-U.S. fixed income.

If you have questions about your specific situation, please reach out to us.

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