Taking Risk On The Equity Side

I decided to expand a bit on my answer to a very good reader comment on my Optimizing Investment Portfolio With Municipal Bonds article. The reader was wondering/arguing whether it made sense to pass over muni bonds in favor of CDs on the fixed income side (sacrificing ~1% in annual yield after taxes) and instead slightly increase equity allocation thereby taking risk on the equity side of the portfolio instead of on the fixed income side. I addressed the reasons for why I think munis represent good value even relative to the CDs (which themselves are easily better than the treasuries and probably corporates too) in my comment. But I didn't address the second part of the question, about taking risk on the equity side of the portfolio while keeping fixed income side perfectly (or as close to perfect as we can get anyway) safe from defaults by sticking exclusively with US federal government-backed holding such as CDs, I/EE-Bonds, and treasuries.

I think the notion of not reaching for yield and taking risk in equities instead is a reasonable one, but not all "reaches for yield" are created equal. Moving from, say, a 4-8 year average maturity to, say, a 25-year average maturity (while keeping average credit quality the same) changes the risk profile of the fixed income side rather dramatically. Instead of (roughly speaking -- remember to not read too much precision into any of these numbers) expected annual price fluctuations in maybe 4% range you'd be exposing yourself to fluctuations in maybe 15% range. And the "worst-case" scenario might go from, say, a 10% drop to, say, a 30% drop. Similarly, moving from investment-grade corporate to junk (while keeping average maturity the same) takes you from roughly 0.1% average annual default rate to around 4% with historical maximums of about 1% versus 10% defaulting in one year (see Moody's Corporate Default And Recovery Rates). Those are good examples of big reaches for yield that have a lot of potential to backfire if the market moves against you.

The situation is simply not the same in a more conservative reach for yield such as moving from treasuries/CDs to investment-grade munis -- or even to invesment-grade corporate bonds -- of the same maturity. As I noted in my response to the reader comment mentioned above as well as in the previous paragraph, the historical worst-case scenarios for investment-grade bonds are simply not very dire. Investment-grade munis never hit even 0.1% default rate in any one year. Investment-grade corporates did get to 1.0% default rate during the depths of the Great Depression. Given the yield spread of 1.0-1.5% between today's treasuries and investment-grade corporates I can certainly understand being wary of moving from the former to the latter. But roughly the same size spread is found between treasuries and munis, and that's well over 10 times worse that the historical worst-case scenario for any one year, let alone several years in a row.

Granted, price fluctuations will likely be more dramatic in a crisis than suggested by likely -- or even worst-case -- default rates. Everyone has different risk tolerance and for some seeing price swings in the "safe" side of the portfolio may just be too painful. The extra price stability of the treasuries and especially their potential to go up in value (which I think is somewhat overrated now, based on the 2007-9 events -- but that's a separate story) when everything else is crashing may be well worth their lower yield. CDs are even more attractive, with absolute price stability, safety equal to that of treasuries, and higher yield as things stand today. Which is why I don't think anybody investing exclusively in CDs is making any sort of  bad mistake. But for those who like to tinker and optimize, moving from treasuries (and from CDs in taxable accounts, especially at higher income brackets) into investment-grade munis provides a good way to squeeze a bit more yield with acceptably low -- in my opinion, of course -- level of additional risk.

What about keeping fixed income exclusively in CDs but allocating more to equities versus moving fixed income to munis and allocating less to equities? Obviously there is no way to put exact numbers on it since there are so many variables but let's make some guesstimates. Let's say equities are expected to return 8% going forward (in my opinion rather optimistic but not unreasonable) with worst-case scenario of 50% loss in value (very optimistic -- they lost 80+% during the Great Depression and over 50% from peak to bottom in the 2007-9 meltdown). Let's say CDs are expected to return 1% (after taxes) with, obviously no price fluctuation. Let's say munis are expected to return 2% (after a much-worse-than-ever-happened-historically rate of defaults!) with worst-case scenario loss of 10% in value.

A 50/50 CD/equity portfolio would then be expected to deliver 4.5% return with 25% downside. A 50/50 muni/equities portfolio would be expected to deliver 5% return with 30% downside in our "worst case" scenario. Let's adjust our CD/equity portfolio to match the 5% return of the muni/equity portfolio. That puts us at something like 42% CDs plus 58% equities with 29% downside. Do you see much risk savings here? And remember we rather optimistically and arbitrarily drew the line at 50% maximum downside for equities.

Ultimately all such arguments will boil down to our starting assumptions and to how much the future resembles the past. I, of course, happen to be partial to the set of assumptions laid out above. I feel they are quite conservative regarding eventual muni default rates (expecting them to be quite a bit worse than ever happened historically) and quite optimistic regarding equities returns and downside (8% nominal would equal historically-average 6% real with current inflation expectations, despite US equities being on the pricier side by measures like P/E10 and dividend yield). But your assumptions may well be different -- I appreciate any and all comments, including from those who see things very differently from me.