Horizon Kinetics: Classifying Equities By Geography Is Old HatVW Staff
Conventional asset allocation is divided by security type: bonds and equities. Equities are further sorted according to market capitalization and, not infrequently, by geographic location. Major geographic subdivisions include domestic (U.S.), emerging markets, and Europe. In some cases, the latter two are further subdivided by nation. In the estimation of all, the emerging markets are considered inherently more risky than the developed markets. The contention of this brief essay is that this classification system is completely unworkable.
To illustrate, would anyone seriously suggest that purchasing the common stock of a company such as Bank of America would entail significantly less risk than purchasing the common stock of a company such as the United Overseas Bank of Singapore? I don’t believe anyone would make that assertion.
Similarly, let us compare two bonds. First, consider the Bank of America 6.5% due August 1, 2016 and, second, the Republic of Lebanon Sovereign Debt 9% due March 20, 2017. The two bonds have comparable, though not identical maturities. As of December 2, 2011, the yield to maturity for the Bank of America bond was 7.33%, or a small discount to par. As of the same date, the Republic of Lebanon bond was priced to have a yield to maturity of 4.91%.
The market’s risk assessment for those two pieces of paper does not correspond to the classification system currently embraced by asset allocators. The asset allocation building blocks cannot be utilized to assess risk, because the definitional categories completely ignore the market’s risk assessment. How can definitional categories of risk be relevant when the market’s own assessment of risk differs radically from those definitions, whether or not the market’s evaluation is correct?
Let’s say that an investor purchased shares of the iShares IBoxx $ Invest Grade Corp Bd Fd (NYSEARCA:LQD). It is reasonable to assume that this individual would not be seeking a very high risk profile. Nevertheless, that fund has a very high proportion of bonds floated by issuers such as Morgan Stanley (NYSE:MS), Bank of America Corp (NYSE:BAC), Citigroup Inc (NYSE:C),American International Group Inc (NYSE:AIG), et cetera. Most would agree those issuers do entail a certain degree of risk. LQD has a weighting of 35.79% in financial paper, mostly with issuers of that type. Its 30-day SEC yield is 4.01%, its yield to maturity is 4.33%, and its average maturity is 11.92 years.
The problem with LQD is that the issuers of the debt not only include the combination of those that probably entail very little risk and pay very little in terms of interest, but also includes issuers that might entail somewhat more risk and pay somewhat more. The table below lists the yield to maturity and the yield to worst in the event that it is called, of some of the paper held in LQD. This combination explains much about how the yield to maturity is actually derived. Even though it’s not proper to refer to this fund as barbell structured, in a loose manner of speaking that is an appropriate description. The ETF contains very high grade paper as well as some not so high grade paper, for a yield of roughly 4%.
In extreme circumstances, the buyer of LQD might actually be assuming much more risk than is suggested by the yield to maturity of the fund itself. However, the larger question is definitional. This ETF is a high grade corporate bond fund and, therefore, it is considered to be radically separate and distinct in terms of risk profile from an emerging market bond fund, but perhaps it should not be so considered.
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