Wright Cove Capital: March 2023

March 30th, 2023

We understand that when most investors think about finance, they think about stocks first and foremost. Reading about hot stock tips is more exciting than risk management. There is a reason why we talk frequently about bonds, duration, and liquidity. While stock picks sell, understanding the implications and mechanics of the bond market has never been more essential to protecting and growing one’s personal investments.

To Review:

In October we wrote:

“We began the year cutting back on both duration and credit-risk across fixed income, now that short term interest rates have risen from near 0% to over 4%, we continue to rotate back into areas of fixed income that offer the most attractive risk-adjusted returns in years.”

In our Year End insights, we summed up the year in the bond market:

“…longer duration bonds are off by 25% or more whereas a portfolio of shorter duration Treasury Bills had positive returns on the year. Those who held onto the same generic bond funds or passive indices that worked in the past, saw double-digit losses in their fixed-income portfolios this year as interest rates rose.”

We bring this up not to brag about how we managed to get something right, but rather to emphasize what can happen when prudence is not taken. The events surrounding and leading up to the collapse of Silicon Valley Bank and the stress on the banking system these past few weeks will be discussed for years to come. Added information will surely arise, and the media and regulators will attempt to put blame on the executives and parties that were responsible for the collapse, but SVB ultimately collapsed because of a major miscalculation between the duration of their bond portfolio versus their liquidity needs. They invested deposits in safe, government guaranteed assets BUT they took a big risk (or bet) on longer duration bonds which lost significant value as the Fed raised rates. While the velocity of withdrawals from SVB was unique, (they catered to clients with assets well over the $250k FDIC limit) they were put into a position of weakness and were forced to sell assets at a significant loss – ultimately leading to the bank being taking over by the FDIC.

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Success in investing is about understanding the full picture and taking the appropriate precautions when circumstances change. We began talking about the potential effects of rising interest rates last year and now we are seeing in real time that the difference between being well capitalized and being liquid can make all the difference in the world.

Being able to meet potential liquidity needs as an individual investor is not the same as managing a bank portfolio, but many of the underlying fundamentals hold true.

Understanding what asset-classes are liquid vs being just “safe” is crucial to any investment plan.  Last year’s painful lesson for many individual and institutional investors being down 10-20% in their “safe” bond portfolio was also an excellent example of how safe assets can lose significant value in the short-term when interest rates change.

Liquidity risk is not easily learned about from a book or classroom.  Having to sell an asset below its “fair value” because of events beyond one’s control is a terrible feeling. While not every risk in life can be hedged against, having a plan in place and an asset-allocation mix that accounts for both short-term and long-term goals is paramount to success in investing.

Conversely, when practicality has been taken and liquidity needs are isolated from long-term investment goals, investors are able to take advantage of the volatility by adding to quality stocks and bonds when prices drop. By having a defensive mindset and not locking up capital in longer duration bonds, we have been able to take advantage of recent volatility by slowly reinvesting the proceeds from T-bill maturities into other sectors of the market – such as international equities, healthcare, energy, commodities, and short-dated inflation protected securities as we are not convinced that inflation will be easily tamed.

As we close out the first quarter of the year, our thesis continues to be overweight short-term treasuries. It has been a great place to ride out the markets over the past 12 months from both a risk and return standpoint. The modest positive return that T-bills have produced may not excite at cocktail parties, but they have outperformed both the S&P 500 (down over 9%) and the aggregate bond market (down over 4%) by a wide margin in the same period.

Longer term, we still contend that equities offer the best growth prospect and should be owned in a portfolio that seeks capital appreciation and growth over an extended time horizon – and we have begun to slowly increase our equity exposure. However, there remain warning signals throughout the financial system that we respect so we will remain vigilant before shifting to a more aggressive or over-weight risk sentiment.

Our task remains to balance the policies and rhetoric of restrictive monetary policy with the realities of global markets and current events. What has worked in the past is not working today.  Instead of waiting for things to normalize, we continue to look ahead with equal parts caution and opportunity to better position clients for success no matter which way events unfold.

We thank all our clients for their continued trust and support. We continue to define our success by our ability to listen, understand and achieve each of our clients’ unique goals. As always, if you have any questions or concerns – or believe someone you know would benefit from working with Wright Cove Capital, please free to reach out.

Regards,

Eric and Cass

Eric Leinwand, Principal – Eric@wrightcovecapital.com

Cass Tokarski, Principal – Cass@wrightcovecapital.com

The themes and strategies that we speak about and the positioning we take in portfolios are all customizable to best reflect each of our clients’ own unique goals and should not be interpreted as general investment advice.


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