You are what you eat?

The graph above says it all. It compares the yield spread between a Procter & Gamble corporate bond maturing in 2012 to a comparable treasury bond (same coupon and similar maturity). A positive spread occurs when the yield to maturity of the corporate bond is more than that of the treasury (which is as it should be). Lately, a certain number of corporate bonds have been priced with yields that are inferior to that of treasuries. This is an interesting situation because it means that investors perceive treasuries (backed by the full faith and power of the U.S. government) as being riskier than that of a corporate bond. Mind you, there are many businesses out there that have very clean balance sheets (at least cleaner than that of the Fed) and for some of them (we all know who they are), it is partially thanks to government intervention that they are in better shape.

The perception of risk is clearly shifting for government debt mainly because it has a large (and growing) inventory of the riskier kind of debt that is starting to take over a larger portion of their balance sheet. As the saying goes, you are what you eat!

Asset allocation insights...

We all know that the risk profile of a person changes with time. As a result, the tradeoff in allocation between riskier (equities) and less riskier (high investment grade bonds) assets should also change through time. Riskier assets are basically required so that the portfolio can grow in real terms (faster than inflation) but, over the short term, can prove volatile. Riskless or low risk assets, on the other hand, tend to exhibit far less volatility (much appreciated in down markets) but won't provide you much in terms of growth.

At a younger age, a more "dynamic" risk profile, defined as a portfolio with a larger allocation to "riskier" assets such as equities, is more appropriate mainly because the person in question typically has a job, which provides a steady stream of income into the future. In other words, the human capital in terms of income generation is much larger for a young person. As the person approaches retirement age, however, this steady stream of income is expected to expire as the human capital potential continues to decay steadily. Human capital is similar to a "bullet" type bond in the sense that a steady income is generated until "maturity". If we are to optimize portfolio, we need to adjust it for the human capital potential. Thus, at a young age, the portfolio allocation to equities should be significant, as the income is assured by the human capital. As the person approaches retirement, however, the human capital can no longer assure a steady stream of income and, hence, a larger allocation to fixed income becomes necessary.
It goes without saying that the shift from one risk profile to another should not be abrupt but progressive.

We can take this thought one step further and think of human capital containing an "embedded option" in the form of the individual's ability to change jobs (with potential repercussions on future income streams). Just like the human capital itself, however, the "embedded option" is subject to time decay. As we get older, our ability to change jobs diminishes. This would imply that as we shift to a more conservative risk profile, in addition to a larger allocation to fixed income, we may need to somehow account for the gradual loss of the "embedded option".

A lurking danger...

Bond yields have been steadily rising ever since the stock markets began rallying, right about a year ago. The reversal in trend was a reflection of the growing appetite for risk, following the market turmoil of 2008. The long end of the curve may also reflect anticipation of both inflationary pressure over the longer run and the gradual withdrawal of government support (such as quantitative easing) for the economy.

The problem with rising yields is that maturities on the yield curve are typically used as reference benchmarks to set interest rates for various industries. The mortgage market, for examples, typically looks at the 10 year segment of the curve to set the interest rates that will be charged to the home buyer. With recent economic releases suggesting weakness in housing, employment and consumption, a rise in the yield curve is likely to have an asphyxiating effect on the health and recovery of the economy.