How Advisors Are Positioning Fixed-Income Portfolios in Advance of the Next Fed Rate Hike Slouching Toward “Bondmageddon”
March 17, 2015
by Bob Veres
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Most observers believe that the Fed will begin taking its massive foot off of short-term interest rates after the FOMC meeting in June. Nobody knows what will happen next: whether rates will rise dramatically or the bond community will respond with a yawn.
Earlier this year, I asked the readers of my Inside Information newsletter service to tell me how they’re preparing for this impending “bondmageddon” (as some alarmist pundits are calling it). The questions were simple ones: What are they investing in and why? What investment products or strategies will give their clients the best chance to emerge unscathed, and at the same time won’t create a lot of opportunity cost if there is no catastrophic rise in rates?
To date, I’ve received 178 pages of responses from advisors all over the country and across the spectrum, from indexers to fervent believers in active management, representing large and small firms investing on behalf of wealthy or middle-income clients.
The most interesting thing about the responses was that, with a few exceptions that I noted at the end, most advisors talked about the type of vehicles they were using to invest in fixed income, rather than the investment strategy itself. Many said they had been humbled after years of positioning clients for higher bond rates that never actually manifested. But the strategies they reported generally fell into two camps: 1) to stay short in anticipation of rising rates (for advisors who buy exposure through funds) or 2) build ladders where some bonds are maturing each year, and can be reinvested at higher rates (for advisors who buy individual bonds).
When it came to which vehicles they use, and why, the debate became much livelier and more interesting. Based on more than 100 responses, most advisory firms can be placed into one of five different camps.
1. Those who are out of bonds altogether
Count in this group Phil Taggart, of Taggart Financial Group in Houston, TX. He’s currently invested in income-bearing equities – convertibles, preferreds, closed-end funds, high-dividend ETFs and individual stocks that have a record of growing their cash payouts to shareholders. “None of these are truly free from the potential for disruption over the next two years,” he admits, adding that he’s waiting for the right time to get back into bonds.
Tresa Leftenant of My Financial Design in Bellevue, WA is using a hybrid approach, mixing preferred stocks with high-yield bonds that have a good credit history to give her highest-risk-tolerance clients a 4-5% distribution rate.
2. Advisors who use mutual funds for exposure
Lou Stanasolovich, of Legend Financial Advisors in Pittsburgh, PA was the most articulate spokesperson for a large minority of the people who responded to my request. He offered three reasons why he prefers funds over individual bonds.
Reason number one: pricing. “PIMCO suggests that each trade needs to be at least $1 million to obtain institutional pricing in anything other than Treasury securities,” Stanasolovich says. Others (as you’ll see below) have reported that it’s possible get bargains when you’re willing to buy small odd-lot packages of bonds, but selling them is a different story. “In the menagerie of muni bonds and corporate bonds, the bid price is often 15% or more below the stated price listed at the custodian, if there is a price listed at all,” Stanasolovich continues. “Given the small sizes of the typical advisor allocation and the complexities of each issue, this often results in liquidity problems.”
Second, Stanasolovich points to the bewildering variety of bonds and their shifting relative values. “Advisors simply don’t have the expertise or staff that mutual funds do,” he says, “to research high-yield bonds, variable and fixed rate agency and non-agency mortgages, bank loans, foreign developed market bonds in their home currency or hedged against the dollar.”
Third: Stanasolovich believes that if individual bonds are going to make up a significant percentage of client portfolios, the firm would need its own bond trader – preferably more than one, to ensure continuity if one of them leaves. “In order to justify this cost,” he says, “the firm would probably need to trade at least a few hundred million dollars in bonds annually.”
In contrast, any open-ended fund provides access the world of bonds, and the ability to sell out of the position instantly is a big plus over individual bonds. “The fund’s role is not only to provide expertise, but also liquidity to the investor,” says Stanasolovich. “That’s worth the small fee that the open-end fund charges.”
Stanasolovich says that his firm avoids ETFs and ETNs. Why? Suppose there is no market for the bond instruments in the ETF or ETN portfolio? When investors want to liquidate their shares, they will (at best) be hurt by the forced selling at fire-sale prices. At worst, the ETF has the option of delivering their money back in kind, and they may end up receiving the un-sell-able bonds rather than cash. “Furthermore, ETF portfolios are, for the most part, stagnant,” Stanasolovich adds. “Open-end mutual fund managers can take advantage of investment opportunities.”
Jeff McClure, who practices in Salado, TX, advises clients to have 18-24 months of cash and short-term fixed-income, as a hedge against having to liquidate equity positions in the middle of an unexpected market panic. So he wants maximum liquidity with his bond allocation. “In an emergency, the bonds you expect to hold to maturity will be in line for liquidation,” he says, “and if interest rates are higher five years from now, that equates to a loss.”
Dave Demming, of Demming Financial Services in Aurora, OH, spoke for a number of respondents when he said that he worries that individual bonds introduce non-diversified credit risk into his client portfolios. And he’s wary of hidden mark-ups where the dealers and brokers take advantage of small investors. “Do you honestly think we can buy a bond as cheaply as PIMCO?” he asks.
Lori Kaufman, of Kaufman Kampe Advisors in Mercer Island, WA, expanded on the lack of diversification issue. Unless a client is allocating tens of millions of dollars to bonds, she says, you end up with concentrated sector exposure. Beyond that, few advisors are prepared to do the credit research on individual holdings, or track changes in the creditworthiness of the issuers, which adds to the danger.
The fund management team, she adds, will also do a better job than an advisory firm of responding to the constant changes in the dynamic bond market environment. “The people hired by the good institutional firms are literally rocket scientists, who have the mathematical skills to create and interpret these models,” Kaufman says. “They can fine-tune their portfolio exposures in terms of duration, convexity, etc.”
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