As advisors count down the short days of summer to an all but inevitable Federal Reserve interest rate hike, some are turning to fixed-income to prepare their ultra-high-net-worth clients for the increase.
Laura LaRosa, Glenmede Investment and Wealth Management's managing director and director of portfolio management, likes the high-yield end of municipal bonds right now. They are “very interesting picks with the right manager,” she said. “As a rule, we have been underweight bonds because the yields just have not been compelling.” The principal of the portfolio has to be protected, too, she added.
Most every government issuer's situation is unique these days, with credit ratings declining on some U.S. cities and states, including Detroit, Chicago and New Jersey.
“Investors don't want a manager that went long Puerto Rican bonds,” said LaRosa.
Tax-free munis are “the only area for true tax-exempt yields for our clients,” who have $40 billion in assets under Glenmede's management, she said. Assets are comprised of 28 percent family client deposits, with over $25 million and 43 percent foundations and endowments, for an average client balance of $55 million.
LaRosa expects a gradual Fed hike to affect the shorter end of bond durations. “I don't anticipate a rate rise across the curve. There is no inflation in the system and the dollar is strong.” Glenmede's average core bond duration is 4.5 years.
Cam Albright, who heads asset allocation at Wilmington Trust, is ready for a somewhat broader impact. “What happens in the Treasury market doesn't stay in the Treasury market,” he quipped. Muni curves price off its movements. If that yield curve flattens or rates move higher, there is a bigger impact on the shorter-term issues. “Duration positioning is really important,” he said. Income as opposed to total-return investors should not worry, he said. “They just need to be more defensive.”
Playing defense is harder since the financial crisis all but wiped out bond insurance, he noted. “People had a false sense of security,” said Albright, none of whose clients hold Puerto Rico bonds.
People used to insure bonds without thinking, but “those days are pretty well gone.” Now, “credit really does matter,” he said.
Covenants in bond offerings have grown critical. In a higher rate environment, massive “benefits that munis are not able to deliver become a much bigger problem,” said Albright. Citing Detroit and Atlantic City, he noted “people looking at getting cities on a better footing have not been very kind to bond holders. You don't want a situation where you're looking at bankruptcies protecting pensioners and taking it out on bond holders.”
Conversely, managers who know the difference between the debt profiles of stable Ann Arbor, Mich., and Detroit may find hidden diamonds for their clients.
A rate rise may also provide a teaching moment, advisors said. “We need to remind all clients about the basics of bond math,” said Leo P. Grohowski, chief investment officer and executive vice president at BNY Mellon Wealth Management. “A 2 percent rise in a low interest rate environment feels OK,” he said. “But when interest rates are this low, it doesn't take much of a backup in interest rates to cause a more significant erosion of principal.”
A solid single A-rated muni bond with a good 10-year credit outlook, however, will provide a higher yield than a 2.1 percent Treasury note—and unlike the note, the muni is tax-free, said Grohowski. Despite expecting more downgrades than upgrades, he would not avoid the asset class. “It just puts a premium on due diligence,” he said.
BNY Mellon is thinking past September to 12 and 18 months out—the period required to make its asset allocation decisions. In that period, the firm expects treasury bonds to be in “a coupon-minus return structure,” said Grohowski. During the bond bull market, investors have enjoyed a coupon plus principal appreciation caused by dropping interest rates. In fact, said Grohowski, "purchasing a 10-year U.S. Treasury note today at a yield just over 2 percent would actually produce a total rate of return approximately -3 percent if interest rates increase by 1 percent over the next 12 to 18 months."
Other securities, including equities, have some bond characteristics and could be negatively impacted by rate rises in the next year or two. Utility stocks could find their dividend growth challenged, Grohowski said, because utilities have to reinvest in themselves.
REITs, due to linkage to commercial mortgage backed securities and preferred stock, are sensitive to interest rates on mortgages. Master limited partnerships, “an area where high net worth investors have been active,” could experience a “double whammy” if rates rise and energy prices stay low, Grohowski said.