Some clients don’t understand the dangers of a narrowly structured bond portfolio. Others understand the riskinesses of interest rate spikes and need a strategy to ally their fears.
Inadequate bond diversification—caused by an investor looking for bigger yields—means clients could be taking many interest-rate risks, officials of a big bond manager warned on Wednesday.
Given the potential dangers of volatile interest rates after a long period of stable low rates, clients should be using diversified floating rate bond funds, Delaware Investments officials said at a New York news conference.
Although they said that interest rates over the short term probably will not significantly rise, they warned advisors that now is not the time to lock in on fixed rates for the long term. Better to hedge or diversify a bond portfolio, said J. David Hillmeyer, a senior portfolio manager.
“A floating rate in a fixed-income portfolio makes a ton of sense right now,” Hillmeyer and other Delaware officials said.
Risk is a big issue as the Federal Reserve Board continues winding down its policy of creating new money, Hillmeyer added. “It seems to me that there is a much bigger list of unknowns than we were facing just a few years ago,” he said.
Back then, the unknowns were much less threatening to a client’s bond portfolio.
“It was much easier to address an unknown in the last few years when evaluations were at levels that offered tremendous deep discounts on bonds. Equities were also at levels we hadn’t seen for a years. There were a lot of knowns,” Hillmeyer said. But now valuations are much bigger, so a diversified floating rate bond portfolio is critical, Delaware officials said. That’s because some bond investors, who are relying on bank loans in a bond investment, can miss the potential dangers.
“There are issues that are introduced in the fixed-income market that can cause problems for investors that a lot of investors just don’t understand on the retail side,” Hillmeyer said.
Many retail investors, he said, misunderstand the nature of bank loan investments. They are not aware that the bond bank loan market is in the high-yield category, which means it is below investment grade.
“So in order to get that floating rate exposure in their fixed-income portfolio, they’re stepping out and taking high yield credit risk,” he added. But that may or may not be appropriate for an investor, Delaware officials said. The point, they added, is to diversify and not over rely on bond funds that are only using using bank loans. These often callable assets made sense when, four or five years ago, they were were trading at 60 cents on the dollar. Today, many of the bargains are gone, they said.
"Many of these funds are buying bank notes at par today or, in many cases, at above par,” Hillmeyer said. That’s an investment that could easily blow up today.
“I as the investor am in danger of buying a bank loan fund that I just gave a hundred dollars of my hard earned money and they bought a loan at 101 and I lose money on that loan in the form of a call the next day. That transfers wealth right back to the issuer in the form of a refinancing,” Hillmeyer cautioned.
The key to floating rate bond diversification is having a portfolio that includes numerous options, he added. These include municipal and U.S. Treasury floaters, foreign floaters and investment grade and high yield corporate floaters.
“By blending some of these asset types, active investors may create the means to better manage overall portfolio risk, including both interest rate and credit risk,” according to Roger Early, senior vice president, co-chief investment officer for Delaware Investments’ Total Return Fixed Income Strategy.
Derivatives, especially interest rate swaps, are now a tool managers can use. They are safer than they were six years ago, Hillmeyer said, when the market blew up. Derivatives can also be used to “hedge out fixed-rate coupons.” This diversification, Delaware officials emphasized, is critical to successful bond investing because it will mean the bond investor is less vulnerable to a sudden spike in rates.
Delaware officials were repeatedly asked if the central bank is going to raise interest rates.
“I don’t know if they are going to go higher or lower,” Hillmeyer said. “But I will say longer term they will go higher because the absolute level of yields tells you they are going to go higher for the most part.”
It is easy to stay with only a bank loan strategy and get more yield, he added. But that strategy could quickly run into problems. "When valuations are stretched, a diversified strategy is a good way to address a client’s concerns about rising rates,” he said.