Unless investors have been living on a deserted island in recent months, they have probably had some anxiety attacks over the bond market, which is facing its worst losses in decades. Bond prices fell sharply this spring after the Federal Reserve said it might taper its quantitative easing efforts sooner than expected. Speculation over how new Fed leadership next year will handle monetary policy has been rattling the bond market since summer.
But financial advisors aren’t pushing the panic button despite expectations of rising interest rates. Instead, they are shortening duration of bond portfolios to decrease interest rate sensitivity. They are also tweaking these portfolios in other ways to try to capture higher yields.
“We’re going from playing offense to defense,” says Mark Balasa, co-CEO and chief investment officer of Balasa Dinverno Foltz LLC (BDF), an Itasca, Ill.-based wealth management firm which manages $2.5 billion for approximately 800 clients.
Balasa sees no other choice. “If we sell bonds, where do we go?” he says. “A bad day with bonds is a couple-percent loss, but nothing at all compared to the risk on stocks.”
While the Barclays U.S. Aggregate Bond Index declined 2.84% this year through August 31, in 2008 stocks lost 30% to 40% depending on their asset class, he notes. Meanwhile, cash offers no return and real estate values could be impacted by rising interest rates, he says.
To prepare for higher rates, BDF has incrementally shifted its fixed-income asset allocations several times since the fall of 2012. “We’re telling clients they’ll probably have more changes in their bond holdings over the next two years than in the last 10,” says Balasa.
In late August, BDF boosted its allocation to U.S. corporate bonds (from 15% to 25%), developed foreign market bonds (from 15% to 20%) and high-yield bonds (from 8% to 12%) while reducing its share in government-related mortgage-backed securities (from 23% to 15%), U.S. Treasuries (from 18% to 14%) and Treasury Inflation-Protected Securities (from 12% to 4%). Allocations remain unchanged in non-agency mortgages (4%) and emerging-market debt (5% to 6%).
Clients are also getting exposure to floating-rate bonds—which sport low duration—that are included in BDF’s high-yield and corporate bond asset-class allocations.
BDF’s current fixed-income composite mix has a duration of 3.5 years, compared with 5.3 years for the Barclays U.S. Aggregate Bond Index. “Shorter duration is another step on the road to making a portfolio more defensive,” says Balasa, “but if you go too short too quickly, there’s no yield.”
He anticipates that through year-end, interest rates will be generally stable and the principal side will be fairly quiet as well. Over the next couple of years, depending on what the Fed does, “There will be pressure for higher rates, concerns about increased inflation, a slowly recovering economy and a need to be defensive with a bond portfolio,” he says. As for who succeeds Fed Chairman Ben Bernanke, “I think there will be differences, but not huge,” he says.
Meanwhile, BDF is trying to get ideas from “people who have an ear to the ground,” he says, including asset managers Pacific Investment Management Co. (Pimco), State Street Corp., BlackRock and the Vanguard Group.
Long, Erratic Uphill Climb
FAI Wealth Management (formerly Financial Advantage Inc.), a Columbia, Md.-based firm that manages $330 million for approximately 220 families, shortened the duration of its bond portfolio at the beginning of both 2012 and 2013. “That’s the best defense against rising interest rates,” says J. Michael Martin, the firm’s chairman and chief investment officer.
“Our expectation, and that’s a lot different than knowledge, is that we have seen the low point in bond rates and it’s going to be a long, erratic uphill climb,” he says. Namely, he sees a continuing struggle between monetary policy and real-world supply and demand for capital.
While the Federal Reserve and some other nations’ central banks will likely continue to manipulate currencies and supply and demand for bonds, global economic growth won’t be anything like its pace over the past 30 to 50 years, he says. A major deterrent, he says, is an aging global population that could slow down and even shrink workforce growth.
Martin isn’t worried about the Federal Reserve tightening rates. “I haven’t seen anyone tightening anything yet. It’s been loosey goosey for the last six years,” he says. “What they’re deathly afraid of is a repeat of the Great Depression,” he says.
Still, he thinks that inflation risk and credit problems associated with the huge increase in government debt over the last decade will put some upward pressures on rates. Lenders have begun demanding higher yields on municipal bond issues in Michigan since Detroit’s July bankruptcy filing, and other financially challenged states could potentially see similar situations. Furthermore, if the Federal Reserve stops buying bonds at its low overnight rate, the public will have to buy them and will demand higher returns, he says.
To shorten duration in the face of its concerns, FAI Wealth Management has made a number of changes to its fixed-income asset allocations. Its biggest move has been eliminating long-term corporate bonds, which had made up 10% of its bond portfolio, and switching these assets into floating-rate notes, which now comprise 24% of its total fixed-income holdings.
Earlier this year, the firm sold off its position in a bond fund it had owned for 25 years, the Loomis Sayles Bond Fund (LSBDX), which had a 5.5-year duration. It substituted it with the Eaton Vance Floating Rate Fund (EIBLX), which has a two-month duration. FAI Wealth Management also owns the John Hancock Floating Rate Income Fund (JFIIX).
The balance of FAI Wealth Management’s bond holdings are in mortgage securities (20%), short-term investment-grade corporate bonds (18%), investment-grade corporate bonds (14%), global bonds (13%) and multi-sector lower quality bonds (11%), says Martin.
For mortgage securities, FAI Wealth Management uses the FPA New Income Fund (FPNIX), which has a duration of two years. Its other funds and their durations (in years) include the Vanguard Short-Term Investment-Grade Admiral Shares (VFSUX), 2.4; the Loomis Sayles Investment Grade Bond Fund (LSIIX), 5.3; the Templeton Global Bond Fund (TGBAX), 1.6; and, for multi-sector lower quality bonds, the Osterweis Strategic Income Fund (OSTIX), 2.4.
Martin doesn’t plan to further shorten the duration of his bond holdings. “They’re about as short as they can go and still have a bond portfolio,” he says.
Bonds are critical to FAI Wealth Management since more than half its clients are retired. They comprise 58% of its asset allocation in its most conservative risk profile, designed for clients who use their portfolio for retirement income. Bonds make up 41% of its core or middle-risk profile and 23% of its accumulation profile, its most aggressive profile. The latter is geared mostly to younger clients who are still saving, as well as older clients who have a nest egg and are partially investing for the next generation. All three bond allocations, largely determined by the firm’s equity exposure, have been fairly consistent the past two years, he says.
From Belly To Barbell
Sage Advisory Services Ltd. Co., an Austin, Texas-based registered investment advisory firm with approximately $10 billion under management, has also been altering its fixed-income allocations. Until recently, it has focused on what co-founder and managing director Mark MacQueen calls the “belly” or the middle of the yield curve by buying a mix of three-, four- and five-year securities. It has begun to shift away from this strategy and is now moving its portfolios to a barbell allocation that balances longer-dated securities with very short-dated securities.
“To most, buying longer-dated securities is counterintuitive, but we create the same duration (interest-rate risk),” he says. “We believe this will be more defensive when the Fed starts tightening monetary policy.”
Why? As interest rates have risen, most of the increases have been in 10-year and 30-year bonds, he says. Since the yield curve is historically very steep, Sage believes that going forward the long end will adjust up less than the intermediate sector when rates rise. Meanwhile, bonds on the front end of the barbell have very little duration risk since their maturities are so short, he says.
Sage, which runs separately managed accounts using individual securities, is also overweighting its use of corporate bonds—particularly in the financial corporate sector. Major banks are still improving the quality of their balance sheets and getting their legal issues behind them, says MacQueen.
The firm is also adding to positions in AAA-rated asset-backed securities, commercial mortgage-backed securities and agency mortgage-backed securities. It thinks the real estate side of the equation looks very stable based on delinquency and occupancy data, and it thinks the real estate market can continue to recover, he says.
Currently, Sage’s fixed-income allocations are 22% in U.S. Treasuries and U.S. agency debentures, 48% in corporate bonds, 12% in AAA-rated asset-backed securities (such as credit card receivables and automobile loan receivables), 8% in agency mortgage-backed securities (like Ginnie Mae, Fannie Mae and Freddie Mac), 5% in commercial mortgage-backed securities and 5% in cash.
Sage is interested in the high-quality parts of the market, says MacQueen. “We think spreads have tightened tremendously,” he says. “Though not yet back to 2007 tight, they have recovered the majority of the widening caused by the financial crisis.”
Likewise, Sage believes that the other sectors of the bond market offer a better relative value compared with U.S. Treasurys and U.S. agencies. “You are being compensated appropriately for the additional risk,” he says, and “as the economy improves, these sectors should all benefit from better balance sheets and more security and certainty to bond holders.”
For each asset class, Sage uses products across the yield curve from short duration through long duration. “Within each product, I’m between 10% and 25% short of the benchmark from a duration perspective,” he says. “If it’s four years, I’m somewhere between 3.25 to 3.6 years of duration.”
MacQueen doesn’t expect a big increase in interest rates anytime soon. “We need to see higher GDP and lower unemployment for me to say we are going to see significantly higher rates in the future,” he says. “Ten-year notes I guess could go to 3.5% or 4% easily, but seriously, there are a lot of ifs before that can happen—meaning economic growth in the U.S. and globally.”
“Europe has kind of bottomed out, but they have a lot of work to do to fix themselves,” he says. “They’re much more intent on keeping rates low because they were late to the party of bringing them down in the first place.” He also notes that emerging markets growth has slowed, particularly China.
Martin of FAI Wealth Management understands client concerns about potentially rising interest rates. Keeping them calm “is probably our biggest challenge,” he says. “When you used to be able to get 5% or 6% nominal yield and now you get 3%, and then you get an increase in interest rates that knocks 2% off the value of your bond, you’re an unhappy camper.”
To help improve client communications about the current bond environment, BDF has developed a three-part Webinar, has sent letters to clients and makes this part of the agenda in client meetings. But ultimately the firm takes the cues from clients on how deeply to delve into these discussions. “Some want to know the details,” says Balasa, and “some yawn and keep moving.”