Maintain A Proper Risk Profile
Devereux emphasized the importance of keeping risk in proper perspective within a fixed-income allocation.
For example, she said, many advisors have shortened the duration of their fixed-income exposure to reduce interest rate sensitivity. (Duration is a measure of a debt instrument’s sensitivity to changes in interest rates.) Lower-duration fixed-income securities typically have lower yields, so advisors try to fill in the yield gap by adding credit risk such as high yield or emerging markets.
This is strategy might look great on paper because riskier assets are expected to produce higher returns on average, she said, but this could produce a more equity-like fixed-income portfolio that may not respond as expected in an equity market correction.
"When equities tumble, higher yielding bonds, such as high yield and emerging markets, tend to have a similar risk-off action to equities, failing to provide the cushion that investment-grade bonds offer,” she said.
Devereux added that she’s not against trying to diversity bond exposure in an effort to generate more income for clients, but she suggests funding that from a portfolio’s equity allocation to remain in line with a client’s risk tolerance profile.
Harness Duration
Devereux said she often sees advisors shifting duration because clients expect it or even demand it. “Typically, we’ll see advisors stack portfolios at the short end of the yield curve because it might feel safe,” she noted, adding that such a move might have a negative impact on returns because it is mathematically proven that trading duration isn’t a reliable source of return.
“We suggest that rather than trying to time the duration market, you harness duration by constructing portfolios tailored to the appropriate time horizon,” she said.
She explained that rising rates can actually be good for bond investors if their investing horizon is longer than the portfolio’s duration.
“If that’s the case, the higher yields on reinvested cash flow can outweigh market price declines,” she said. “There may be some short-term pain, but your clients should be rewarded long term because coupons help cushion the blow no matter what the duration, and if you’re reinvesting the coupon payments for clients the rising rates over time will help deliver better results.”
Take Control
“Whatever strategy you use for clients, there are three things that are a must: low cost, risk management and skill,” Devereux told advisors in the audience. “How you implement the fixed-income allocation in your clients’ portfolios depends on how much and what type of control you want to have” whether that’s picking the investments yourself or hiring an outside manager to do it.
Advisors can get general exposure to the entire bond market via one or a few funds such as an index-based total bond-type ETF or a core, actively managed bond fund. And they can supplement that with a building-block approach enabling them to be active in sector rotation by overweighting or underweighting certain parts of the bond universe.
“You can also target duration in a precise manner, which can be done to help clients meet their needs within a specific time horizon," Devereux noted.
She added that some parts of the bond market, such as high yield or emerging markets, lend themselves to active management. Regarding active funds, Devereux stressed it’s important to work with an experienced manager with strict risk controls, and to be mindful of fees because it affects risk taking.
“High-cost active managers must take more risk just to reach their fee threshold before they can return a single basis point of return to their clients,” she said.