Watching interest rates is similar to monitoring Iceland’s volcanoes. After years of staying low, it’s inevitable they will flare up but difficult to accurately predict when and to what extent. Just as observers were attuned to recent alerts about the possible eruption and disruption of the rumbling Bardarbunga volcano, investors have been preparing this year for rising rates amid expectations of stronger economic activity.

Higher rates have yet to surface. At the start of 2014, the Wall Street consensus pegged yields on 10-year Treasury notes, then around 3%, to hit 3.44% by year’s end. Instead, 10-year Treasury yields slid in mid-August to a 14-month low of 2.34% and kicked off October at 2.42%.

“I always say that when everyone’s on one side of the ship, that’s when the ship is not going in the right direction,” says Mark MacQueen, co-founder and managing director of Sage Advisory Services Ltd. Co., an Austin, Texas-based registered investment advisory firm with $10.7 billion of assets under management. Approximately $9 billion of this is invested in fixed income.

“The market surprises this year for multiple reasons,” he says. The U.S. economy got off to a very weak start because of severe winter weather. Offshore investors have engaged in the tremendous buying of U.S. Treasurys, which offer yield advantages over debt issued by many Asian and European countries. There is also a smaller supply of Treasurys to purchase because the Federal Reserve has continued to buy them and because the U.S. budget deficit has recently shrunk significantly.

“It all kind of mixed into not a seller’s market but a buyer’s market,” he says.

During a recent annual Federal Reserve conference, the central bank’s chairwoman, Janet Yellen, said the Fed expects to complete its asset purchases program by October 2014 but hinted that it wants to see the labor market strengthen before raising rates. Many economists now expect a Fed rate increase—the first one since 2008—in mid-2015.

Sage anticipates that higher economic growth and inflation could push 10-year Treasury yields to the 2.5%-3% range by year’s end. This is barring a surprise such as a major stock correction or an outside event like the acceleration of a war or continued unrest in the Middle East or Ukraine, says MacQueen. He expects U.S. economic growth to get back on pace to 2.5% to 3%, noting that 2.5% may be more logical.

Spreads between Treasurys and corporate bonds are also likely to stay very tight for some time, he says, noting that tight spreads have made it tougher to make money for clients. To help cope with this challenge, Sage has been seeking out corporate issuers who have been in some kind of trouble that creates widening spreads.

“We’ve taken advantage of some of those situations, thinking that when they widened out they were more attractive,” he says. One example is BNP Paribas SA. In July, the U.S. Department of Justice slapped the French banking giant with an $8.97 billion fine for its transactions with parties subject to U.S. sanctions.

MacQueen cautions that some corporate credits are already fully priced with the tighter spreads. So when it comes to investing, “It’s more name-specific than it used to be, and you really have to do your homework on everything now.”

 Currently, Sage’s fixed-income allocations are 45% in corporate bonds, 22% in government and agency debentures, 12% in “AAA”-rated asset-backed securities (credit card and automobile loan receivables), 10% in commercial mortgage-backed securities, 8% in agency mortgage-backed securities and 3% in cash.

This year, the firm has slightly reduced its exposure to corporate bonds while increasing exposure to mortgage-backed securities. In agency mortgage-based securities, it is buying 3.5% and 4% coupon issues. “New production of these are a fraction of what the market anticipated, so they can outperform,” says MacQueen.

Sage continues to move out of higher beta names and into lower beta names—those with lower volatility than the market as a whole—because when corporate spreads do widen, the firm wants to have less spread risk, he says. Its fixed-income portfolio is overweight in the financial, utility and transportation sectors.

Within its government allocation, Sage has added some Treasury inflation-protected securities (TIPS) to hedge against the expected modest inflation. The company thinks the Fed may start tightening interest rates, at the earliest, in late 2015 to help curb inflation.

High-yield bonds are not held in Sage’s traditional accounts but are currently part of its core-plus allocation. Sage approaches the high-yield market through exchange-traded funds. Earlier this year, it swapped the longer-duration iShares iBoxx $ High Yield Corporate Bond ETF (ticker: HYG) for the shorter-duration Pimco 0-5 Year High Yield Corporate Bond ETF (HYS) to try to lower interest rate risk.

In general, the duration on Sage’s fixed-income portfolio runs 10% to 20% short of its benchmarks’, says MacQueen. That has hurt its performance this year, he says, but will be a benefit when rates rise.

All of Sage’s clients have some allocation to fixed income. “I say to my clients, ‘I can’t just decide I’m not going to be in the bond market because there’s nowhere else to be, and it is your safety net,’” he says.

Moderately Defensive
Atlanta-based Brightworth, a fee-only wealth management firm, currently has about one-fourth of its approximately $1.1 billion in assets under management allocated to fixed income. “We’re a little underweight to fixed income right now because of current low yields,” says Don Wilson, Brightworth’s chief investment officer.

Brightworth’s base-case scenario for the next several years—the one it thinks is most likely—is continued slow economic growth with some rise in interest rates, though nothing dramatic.

Still, one can’t rule out the possibility, Wilson says, of faster-than-expected economic growth (which could push up rates) or an exogenous shock—such as deteriorating conditions in China and Europe or escalating conflicts in the Middle East that affect oil prices. If a shock were to push the U.S. economy into a recession, Brightworth would expect interest rates to come down from current levels.

As for its investment strategy, “We’re a little defensive in our portfolios,” says Wilson, “but we don’t want to be so defensive that if we do stay in this low-yield environment we miss out.”

Brightworth’s fixed-income portfolio is divided into three buckets: core U.S. bonds (representing approximately 35% of assets), a flexible allocation to more unconstrained bond managers (35%) and a satellite piece (30%) that includes high yield, TIPS and international and emerging markets debt. The global portion provides some diversification protection against U.S. interest rate risk, he says.

Brightworth is allocating more to flexible bond managers than it has historically because the firm thinks rising rates could hinder intermediate core bond funds. One product it uses is the J.P. Morgan Strategic Income Opportunities Fund (ticker: JSOSX). “They’re trying to make money without just getting a tailwind from duration and falling interest rates,” says Wilson, who notes the fund goes long and short in different sectors and often holds significant amounts of cash.

In its core bond strategy, Brightworth uses the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX), a low-cost municipal bond fund, and for clients with tax-free accounts, the firm uses the Dodge & Cox Income Fund (DODIX). It also uses other products in its core bond strategy.

The firm works with approximately 450 clients—primarily high-net-worth individuals and families. Each client’s allocation to fixed income is based on his or her goals and objectives, time horizons and risk tolerance. The firm’s middle-of-the-strategy portfolio is 50% in stocks, about a third in alternative managers and about 17% in bonds. Brightworth has increased its use of alternatives as stock prices and valuations have risen and as the return expectations for both stocks and bonds have fallen, Wilson says.

The firm tries to keep the next five to six years’ worth of anticipated withdrawals in fixed income and cash so clients won’t have to touch or sell their stocks in a downturn, he adds.

“I haven’t heard of any clients who aren’t able to sleep at night because of their fixed income,” he says, “but this is not the time to be reaching for yield.”

Mad for Munis
Cumberland Advisors, an RIA managing $2.25 billion in separate accounts for high-net-worth investors plus additional assets in institutional accounts, is using federally guaranteed U.S. debt in “a very sparing and limited way,” says David Kotok, the firm’s co-founder, chairman and chief investment officer.

Cumberland, which is headquartered in Sarasota, Fla., and has a second office in Vineland, N.J., is inclined not to own intermediate and longer-term Treasurys since they currently have low yields and could suffer a decline in value amid somewhat higher interest rates. “I wouldn’t lend my money to the government of the United States at that interest rate,” he says, “so I certainly wouldn’t do it for my clients.”

The firm is using short-term Treasurys strictly as a parking place for cash alternatives, says Kotok, noting that it’s very likely cash will pay zero for the next six months. He currently favors three-year Treasurys for their yield advantage over two-year Treasurys.

The firm holds some high-grade corporate debt but is not emphasizing it because the spreads between corporate credits and Treasury credits remain very narrow. Cumberland doesn’t own junk bonds. Their recent widening spread over corporate bonds could, as history has shown, be a warning sign for stock market investors, says Kotok.

Where Cumberland is aggressive, he says, is in taxable and tax-free municipal bonds. They are cheap relative to Treasurys. The firm especially likes essential service revenue bonds—those that have a senior pledge off a revenue stream of a necessary utility or service. These include the bonds of sewer companies, airports and water utilities.

Cumberland holds a big position in taxable and tax-free bonds issued by the New Jersey Turnpike Authority. Kotok says these bonds offer attractive yields. “The New Jersey Turnpike is one of the strongest toll road credits in the U.S.,” he says. “What are you going to do if the toll goes up two bucks?” he says. “Get mad and take some other way [from Wilmington, Delaware] to New York?”

Utah also offers very solid high-grade credit and attractive yields, he says. The state’s public debt structure doesn’t allow issuance of new debt until old debt is paid off, its unemployment rate is very low, its economy is growing, its budgets are balanced and its funding levels for promised post-retirement benefits and other benefits and obligations are very strongly backed, he says.

Cumberland has five people devoted to researching Puerto Rico, whose credit has been downgraded to junk status. It owns some of the territory’s insured bonds but won’t touch uninsured ones. “Puerto Rico is not a place for the uninformed investor to go,” cautions Kotok.

The firm holds little non-U.S. fixed income because the yields are lower and the risk is higher overseas. And the firm thinks the dollar will strengthen as the Fed adopts a neutral monetary policy and gradually tightens rates and as the economy grows modestly.

Kotok says fixed income was a constant topic of conversation in July at Camp Kotok, his annual Maine fishing trip for asset managers and economists. “We had 58 people, which means you get 58 opinions,” he says. However, “There was agreement that circumstances are changing and that that’s global, not just in the U.S.”