As investors await the next interest rate increase, bond experts have buckled themselves in for what they expect to be a bumpy ride. It’s a good time to remind clients about the importance of diversification and the long view in wealth building, they say.
“It has been a volatile start to the year across asset classes, and particularly in bonds, so this is a good time to look at long-term portfolio construction. Discipline is really important,” said Margaret Steinbach, a fixed-income investment director at Capital Group, based in New York. “Try to look through the current volatility. There’s an important role for financial advisors in helping investors focus on the long view, especially when the human inclination is to pull out of the market.”
And if those same financial advisors haven’t yet figured out a plan to approach the greatest bond volatility since the 1980s, they’re running the risk of being reactive, not proactive, sources said. But opinions seemed to vary on what the plan should be, so maybe there’s still some time to tinker with portfolios and come out a winner.
“By the time you start thinking about doing something differently, the time for that has passed,” said Michael Dow, chief investment officer and CFA at Beacon Pointe, headquartered in Newport Beach, Calif. “Part of our jobs in the investments office is to forecast investment returns. The Beacon Pointe investment committee meets once a quarter. In the morning, we’re looking at hundreds of charts and graphs on the macro economy. In the afternoon, we look at asset allocation and investments for the short term, mid-term and long term.”
Dow, like the other investment officers interviewed for this article, said one of the major drivers of the current investment environment was set two years ago in response to the pandemic. “We were just coming out of the disaster of late February and March, the government was cranking up the printing press, and the Treasury Department was issuing bonds hand over fist. And that was the proper response; it was the right thing to do,” he said.
“But there’s a bill to pay for all that stimulus, and that comes in the form of a higher debt to GDP ratio and a larger monetary base,” he continued. “When you have that and you’re the federal government, it’s necessary to try to keep interest rates low, because all the current debt has to be rolled over into new debt, and if you replace cheaper bonds with higher coupon bonds, you’ll have to squeeze taxpayers to make ends meet.”
Adding higher inflation to the mix doesn’t pose a problem by itself, since paying back debt with devalued dollars is a common strategy to reduce debt and is relatively painless, Dow said. “However, the combination of low nominal interest rates and higher inflation leads to negative real interest rates. Negative real interest rates are a problem for fixed-income investors. It’s destructive to purchasing power.”
Dow’s recommendation to clients in the fall of 2020 was to reduce fixed income, add inflation hedges (real estate, commodities, equities, Treasury Inflation-Protected Securities) and look for risk premiums outside the public markets in alternatives, he said. But that was then.
“Now it’s April of 2022, and the Federal Reserve is going to raise interest rates until they can gain control of inflation expectations. We’re hearing a lot from clients about TIPS, but now is not the time to own TIPS. The price of TIPS already included the price of high inflation, so they won’t outperform nominal bonds,” he said.
Instead, Beacon Pointe is staying neutral-risk given the uncertainty of recession, and Dow said he recommends staying intermediate for fixed income.