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.

“Natural resources and TIPS have had their time to shine, but that’s over. For an afternoon, high-yield corporate bonds looked good in the recent selloff, but prices recovered quickly. Right now we’re favoring alternatives, specifically private credit, equity and real estate investments,” he said.

According to Capital Group’s Steinbach, it generally can be helpful to look at past inflationary environments and historical routes of action to guide investments on the fixed-income side of a portfolio.

“But things are really different this time. The Fed’s balance sheet is bigger than it’s ever been. There is significant stimulus in the system,” she said. “We’re really in an unusual time where everyone is focused on higher inflation rates and fixed-income underperforming.”

That inflation is going to persist well through this year, she said, and supply pressures won’t be abating either.

To protect against this, Steinbach is looking at relatively short duration positions while waiting for the yield curve to flatten, and being cautious about credit risk.

“In high yield we’ve found more opportunities, but valuations are changing. Interest rates have completely repriced, and we expect the Fed will have to hike rates to combat inflation that will run higher and longer,” she said. “This is where investing with an active manager can help. You need to own fixed income and you need to own duration in order to have a balanced portfolio.”

Meanwhile, Matt Dmytryszyn, a CFA and chief investment officer at Telemus Capital in Chicago, has been taking a third approach.

“Bonds diversify a portfolio but not over a quarter. They diversify over five years, or 10 years. In an environment of rising interest rates, any maturity you get back you reinvest at a higher rate,” he said.

The two main drivers Dmytryszyn looks at, besides yields, are interest rates and credit spreads. He said he doesn’t feel like the market is compensating for interest rate risk, and it’s the credit fundamentals he’s more concerned about.

“Spreads have widened, but not all that much,” he said. “If margins come down, does that change things? Right now we haven’t seen that, but we’re watching.”

Instead, Dmytryszyn said he’s more interested in bonds now than he was at the beginning of the year. “You’re at least earning more income on the portfolio to cushion against the higher yields.”

Looking at the big picture, Dow said he expects interest rates to rise pretty dramatically in the near future, even if the Fed risks causing a recession.

“They’ll do it because it took them 40 years to get here, to establish themselves as the world’s best inflation-fighting central bank, with credibility second only to the former German Bundesbank,” he said. “During the ’80s, the Fed tipped the economy into recession several times in order to anchor inflation expectations near 2%.”

The late cycle is the worst time to be an asset allocator or investor, he acknowledged.

“This doesn’t sound exciting, but having a diversified portfolio is the best protection an investor can have right now” he said. “And know that in the short run, we’re going to see volatility. Volatility is the price we pay for building wealth."