Ignorance is not bliss

Sooner or later, there is going to be a bloodletting in the bond market and it is up to financial advisers to make sure their clients don’t get caught in the middle of it. As of late last week, the bellwether 10-year U.S. Treasury note yield stood at 2.78%. While that is down modestly from a multi-year high of 2.94% reached on Aug. 24 — driven, no doubt, by the flight of investors to safety over the Syria crisis — the yield pullback is likely to be short-lived as the Federal Reserve begins to phase out its five-year strategy of keeping rates low by buying Treasury bonds.

The Fed is expected to begin dialing back its bond purchases soon. Already, the yield on the 10-year Treasury has gained a full percentage point since mid-May, largely due to anticipation of a reduction in quantitative easing, as the bond-buying program is known.

Since bond prices move in the opposite direction of yields, the rise in market yields could spell huge losses for investors — especially those in bond mutual funds, where portfolio managers would be forced to sell their holdings at a loss to meet redemption demands.

Simple bond math holds that a 1-percentage-point rise in interest rates would result in a roughly 1% decline in prices for every year of a bond’s duration. That means a bond fund with a 10-year duration will plunge in value by 10% for every percentage point rise in rates.

If that’s not bad enough, investors are clueless about the effect of rising rates. A recent survey of U.S. investors by Edward Jones found that two-thirds of the respondents don’t understand how rising rates are affecting their investment portfolios. Twenty-four percent of those surveyed admitted that they “feel completely in the dark” about the potential effects of rising rates.

It is the responsibility of financial advisers to make sure their clients understand the effect that steadily rising interest rates will have on their bond portfolios. Then they should be weighing strategies for dealing with the situation.

In an interview last week with InvestmentNews senior reporter Jeff Benjamin, Robert Isbitts, founder and chief investment strategist at Sungarden Investment Research, expressed concern that too many advisers are ignoring the impact of rising rates — or, even worse, completely in the dark themselves.

‘Herd mentality’

“There is a herd mentality among advisers that the clients don’t care to know the dangers because the adviser has their back,” he said. “If that’s the case, then why does every portfolio I see from an investor seeking to change advisers have bond funds and individual bonds up and down the monthly statement?”

Mr. Isbitts warned advisers not to ignore the possibility, if not the likelihood, of a prolonged bear market for bonds — something that hasn’t happened in the past 30 years.

“The fact that something hasn’t happened in our investment lifetime doesn’t mean it can’t happen,” he said. “We’re facing a dramatic change in the way investors — and therefore their advisers — should view fixed income and conservative investing in general.”

Mr. Isbitts is correct.

Financial advisers should consider client strategies for dealing with rising rates. There is, of course, no one-size-fits-all solution.

For some, it makes sense to steer the bond portfolios toward short-term investment bonds, primarily in the form of low-cost bond mutual funds or ETFs. For others, incorporating more high-yield bonds — which tend to be less sensitive to interest rate changes — makes sense.

Advisers also may want to consider building a bond ladder for investors willing to own individual bonds. This means buying bonds maturing at different dates so that when rates rise, the proceeds from a maturing bond can be reinvested in a higher-yielding bond. Of course, investors in individual bonds also have the option of holding their bonds to maturity — thereby limiting their losses to opportunity costs.

No matter what the solution, advisers should be talking to clients about rising interest rates.

Ignorance is not bliss.