With bond yields near historic lows and poised for a cycle of rising interest rates now that tapering is set to begin, financial advisers might do themselves a favor by looking once again to institutional investors for guidance.
In typical institutional investor fashion, the managers of pension funds, foundations and endowments are deliberately but steadily trimming fixed income exposure in exchange for alternative strategies, including hedge funds.
“The flows into hedge funds is coming from the fixed-income bucket because institutional investors are looking at 2% or 3% returns from bonds compared to 4% to 7% returns from hedge funds,” said Donald Steinbrugge, managing partner at Agecroft Partners.
While it would be difficult to imagine that most financial advisers are not acutely aware of the risks facing the bond market at this point in the cycle, it is interesting to see the pattern unfolding in the institutional space. In essence, the investor category generally viewed as the smart money is moving further and further from the old model, which relied heavily on bonds as portfolio ballast.
Mathematically, it just makes sense that if the bond side of a portfolio is likely to generate a lot less income than it has historically, there needs to be a change to the strategy, the expectations or both.
“From a financial planning perspective, I don't think there's a lot of software that is taking into account what's about to happen to the bond market, which means you can't build a financial plan the way you used to with regard to fixed income,” said J. Brent Burns, president of Asset Dedication.
“If the bond side is going to generate 2% or 3%, the stock side has to work stronger or the planning has to change,” he added. “The problem with where we are with bonds is that rates are low and could remain low for a long time, which means the safe option doesn't have much return.”
A 2014 Investment Outlook survey of InvestmentNews readers found that nearly 48% of financial adviser respondents plan to decrease exposure to fixed income in the year ahead. Meanwhile, 50% of respondents plan to advise increasing exposure to emerging-markets stocks, and more than 59% plan to advise clients to add to their international equity exposure.
The survey results illustrate a shift away from bonds, but don't provide a clear indication of where those assets might go instead.
It seems like most advisers are just biding their time, and hoping to avoid trouble.
“Like everyone else, we're trying to keep the bond duration as short as possible, but that's probably going to create a new problem as rates start to rise,” said Clinton Struthers, owner of Struthers Financial Services.
“We've also been using things that don't correlate to the bond market like some real estate and preferred stocks,” he added. “The low yields on the bond side of the portfolio has created a demand for things like heavy-dividend-paying stocks where the returns are better, but then you have this big pregnant part of the portfolio that will sooner or later create a new problem.”
It is, in many ways, a riddle without a answer beyond the reality that the old models can't possibly work going forward.
What used to be the safe and easy part of a client's portfolio is fast becoming the area of tremendous risk and uncertainty. Sooner or later, that reality is going to force advisers out of their comfort zone toward models that might include new definitions of safety and allocations to asset classes that are carved out of fixed-income positions.
“I think we're going to see yields move higher as we get through 2014, and that's as much economics related as anything else,” said Jack Rivkin, chief investment officer of Altegris.
“When rates rise, if you're sitting there in a classic fixed-income mutual fund that invests in high-grade securities, you're going to have a problem,” he added.