As the good old days of low-maintenance bond allocations fade from memory, financial advisers are being forced to learn how to be more creative and nimble when navigating the new reality of fixed-income markets.
“For the first time in my career, I'm very nervous about making sure our clients are protected, should interest rates start rising,” said Bruce Allen, president of Bruce G. Allen Investments.
The problem is complex: With bonds in the dumps, many advisers are cutting their clients' allocations to fixed income. But they have to figure out where to put that money, because it isn't a slam-dunk “toss it into stocks” decision.
Like most advisers these days, Mr. Allen is recognizing the need to confront rising bond yields and the accompanying risks associated with traditional bond mutual funds rapidly losing value.
“When I started in the business in 1985, you just bought the highest-yielding muni bond and you only had to hope it didn't get called away,” he said. “The winds were at our backs and you could do no wrong in fixed income, as long as you had at least a five-year time horizon, but now the winds are at us.”
Although bond strategies of the past might have been of the set-it-and-forget-it variety, any adviser paying attention is talking about anything but.
“The fixed-income side is where the most important work is being done right now, and we're not using any bond mutual funds for our clients,” Mr. Allen said.
With the equity markets on a five-year run, including a 32% gain last year, it would be easy to overlook low yields and increased risk on the bond side of the portfolio.
But that would be extremely short-sighted and dangerous, experts said.
“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 only 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 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 be going.
It turns out that advisers are mostly scrambling for answers and strategies by keeping bond durations as short as possible and looking for new ways to defend a rising rate cycle with allocations to floating-rate strategies and flexible investment mandates.
“We've been positioning clients for the past year by looking for other tactical managers and those that aren't tied to a benchmark,” said Leslie Thompson, managing principal at Spectrum Management Group.
She added that a typical 60% stock and 40% bond portfolio is now down to 30% in bonds, with the bulk of that reduction now at least temporarily sitting in cash.
And the remaining portion in bond allocation is now being largely allocated to various types of bond alternatives, including master limited partnerships and long-short bond strategies such as the BlackRock Global Long/Short Credit Fund (BGCIX).
Drew Horter, chief investment strategist at Horter Investment Management, has been navigating the bond market challenges by applying a tactical overly strategy to a portfolio of mostly high-yield bond ETFS.
“If you look at what took place in 2013, it was pretty horrid for most fixed income managers, but our strategy made 6.9% last year,” he said. “When rates start to rise, all fixed income assets, we believe, will get hurt except for high yield bonds because they are less interest rate sensitive.”
The tactical overlay strategy basically helps Mr. Horter to move in and out of the high-yield market as risk indicators dictate.
The difficulty of finding yield without taking on too much risk is a theme that echoes across the financial advice industry. And the double-edged sword is that reducing bonds by too much also adds risk.
“As painful as it might be in the short term, it would probably benefit our clients if rates just went up,” said Brian Ullsperger, managing director at WTAS, a tax and wealth advisory firm.
In the meantime, he is navigating the uncertainty of the bond market by underweighting the asset class and allocating to alternative funds such as the Driehaus Active Income Fund (LCMAX), Driehaus Select Credit Fund (DRSLX) and JPMorgan Tax Aware Income Opportunity Fund (JTASX).
Although advisers appear to being leaning more heavily on alternative bond strategies, a common thread is also a move away from traditional bond mutual funds, as was illustrated by the record $86 billion that exited bond funds last year.
Bond funds had their worst year last year since the rising rate cycle of 1994.
Taxable bond funds generated an average decline of 0.2% last year, compared with a decline of 3.4% in 1994, according to Morningstar Inc.
Municipal bond funds declined by an average of 3.75% last year and by an average of 5.86% in 1994,
“We are staying away from bond funds because if they have to liquidate anything in the fund, you will be locking in sales at an inopportune time,” said Jeff Phillips, chief investment officer at Rehmann Financial.
“For those clients looking more for the income stream, we're looking at higher-yielding asset classes like business development companies, real estate investment trusts and preferred stocks, but we're staying away from things that are highly correlated to equities,” he said. “You're better off getting more creative on the bond side than trying to replace bonds with equities, because if you do that, you will get the risks of equities.”