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Take charge with fixed-income strategies for a rising-rate environment

As the bull market celebrates its 5th birthday, the party favors that financial advisers wish for most – other than predictability – are answers.

Apr 30, 2014 @ 8:50 am

By Scott E. Couto

As the bull market celebrates its 5th birthday, the party favors that financial advisers may be wishing for most — other than predictability over the next five years — are answers. One of today's greatest challenges for advisers is to be able to answer the many questions that are on the minds of investors, questions such as:

• "What should I consider if interest rates rise?"

• "Are there still growth opportunities in equities?"

• "How can volatility create investment opportunities?"

Six years after the financial crisis and five years after the bull market began its run, advisers have never been more in demand or have had such demanding jobs.

So, what should advisers consider if interest rates rise?

This question is critical and timely. With rates trending downward since the 1980s, the potential rising interest rate environment represents a significant shift for financial advisers — one that many of us have never experienced.

While the prevailing wisdom may be that when interest rates rise, you should move out of bonds, the truth is that doing so may not be a wise move. Diversification is always important. In a rising interest rate environment, financial advisers may want to consider a broad range of fixed-income classes:

1. Anchor your portfolio with high-quality bonds

Rather than abandoning bonds in favor of stocks, advisers can help investors focus on the role bonds play in a diversified portfolio — income, total return potential and an offset to equity volatility. Anchoring your client's portfolio with high-quality bonds may be an appropriate strategy. Historically, high-quality bonds have performed well when stocks have declined and typically have provided steady income.

2. Explore non-core income options

In a low-yield environment, building a portfolio with the potential to generate income may mean exploring non-core income options. For investors who can tolerate more risk, adding non-core income assets may offer higher income potential as well as diversification benefits such as lower sensitivity to rising rates. Some of these fixed-income investments include: high-yield, which can be less sensitive, floating rate, which can move with rates, emerging markets, which can provide diversification, or real estate, which offers lower correlation.

3. Use short-term bonds to help lessen interest rate sensitivity

Diversifying with short-term bond funds may help reduce the impact of rising rates. In general, bonds with shorter durations typically experience smaller price changes when interest rates move, compared to longer-duration bonds.

4. Add municipal bonds

Sixty-five percent of the time, municipal bonds outperformed taxable bonds over the past 20 years when adjusted for a 25% tax rate. Municipal bond funds historically have provided attractive benefits — tax-free federal income that can add total return and attractive diversification benefits due to their low correlation to stocks and other fixed-income investments. Moreover, state revenues have risen for 14 straight quarters, which may bode well for the municipal bond market. Investing in high-quality municipal bonds may reduce credit risk and volatility. Extensive credit research is instrumental in identifying financially sound issuers and potentially avoiding defaults.

One of the most critical take-aways for advisers in this interest rate environment is to always keep risk in mind. In chasing yield, many investors lose sight of the risk side of the equation. They may have exposed their portfolios to risks more closely correlated to equities. Now more than ever, it is important for investors to know what they own in their bond portfolios.

While we can't predict the future — what will happen with interest rates, and whether the bull market will continue — we know that advisers will continue to play a critical role in helping to guide investors through our new reality, and that we must tackle tough questions in order to deliver the best advice. My next column will address another significant question that investors are asking today: "Are there still growth opportunities in equities?"

Scott E. Couto, CFA, is president of Fidelity Financial Advisor Solutions

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