Bond bomb survival guide

New investment strategies that are intended to thrive in a rising-rate environment are fast emerging

Mar 10, 2013 @ 12:01 am

By Jeff Benjamin

Get ready for a new era in fixed-income investing. Whether or not the 30-year bull market in bonds goes out in a blaze of glory tomorrow, new investment strategies that are intended to thrive in a rising-rate environment are fast emerging. For many investors and advisers, their debut comes not a moment too soon.

“The opportunity to take advantage of falling interest rates in a bond fund is pretty much done,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate accounts. “It's been a fantastic ride in bond funds, but now advisers need to be looking for ways to protect principal.”

One way is to invest in nontraditional, or “go anywhere,” bond funds. These funds, the majority of which burst on the scene after the 2008-09 financial meltdown, are completely unconstrained by credit quality, geography and maturities.

“We are seeing a lot more funds come out with broader mandates and that includes things like more flexibility on the duration of the bonds they own,” said Sarah Bush, a Morningstar Inc. fund analyst.


Of the 51 such funds tracked by Morningstar, which represent $66 billion in assets, 32 have been launched since 2009.

“The nontraditional category really points to the way fund companies are looking for different ways to structure products,” Ms. Bush said. “Reflecting concerns about relative value, they're moving away from core bond funds in favor of lighter Treasury stakes, and taking on more corporate and mortgage risk.”

Even strategies that are not considered alternative are scrambling with short-duration defensive moves and all manner of flexibility.

“The bond market right now is different than it has ever been, because this is the first time in 30 years when there is no yield in the investment-grade market,” said Paul Lefurgey, managing director at Madison Investment Advisors LLC, which has $16 billion in assets under management, in-cluding $9 billion in bond strategies.

In the Madison Mosaic Institutional Bond Fund (MIIBX), interest rate exposure has been reduced to about half that of the market, and active management has become the rule, Mr. Lefurgey said.

“We're an active manager, similar to a stock fund manager,” he said. “And we're willing to deviate from the market.”


While nobody is suggesting that core bond funds are racing toward extinction, investors and advisers need to alter their fixed-income expectations, experts contend.

Jeff Rosenberg, chief investment strategist at BlackRock Inc., suggests that bond investing is splitting into three distinct subcategories: income, appreciation and preservation.

“As advisers and investors, you have to choose which one of the three is most important, but you can't do all three at the same time anymore,” he said.

Further, Mr. Rosenberg points out, some subcategories of fixed income don't even involve bonds. Dividend-stock investing, for example, is growing in popularity as an alternative income strategy.

Even traditional bond ladders, which offer predictable income and a certain level of security when bonds are held to maturity, are getting swept up in the changes.

In 2010, Guggenheim Investments Inc. launched BulletShares Corporate Bond ETFs as a series of target maturity bond ETFs that mature on a specific date, just like a bond.

“We saw an opportunity because holding bonds to maturity protects from interest rate risk, but there are challenges to buying individual bonds,” said Bill Belden, Guggenheim's head of product development.

While BulletShares ETFs are designed to work like individual bonds as part of staggered bond portfolio, Mr. Belden said Guggenheim has had to spend a lot of time educating advisers on how they can best be used in a portfolio.

“The BulletShare ETF is not a strategy, it's a component of a strategy,” he said. “I think the thing advisers like about a bond fund is that it is a complete strategy.”

BulletShares have attracted approximately $2 billion in assets and spawned at least one clone. BlackRock's ETF arm has a similar target-maturity-bond product in registration that is expected to launch this spring.

The rollout of target-maturity ETFs by firms such as BlackRock and Guggenheim adds a fresh endorsement to the traditional bond-ladder strategy as a means of protecting principal.

Regardless of an investor's fixed-income objectives, the onus will be on financial advisers to help steer clients through the next cycle for bonds.

“Given how fluid the world is today, and given the influence of politics and unusual central bank policies, we think it is important for financial advisers to conduct scenario analyses with their clients in the context of a solution mindset rather than the traditional product one,” said Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co. LLC.

“The bond market offers you different mixes of liquidity, term, credit, currency and interest rate exposure, and the key for any investor is to understand where they stand in this mix and how it is likely to behave under different market conditions,” he said. “The important reality to remember is that the global bond market is far from homogeneous.”


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