Edward Jones: Stick to the classic bond flavors when rates rise

While alts have risen in popularity as a way to hedge Fed action, their usefulness is overstated, says strategist

Aug 5, 2015 @ 2:59 pm

By Trevor Hunnicutt

A top Edward Jones strategist is warning that the use of alternative strategies to mitigate interest-rate risk could come back to haunt financial advisers.

“Some of those newer strategies are likely to prove less attractive over time as the risks become apparent,” said Kate Warne, an investment strategist with the brokerage. “We say, stick to the vanilla approach that you have in the past.”

Ms. Warne's comments, in an interview with InvestmentNews, come as financial advisers have increasingly sought out illiquid investments and liquid alternatives to mitigate market risks, including the widely predicted end of a lengthy run up in U.S. stock and bond values.

This year, the Federal Reserve could raise the benchmark interest rates it controls for the first time since December 2008. On Tuesday, Federal Reserve Bank of Atlanta President Dennis Lockhart said the Fed was very close to raising rates, now near zero, as soon as next month. That move could set the table for a new era, featuring unpredictable consequences for the economy and potentially eroding the market value of bonds.


But Ms. Warne said those concerns, while real, have been overstated.

“Everyone is worried about fixed income in an environment where rates rise,” she said. “We think that worry is misplaced.”

(More: The data-driven case for alternatives)

It's true, she said, that bond investors benefited from a decline in rates, which set the stage for a three-decade-long bull market in bonds. Exactly when the long-term rally ended, or if it has, is a matter of debate, but it's pegged as having started in 1982. A portfolio of medium-term U.S. government bonds has only delivered negative total returns in four of the 33 years since then, according to Morningstar Inc.

The markets can't repeat that slide in yields, given their low levels today. The benchmark 10-year Treasury note traded at 2.265% on Wednesday. Bond prices move inversely to their yields.

That risk worries William B. Greiner, chief investment strategist for Mariner Holdings, a wealth and asset management firm that builds alternative products. Speaking recently on an InvestmentNews webcast, he said the firm is “most active” in deploying alternatives to deal with a three- to five-year “upward drift” in rates.

“What we've decided within Mariner is duration risk in the portfolio has the sharpest teeth going forward,” Mr. Greiner said, a reference to how bonds' rate exposure is measured. “Now's the time for managers to really earn their keep, if you will, by finding those ideas that can be used in individual client portfolios.”

Among the strategies has been to use funds invested in high-yielding packages of debt, namely collateralized loan obligations, and insurance-linked securities, whose value can be based on whether events such as natural catastrophes occur. The firm has also been focused on fund structures, such as interval funds, that are less easily traded or operate under different rules than traditional mutual funds.


Those aren't the only sorts of strategies gaining attention. Over the last year, 54 nontraditional, strategic income, unconstrained and multisector bond funds have been launched by open-end mutual fund houses, according to Morningstar Inc. On Tuesday, Franklin Templeton Investments launched its own new fund, Franklin Flexible Alpha Bond Fund (FABFX), which it said would aim “to provide attractive risk-adjusted returns generated from various sources — other than primarily from interest rates.”

Fidelity Investments executives have long argued those funds aren't what they're cracked up to be.

“What you find is that they're marketed as a fund that can protect against raising interest rates or really be tactical to take advantage of and exploit macro moves in the market,” said Scott E. Couto, president of the Fidelity unit that sells funds to financial advisers. “The cost of hedging against rising rates is prohibitively high, and I don't think the average investor understands how much they are paying.”

(More: Flows to liquid alts funds slow after torrid run)

Edward Jones, too, is pitching vanilla. The firm works with a stable of mutual fund companies — American Funds, Franklin Templeton, and Invesco, among them — who pay for privileged access to its network of more than 14,000 advisers.

Despite rising rates and initially negative returns, investors will see positive long-term capital appreciation from their bond stakes as they or their bond-fund managers reinvest at increasingly higher rates, according to Ms. Warne.

Among the problems with alternatives, she said, are their high fees. A better way to improve bond portfolios is to lower exposure to longer-term bonds, and to diversify somewhat into higher-yielding bond funds. She said that change would have the effect of exchanging some of the risk of rising rates for the risk of a default or similar credit event.

A more potent risk for the average investor, she said, is a portfolio whose holdings no longer align with the goals of an investor because rising stock prices have decreased the relative weight of bond holdings. Her advice is simple: rebalance, selling some stock exposure and buying bonds.

“They need to pay some attention, or the markets will rebalance for them,” she said.


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