There's increasing concern over the Fed's ending of asset purchases, an eventual rise in the Fed funds rate, as well as structural and regulatory changes. Against this backdrop, the bond market is seeing an increase in volatility and a decrease in liquidity. Many investors and advisers, distracted by these concerns, seem to have lost sight of the role of core bond funds.
This presents a timely opportunity for advisers to manage their clients' emotions and to remind them of the crucial role fixed income plays in building a diversified portfolio and helping meet their need for income.
Many advisers who responded to the Q4 2014 Fidelity Advisor Investment Pulse survey, which identifies the topics that are top-of-mind for advisers, said fixed income was one of their main concerns, that yield has been difficult to achieve for years, yet moving further out on the risk spectrum hasn't necessarily paid dividends either.
So how can you make the best use of fixed income? Consider a few things when you help your clients build – or in some cases, rebuild – their bond portfolios:
1. Remember why you own bonds in the first place.
Fixed income can help meet investors' need for income and provide diversification. While high-quality bonds don't guarantee against a loss, they can provide that diversification, playing an important role in a balanced portfolio and offering protection against the downside risk of equity holdings due to their low correlation with stocks. It's also one of the reasons why core bonds are an important part of retirement plan menus.
Non-core fixed income funds oriented toward absolute returns, like unconstrained bond funds, can be very different. They can shift strategies very often and it isn't always easy to determine their correlation with equities at any given point because they regularly shift their sector weightings dramatically.
2. Understand why some bond funds have failed – and may continue to fail – to live up to their promise.
Many investors expecting the Fed to make an historic departure from its zero interest rate policy have responded by selling their core fixed income holdings. At the same time, more flows are going into unconstrained bond funds and absolute return bond funds. Some of these flows are a result of what isn't known – namely, how far, and crucially how quickly, the Fed will go in moving away from zero interest rates. However, advisers should keep in mind that the global macro environment remains uncertain and that bond yields outside the U.S. remain even lower. In other words, long-term interest rates may settle at lower levels – and for a longer time – than many predict.
What's more, the U.S. economy remains firmly in its mid-cycle expansionary phase, and an eventual shift toward the late-cycle could represent a shift to an environment in which credit-intensive bonds like unconstrained and absolute funds historically underperform relative to core fixed income. In addition, Fed policy tightening often causes correlations between rates and spreads to rise and this can cause credit to underperform during market volatility.
So while credit-intensive bonds may have the potential to provide higher yields as well as protection against rising interest rates, they may also result in less diversification and less downside protection while potentially carrying a bit more risk.
3. Bond investors may benefit from active management.
Unlike an equity index – say the S&P 500 – where every name trades daily, bond indexes contain thousands of issues and the majority trades infrequently, making them difficult to passively replicate. In addition, while the composition of the S&P 500 is based on a company's market capitalization, the
Barclays Aggregate is based on who borrows the most, and that may not always be a reflection of a well-managed business.
This is where active management can make a difference in potentially generating excess returns over the benchmark. Managers can exploit these inefficiencies to generate better outcomes for investors in the long-run. To balance between credit and interest rate risks at varying stages of the economic cycle, including during periods of change in monetary policy such as a rise in interest rates, managers can leverage credit, duration, yield curve, structure and roll. In fact, higher levels of volatility can create opportunities for managers who have the skills and research resources to evaluate these debtors' liquidity conditions, credit quality and pricing.
Over the past five years, while interest rates have reached and stayed at historic lows, these advantages allowed many active fund managers in various bond fund categories to outperform fixed-income benchmarks.
In the post-QE world, advisers are being bombarded by a relentless barrage of commentary about rising rates, reform, structural changes and less liquidity in the bond market. On top of that, the bond market can be volatile and fixed-income securities can carry inflation, credit and default risks. Understandably, all this can be unsettling. But as long as you keep things in perspective and remind yourself of the basics of core bond funds, you can navigate the new reality and derive the benefits clients expect from fixed income.
Scott E. Couto, CFA, is president of Fidelity Financial Advisor Solutions.
