<b>Take Five</b> with Sungarden Investment Research’s Robert Isbitts

As the Federal Reserve prepares to start dialing down its five-year-long quantitative-easing program, interest rates are fully expected to start climbing — an issue of major focus for financial advisers.

But Robert Isbitts, founder and chief investment strategist at Sungarden Investment Research, thinks that too many in the advice business are ignoring the impact of rising rates, or worse, missing the point entirely.

“There is a herd mentality among advisers that the clients don’t care to know the dangers because the adviser has their back,” he said. “If that’s the case, then why does every portfolio I see from an investor seeking to change advisers have bond funds and individual bonds up and down the monthly statement?”

Mr. Isbitts, whose firm works directly with individual investors and does portfolio allocation strategies for advisers, compared the current attitude toward rising rates with the period just prior to the 2007 housing market collapse.

“No one really thought their home price could go down, either,” he said. “Until it happens in your lifetime, it’s human nature to feel invincible.”

InvestmentNews: Do you think that advisers in general are embracing the reality that comes with a cycle of rising rates?
Mr. Isbitts: In 95% of the cases I’ve seen, having visited and talked with hundreds of advisers over the last couple of years, the answer is clearly, “No.”

The fact that something hasn’t happened in our investment lifetime doesn’t mean it can’t happen. At this point the issue a lot of advisers are missing is pure mathematics. We’re facing a dramatic change in the way investors — and therefore their adviser — should view fixed income, and conservative investing in general.

InvestmentNews: Why do you think that advisers are so disconnected from the impact of rising rates?
Mr. Isbitts: I think advisers have too much on their plates. The vast majority of advisers I talk to are solid people and pretty good businesspeople, but they are in a constant sense of being overwhelmed, and they try to have their hands in too many areas that are not their specialty.

Every portfolio I see has obvious flaws in the matching of clients’ objectives to portfolio allocations when it comes to fixed income. I see two things from advisers. They either say they’re keeping duration short and re-balancing regularly, or they’re on the opposite end with long maturities in classic yield-reaching.

InvestmentNews: Where are the biggest areas of risks that you are seeing in portfolios?
Mr. Isbitts: The biggest risks to the clients is the adviser being either oblivious or in denial about how bonds work. And the client has faith in the adviser.

High-quality bond funds are the worst investments on the planet right now.

The simple math here is if you’re pulling in yields of 2% or 3% and rates are where they are, I believe one of two things will happen: Rates will rise and push your return into the negative, or rates will stay in the same general area but your return will be limited to your coupon.

The problem is, too many bond funds are still being sold to clients as high-quality bond funds with good track records.

InvestmentNews: With so much potential risk in the fixed-income markets, is the traditional 60/40 portfolio of stocks and bonds still viable?
Mr. Isbitts: It is viable, but I think your time frame has to be akin to that of Rip Van Winkle, and you have to be able to stay asleep for decades.

Most balanced portfolios used fixed income in the form of mutual funds that are actively trading the bonds. That’s going to backfire because the head winds of higher rates make that more difficult.

On the equity side, there should be some competitive upside, but it will come more and more in a crooked line.

A 40% allocation to fixed income is like a dead man walking. Some advisers will probably be surprised by the impact of rising rates, but investors will definitely be surprised.

InvestmentNews: Are you advising against all fixed-income exposure?
Mr. Isbitts: I don’t own a single high-quality bond in my entire business.