Gyrations in the bond market and bond mutual fund industry have had income investors on edge for a while now. That’s why giving measured and informed advice to clients — especially those in or near retirement — has never been more critical.
Talking to clients about this subject is a long-term process — with some hand-holding and some re-education (and perhaps readjustment) on income objectives.
For skittish clients, the potential threat of higher interest rates has been akin to the proverbial freight train in the distance. Countless advisors have been warning for years about the impact of rising rates on income portfolios, but the reality won’t sink in until market moves actually change valuations in a significant way.
Patrick McDowell, a planner with Arbor Wealth Management in Miramar Beach, Fla., says he sent his clients a memo about rising rates “two to three years ago.”
McDowell tries to focus his clients on the consistency of income streams rather than short-term market volatility — likening income portfolios to apartment building rents, for instance.
“We tell them they will see enhanced volatility,” McDowell says. “But like renters, we tell them [these bonds] have been paying us for years and will keep on paying us.”
AVOIDING LONG-TERM BONDS
McDowell constructs a diversified income portfolio for clients, investing in single preferred stocks, floating-rate funds, high-yield municipals, a total return bond fund and high-yield corporate bonds.
He’s also shortened average duration — a figure that shows the amount of money a vehicle will lose if rates rise one percentage point — to around five to six years. That strategy means avoiding long-maturity bonds, particularly U.S. Treasuries, which get hit hardest when rates rise.
Another advisor who started the income portfolio conversation with clients several years ago is Richard Gotterer, a senior financial advisor with Wescott Financial in Coral Gables, Fla.
“We shortened durations and improved credit quality of individual bonds,” says Gotterer, who has been lowering risk in clients’ income portfolios. “We also did some back-of-the-envelope math for our clients. For example, we told them that a $100,000 10-year bond with an 8.5-year duration could lose $8,500 if rates rose one percentage point.”
Like McDowell, Gotterer has stocked clients’ portfolios with shorter-maturity bonds that have an average duration of just over two years, with “low exposure to U.S. Treasuries. We’d rather protect principal than reach for yield.”
Gotterer also wanted to dispel any misconceptions his clients had about what the Federal Reserve can and can’t directly influence.
“There’s often some confusion among investors on what the Fed controls,” Gotterer says. “The Fed may control short-term rates, but long-term rates are tied to inflation expectations and investor sentiment.”
CASH FLOW FOCUS
Another approach is to focus on client cash flow. Watching short-term rates can be a red herring because clients may only want to know if they can maintain their monthly income stream, says Stan Richelson, founder of Scarsdale Investment Group in Blue Bell, Pa.
“They only want to know how much they’re going to get paid each year from their bond portfolios,” he says.
For his client portfolios, Richelson avoids ETFs and mutual funds that hold fixed-income investments, instead holding only high-quality individual bonds — rated AA or better. Because the coupons of the individual bonds he buys don’t change, he knows precisely the amount of yearly cash flows for each client.
By focusing on what the bonds pay through their coupons, Richelson shifts focus away from market volatility, which he says is “meaningless” for clients. “Volatility of bond prices doesn’t change their coupons,” he notes. “Bond volatility is only relevant in bond ETFs and mutual funds. We try to get our clients out of the mark-to-market paradigm and to focus on cash flow.”
Another way to help clients is by encouraging them to ignore some of the noise in the income management world — such as the drama that’s surrounded the crowning of a new champion in the world of mainstream, general-purpose bond funds.
In case you missed it, the most popular bond fund is now Vanguard’s Total Bond Market Fund (VBMFX), which outpaced PIMCO Total Return (PTTRX) earlier this year as bond king Bill Gross ended his long reign at PIMCO.
Tallying all share classes, the Vanguard fund totaled some $117 billion in assets through April 30, compared with $110 billion for the PIMCO fund, which saw investors redeem some $10 billion.
Advisors and investors may have made those switches because of the tempest after Gross’ departure. Some were simply spooked about getting burned in an active fund when interest rates climbed.
In the long run, however, asset flows and changes in bond fund management often mean little to clients.
You have to walk them through their own objectives.
Similarly, investors are piling back into income funds just as the U.S. economy is slowly heating up. In the first quarter of 2015, income mutual funds experienced the largest inflow of funds since 2001, according to Bank of America Merrill Lynch Global Research, reversing a recent trend.
Advisors may need to remind clients that shifting in and out of the bond market can introduce timing errors and crimp cash flow. “Holding short-term liquid assets like money markets, CDs, or ultra-short duration funds doesn’t make a lot of sense,” says McDowell.
And of course, predictions of bond market declines in the coming year may be overblown. Even if rates do move higher initially, such a shift may not be followed by a prolonged bear market in bonds.
One economic theory gaining traction is that the U.S. and other Western countries have entered a period of secular stagnation. This idea holds that employment and economic growth may be sluggish for some time to come — due to long-term aging of industrial countries and slowing technological change — necessitating a fiscal policy that keeps interest rates low to provide a broad-based stimulus.
Federal Reserve Chairwoman Janet Yellen has observed that an overall slowdown would prompt a monetary policy that “would need to keep real interest rates persistently quite low relative to historical norms to promote full employment and price stability, absent a highly expansive fiscal policy.”
Another component of the stagnation theory is that corporate earnings growth — reflecting slowing economic activity — may also be easing. And if earnings reflect slower economic activity, that’s yet another argument for the Fed keeping rates low.
For both clients and advisors, this may be a signal to go slow on any major changes in income portfolios, unless economic conditions change so much that significant growth changes the overall picture.
John F. Wasik is author of Keynes’s Way to Wealth and 13 other books. He is also a contributor to The New York Times and Morningstar.com. Follow him on Twitter at @johnwasik.
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