For the past year, investors have been nervously avoiding stocks and pumping billions of dollars into bonds and bond mutual funds, but a new study indicates that a large percentage of investors may have a limited understanding of how bonds work.
This has created a great opportunity for mutual funds and their sales intermediaries to step in and help fill this knowledge void, according to experts at The Hartford Mutual Funds.
"The recession is testing Americans' risk tolerance, and many are turning to fixed-income securities," said Bill Davison, a managing director at Hartford Investment Management Co. "Fixed income can be a key part of managing risk in a portfolio, but not all bonds are created equal. Fixed income is very complex because of all the choices you have to make."
Bonds are divided into 11 major sectors, but the ranking of those sectors changes dramatically from one year to the next. A different sector is on top almost every year, and often the worst sector becomes the best the following year, and vice versa, Davison said.
In 2006, high-yield bonds were the top-rated sector, while short-term government bonds were dead last. In 2007 and 2008, short-term government bonds were on top, and high-yield bonds were last. In 2009, this has reversed yet again, and, once again, high-yield bonds are king.
"When you look at returns over time, you can see a dramatic difference in performance across all fixed-income sectors," Davison said. "There is often a complete reversal of performance from one year to the next""
Most average investors who fled the complicated and volatile world of equities last year may not understand that bonds can be just as volatile and just as complicated. For starters, bonds have different maturity dates, and most investors don't have the time, patience or skill to chase credit spreads or keep track of bond coupons. Fortunately, bond mutual funds can provide the same diversification benefits that investors have come to cherish in equity mutual funds.
"Volatility can be scary," said Keith Sloane, senior vice president of The Hartford Mutual Funds. "Many investors moved to fixed income seeking safety and stability without any sort of understanding of the sectors or a basic strategy. This is a material opportunity for financial advisers to discuss fixed income diversification with investors."
The Hartford found, in a survey of 530 individual investors who work with financial advisers, that 53% increased their allocation to bonds or cash from last year. Forty-one percent said they felt less confident about the market, and nearly 70% said they are taking a "wait-and-see" approach, despite the recent market rally.
While 30% of the investors said there were more bonds in their portfolio than last year, 28% admitted they didn't know how much of their portfolio was allocated to fixed income. Seventy-two percent said they think bond diversification is important, but more than half didn't know which fixed-income assets they held, The Hartford said.
More than half of those surveyed said their advisers have never talked to them about holding different types of bonds in their portfolios.
"This may sound like bad news, but it's actually a tremendous opportunity for financial advisers," said John Diehl, senior vice president of The Hartford's investment and retirement division. "Investors admit they are unsure what path to take as we emerge from the financial crisis, and the adviser can play a crucial role in helping to identify the next steps."
To this end, The Hartford has developed marketing and educational materials for advisers to make it easier to talk to their clients about fixed-income diversification. A brochure explains company's four different fixed-income funds' objectives and strategy. The funds are: The Hartford Floating Rate Fund, The Hartford Inflation Plus Fund, The Hartford High Yield Municipal Bond Fund and The Hartford Strategic Income Fund.
"The materials developed for this campaign can help advisers select appropriate solutions based on their clients' risk tolerance and financial goals," Sloane said.
"Some advisers spend a great deal of time diversifying the equity portion of their clients' portfolios and explaining the importance of it, but they spend less time discussing bonds, even though fixed-income diversification is just as important as equity diversification," Diehl said.
"Investors need to be educated on diversification strategies to help reduce risks even within the fixed-income portion of their portfolio," Davison added. "They need their financial advisers to explain the benefits of diversification."
The concept of diversification can easily get lost in emotions, Diehl said. People can get so traumatized by dramatic events that they will take actions which they believe are safe, but that might actually put them in a riskier situation. As an example, he said that after 9/11, people drove their cars instead of flying because they perceived cars to be safer. Automobile fatalities increased, partly because there were more drivers on the road.
"A lot of the financial world was turned upside down last year," Diehl said. "There was a tremendous inflow into 'safe' investment options like U.S. Treasury options. The demand for Treasuries was so strong that short-term bills actually turned negative in yield. Being concentrated in one particular segment may not be the best approach."
Diehl said the right time to add bond sectors is when they are out of favor, not when they are popular. "Fixed income is not just one lump-sum asset class," he said. "Investors need an approach with a strategy and to create an investment thesis."
And if they are unable to do so because the future is too unclear to them, "the best course is diversification," Diehl said.
Bond Fund Bonanza
Year-to-date through August, investors have pumped $209 billion into bond mutual funds, compared with $16 billion into stock funds. According to Strategic Insight, approximately two-thirds of the money flowing into mutual funds during the second quarter went into bond funds.
Since the recession first began in October 2007, the Barclays Capital U.S. Aggregate Bond Index has risen nearly 14%, whereas the Standard & Poor's 500 Index has dropped 28%, according to Morningstar.
Looking back over the past five years, bonds rose an average of 5% a year, compared with stocks' 1% gain, and over the past decade, bonds rose 6.2% a year, compared with stocks' annual 0.5% loss.
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