Why it's time for clients to focus on short-term bond strategies
Many clients may not be ready for rising interest rates, advisors says.
“I think we’re just coming out of a 30-year bond bull market and investors aren’t used to seeing any volatility in their bond portfolios,” says John Zaller, chief investment officer of MAI Capital Management in Cleveland, Ohio.
That is why it is especially important to talk to clients about the impact of rising rates on fixed-income investments, he says.
“You have to get in front of the potential for negative short-term returns and remind them of why we own fixed income in the first place, which is mainly to preserve capital,” Zaller says.
Advisors need to help clients understand that rising rates can lower the price of a bond but that moving to shorter-term bonds can offer some protection.
Advisors should be talking about fixed income from a total return standpoint, Zaller says.
“It’s easy on the one hand to focus on the yield, but the actual experience is going to include price volatility related to the interest rates. And you’re going to have less of that on the shorter end of the curve and much more on the longer end,” Zaller says.
“In the current environment of rising rates, we’re keeping portfolios on the shorter side, because short-term bonds have less sensitivity to rising rates,” he says.
In other words, when it comes to fixed income, clients should understand that it is all in the timing.
“We think that very long-term bonds don’t make much sense from a risk/reward standpoint, simply because the yield curve is flattened,” Zaller says.
“You’re only picking up 60 basis going from a two-year Treasury to a 30-year,” he says. “We just don’t think clients are being compensated for that extra interest rate risk.”
Another way to explain that to clients is to tell them that all bonds are not created equal when rates are rising, says Adam Phillips, a CFP and the director of portfolio strategy at EP Wealth Advisors in Torrance, California.
“For instance, in the event of a 1% rise in rates, it’s estimated that a 30-year Treasury bond would lose roughly 12% more in value than a five-year Treasury bond after accounting for income,” he says.
Although Phillips’ fixed-income allocations exhibit a bias toward short-term fixed-rate bonds, he also uses floating-rate investments that are designed to adjust coupon rates upward as benchmark rates move higher.
Long-term bonds may still serve a purpose for some clients, such as those whose most important goal is matching liabilities, but he says that for most the downside risks far outweigh the modest upside potential in yield.
Like Zaller, Phillips emphasizes that as rates continue to move higher from record low levels, it will be increasingly important for advisors to remind clients about why they hold bonds in the first place.
“For balanced investors, bonds will likely provide a welcome source of diversification when the nine-year bull market in equities eventually comes to an end,” Phillips says.
This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.