When it comes to interest rates, advisors say their biggest worry isn't whether the Fed will sign off on an anticipated hike this month — it’s what may come afterward.
"What's more important is the pace of the rate hikes: how many do they do, over what time frame, and what's the magnitude from how quickly they raise rates from the first hike to the last," says Anthony Valeri, an investment strategist at LPL.
In light of the latest economic statistics, consensus has grown among members of the investment community that the Fed will raise interest rates this week. While advisors have had time to position clients' portfolios ahead of an initial rate hike, they are also simultaneously making strategic adjustments in anticipation of a series of hikes over a gradual period of time.
"There's a certain playbook for a Fed rate hike, which is generally valid in most cases," Valeri says.
He says bond allocations should be lower, though he would hold onto some bonds that are less sensitive to interest rate changes. Valeri would also take on some exposure to high yield and bank loans, which have historically fared well in a rising rate environment.
Not all advisors share Valeri's sentiment on high-yield bonds. Third Avenue Management's decision to freeze redemptions on a mutual fund sparked a large sell-off of high-yield bonds. For instance, the SPDR Barclays High Yield Bond ETF lost 2% on Friday, Bloomberg reports, its biggest one-day drop in four years.
He also says a greater allocation to stocks is warranted, particularly with a focus on specific sectors that are sensitive to growth, like industrials, technology and consumer discretionary. Technology, health care and energy have been sectors that historically hold up best within one year from the start of rate hikes, Valeri says.
However, there are anomalies from past rising rate cycles, he notes. Energy has been hit by depressed prices, which he doesn't see rising anytime soon. Moreover, he believes consumers are overextended because of the sluggish job growth and slow recovery from the last recession.
He tells clients to look at the sectors that have done historically well, but in the same vein, he helps them to understand that not every rising rate period is exactly the same.
A PLACE FOR FIXED INCOME
"Many people have given up on bonds, but I say they still have a place in a portfolio," David Nethery, an advisor at Merrill Lynch, says.
Nethery says he prefers tax-free and convertible bonds because if the stock market goes up, the client may get two-thirds of their returns, but if it goes down, it acts like a regular bond and generates interest.
Many advisors would consider a sharp deviation from suitable asset allocations to offer more risk than reward. Yet advisors are cautious about their clients who have a large fixed-income allocation, and especially those holding long-term bonds greater than 10 to 15 years.
During an interest rate hike, those yields may be higher but their value will come down. U.S. Bank's John Campbell sees this as an opportunity to incrementally reduce his clients' holdings in long-term bonds in favor of short duration bonds that offer better potential credit and investment grade rates.
"With a slight increase, the individual with fixed income may get a little more in terms of interest income, even though they may lose portfolio value," Campbell says.
Nethery says he will try to go far enough in years of maturity to get meaningful yield, but he will not do so at the expense of credit quality just to get high yield or income.
Clients have been pivoting to different asset classes, notes Craig Brimhall, vice president of retirement wealth strategies at Ameriprise. He says that he has seen clients invest more in products such as MLPs, real estate, including nontraded and traded REITs, commodities, hedge funds and different kinds of annuities.
AGING CLIENTS, RISING RATES
It is tough for some older clients to admit they cannot expect the same returns they once enjoyed a decade or two ago, advisors acknowledge.
"It's been a challenge over the last several years to have a conversation with clients who are retired or are very close to retirement about the income they need to live on versus what their portfolio is producing in income. They might not make ends meet," says Edward Jones advisor Guy Weinhold.
His retired clients are typically more conservative investors with a larger portion of their portfolio assets in fixed income. Yet as the values of fixed income vehicles fluctuate, the income they receive is lower. It’s been more complicated looking for their options, Weinhold says.
Also, as clients age, their risk personality or investment personality tends to become more conservative, Nethery says.
Where appropriate, Nethery recommends alternative assets to his more financially sophisticated clients. He says he also favors private equity because it has little correlation with the stock and bond markets and the returns can be high.
Nethery sees the rate hikes as a test of his skills as a financial advisor. "I look at downturns in markets as good opportunities to see if I've done a good job in building a risk-adjusted portfolio," he says.