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Adding value by investing in SMAs

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The dynamic nature of interest rate movements can create heightened volatility in the fixed-income market, especially when rising interest rates threaten bond prices.

But it can also create opportunities for advisory clients who own separately managed accounts to find added value instead of getting caught up in market volatility. Skilled investment managers in a position to select and trade individual bond securities can identify market inefficiencies and spot better-priced quality investments for client portfolios.

A key aspect of investing in bonds is that, unlike investing in stocks, it is more about total return— including income—than price gains alone.

This is partly what makes bonds an essential component in a well-diversified portfolio. They are defensive assets and a volatility dampener, and rising rates can provide greater yield for those selecting the right individual securities.

Another important aspect of fixed income is the dynamic nature of short- and long-term rates.

Although the prevailing short-term rates are set directly by the Federal Reserve, longer-term rates are fundamentally driven by inflation expectations and other market forces and may not exactly reflect the moves being made at the short end. For instance, as of March 31, the yield on the 1-month Treasury bill had risen 90 basis points over the prior year, whereas the 10-year rate had moved up 35 basis points, and the 30-year rate had slipped 4 basis points.

Given that the yield curve can reshape itself and there is no way to predict exactly when a turn will occur, investors can benefit from individually managed fixed-income portfolios, especially when rates are rising.

There are benefits of SMAs over passive participation in funds.

These include when investors get spooked by the direction of rates and sell, active managers can take advantage of opportunistic prices in individual bonds. Managers could, for instance, sell shorter-duration bonds that are close to par anyway and look for quality bargains farther out on the curve where there is volatility.

In addition, SMA managers can time individual trades to best suit client objectives. At the very least, managers can simply hold onto their bonds until maturity to receive 100% of par, reaping a total-return amount they know with certainty.

On the other hand, investors in a mutual fund have no control of the timing of trades and might be forced into selling, which could lead to unwelcome taxable capital gains.

In sum, skilled active managers can find rising rates to be an opportunistic setting in which to look for inefficiencies in the market created by indices and other investors. Managers equipped with keen insight and deep research capabilities can spot high-quality securities for their SMA clients and add greater value by earning yield in addition to what the market would dictate.

This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.

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