Mutual funds. Separately managed accounts. Laddered portfolios. These are the vehicles of choice for advisors looking to put their clients into bonds.
The first two, mutual funds and separately managed accounts, generally leave the direct oversight to a bond manager so the advisor rarely has a good feel for how clients' dollars are spread over the yield curve. In the case of laddered portfolios, they often take a buy-and-hold approach.
For the next couple of years, though, yield curve positioning will be critical to client performance. So it will be imperative for advisors to stay on top of this subject for the sake of their client portfolios.
Bear in mind, performance in much of the bond market is likely to be poor. And poor performance often causes clients to shine a bright light on their portfolio. And if the portfolio is losing money, the bright light can be very uncomfortable-and rightly so.
CURRENT CURVE
If you look at today's Treasury yield curve, you'll see a gentle slope of rising yields starting from the fed funds rate at about 0%, up to the two-year Treasury at 0.38% (see chart on page 25.)
Then, the curve steepens rapidly to 3% at the 10-year mark. And after 10 years, it only rises by one percentage point over the next 20 years, reaching 4% at the 30-year mark.
The kink at the two-year maturity is caused by investors' expectations about rising short-term rates. Judging from the yield curve, the average investor thinks that fed funds rate will not rise during most or all of the next two years.
For bond investors last year, the middle of the curve performed well relative to the entire bond market due to rising rates. An intermediate laddered approach, a corporate-heavy approach or a short-bond heavy approach were winning strategies.
THE END OF QE
This year promises some big changes for the Federal Reserve.
Ben Bernanke's Federal Reserve lowered short-term rates and then, through Quantitative Easing, lowered longer-term rates.
Quantitative Easing, which Janet Yellen's Fed will bring to an end, has put pressure on the 5- to 10-year part of the curve, depressing yields. But QE's end will allow longer bond yields to rise to a market-set level.
Indeed, yields on longer bonds recently have risen as this ending comes into sight. We expect QE to take most of a year to end altogether.
We will assume the last month of bond purchases will be October 2014. The exact date isn't important, as the bond market will anticipate the end long before and yields will reflect it.
What will the yield curve look like by October of 2014? On the short end, fed funds will still be 0%.
Therefore, one-year, two-year and three-year yields will not be much higher than today. The middle of the curve, however, and certainly long bonds, will be higher. The 10-year could easily be 4% or higher while the 30-year would be marginally higher at 4.25% or 4.5%.
Clearly, with yields rising across the curve, returns will be ugly in 2014. The amount of money lost will be a factor of how much rates rise and the duration of the individual investments. The middle portions of the curve should suffer price losses of 5% to 8%.
If this happens as we expect, losses will be concentrated in bonds near the middle of the curve.
For 2014, we have the possibility of long bonds being down slightly in price while intermediate bonds perform very poorly. This will hit many funds, SMA managers and laddered portfolios very hard.
2014 AND BEYOND
Let's assume that your client owns bonds for diversification, income or other reasons. If the portfolio must have at least an intermediate duration, a combination of short and long bonds will likely fare better than a portfolio of intermediate bonds.
Therefore, selling the middle part of the portfolio to buy short and long bonds makes sense. The portfolio could maintain the same average maturity or duration while avoiding the middle of the curve. This of course conflicts with the basic tenets of a laddered portfolio structure.
For mutual fund accounts, purchasing long and short funds and selling intermediate funds would approximate this strategy.
As the yield curve completes this transition in the summer and fall of 2014, investors will turn their eyes to the next question: When will the Fed begin to raise short-term rates and let the short end reach its natural level?
Once again, knowing the timing is not as important as knowing the direction. Assume they start raising rates in October of 2015. When they do, it will not be a surprise.
The market will have begun to adjust months in advance. And once the Fed starts raising rates, it won't stop until it reaches a level well above inflation.
The proper unfettered level for fed funds is between 4% and 5%. To be conservative, let's assume it only raises it to 3%. The yield curve will change from an extremely steep curve to a more normal steepness.
As this happens, yields across the board are likely to rise but in this case the 30-year and 10-year have already risen and are near where they should be. The largest increases in yields will be on the short end.
Losses from rising rates will concentrate in bonds with maturities as short as two to five years.
Once QE is over and the talk turns to higher short rates in the near future, rates in the intermediate part of the curve will rise.
Of the bonds in the middle of the curve, the 10-year bond should underperform first followed by the seven-year and the five-year. By the time the Fed has stopped raising rates, the portfolio will once again look normal. If a ladder is the desired portfolio, rebuilding of the middle rungs will take place in late 2015 and 2016.
Clearly a passive approach is not going to work well with the upcoming yield curve shape shifts. Clients will not understand why the "conservative" part of their portfolio is performing so poorly.
Clients who today say they are happy with a buy-and-hold strategy may not be so happy when they see a 10% loss in an intermediate bond or portfolio.
An active hand will be necessary to help a bond portfolio avoid the worst of the coming awful bond market.
Brian Sullivan is president and CIO of Regions Investment Management, a division of Regions Wealth Management.
