Market watchers have been predicting an interest rate hike or so long that it's begun to feel like the fable about the boy who cried wolf. But lest the villagers (played in this rendition by your clients) forget the lesson of that tale, the wolf really did appear, finally, and gobbled up the sheep.
The point being that interest rates will come back, finally, and investors need to be ready.
Of course, the key to constructing a portfolio that can protect against risk and generate attractive returns under a variety of market environments remains simple diversification. But heres the conundrum: With the U.S. stock market rallying away, despite claims of overvaluation and intermittent correction fears, strategists continue to advise an overweight in equities for all but the most conservative clients. Balancing that stock exposure means also investing in fixed income with as close to zero stock market correlation as possible, aka U.S. Treasuries. But when interest rates do riseconventional wisdom now says by the middle of next year, possibly soonerbonds typically take a hit, with Treasuries getting thumped the hardest.
With stocks, its less predictable. They can potentially trade off as a result of rising debt costs, although they could perform well, especially certain sectors, because rising rates typically indicates a strong or improving economy.
All of this means advisors need to consider a variety of strategies that can benefit from a rate increase while minimizing any potential volatility along the way. Because putting this barrage of information together and trying to guess exactly when and how it will all play out is no easy feat.
Thats why Im not a guesser, says Brick Sturgeon, a financial advisor with Pinnacle Financial Partners in Nashville, Tenn. Ive learned in 25 years in the business that there are very few good guessers. And I think the majority of us do our clients a disservice when we try to market ourselves as good guessers. I tell clients, my job is not to outguess, my job is to keep you from making a big mistake. (Raymond James is the third-party marketer for Pinnacle.)
So how can advisors help their clients prepare their portfolios for an increase in rates and still maintain sufficient diversification?
Strategist and financial planners shared their preferred strategies, from the basic move of limiting bond duration to investing in asset classes that clients may not be so comfortable with, like emerging markets and hedge funds.
Amid the various opinions, one thing seemed clear: Whether it stems from a general lack of knowledge of investments and risk, or simply good old-fashioned fear, many clients are not as diversified as they should be. And theyre definitely not taking advantage of strategies that can greatly reduce interest rate risk and even boost returns.
CLIMBING THE CORPORATE LADDER
When considering domestic options, one specific type of bond can serve as a relatively safe stand-in for Treasuries in times of rising rates: short duration, high-grade corporate bonds.
Since June 1992, there have been seven times when interest rates have risen one percentage point or more, says Robert Reich, a financial advisor with Wells Fargo in Mclean, Va. So weve looked and asked ourselves: which asset classes performed well then? And which ones gave clients the greatest margin of safety? One of those is short-term, investment-grade corporate securities. During each of these seven periods, short-term corporate securities outperformed the Barclays U.S. Aggregate Bond Index, probably outperformed by an average of three percent.
Part of the reason for this is simple. While all bonds feel the pain when rates rise, the longer a bonds duration, the greater its sensitivity to interest rates changes. (The basic rule of thumb: a bond with a 10-year duration will decrease in value by 10% if interest rates rise 1%; while a bond with a two-year duration, will decline 2% with a 1% rate increase).
Reich and his colleagues are shunning any fixed-income exposure longer than intermediate term, which in their book means two to five years.
This advice is especially important for mass-affluent investors as they more often invest in mutual funds and exchange-traded funds rather than individual bonds. With an individual bond or a ladder of bonds (a group of bonds with staggered maturity dates), an investor can get the full principal back when the bonds mature, assuming the issuer doesnt default.
If you own a bond, you have the ability to hold it to maturity. Although it will see some volatility in a rising interest rate environment, as long as you own a high quality instrument, youre likely to get your money back, says Mary Ann Bartels, chief investment officer of portfolio solutions at Merrill Lynch Wealth Management.
An investor doesnt have that kind of guarantee with mutual funds or ETFs (which have grown significantly in popularity among mass-affluent investors.)
When bond prices fall, bond funds decline in value. And even if someone holds onto that fund, fellow shareholders could very well start selling when they see their balances drop.
Bond fund managers will be positioned for rising rates, but they may be forced to sell maturities to meet redemptions, Bartels says.
So for clients invested mainly in funds, advisors may want to consider funds that hold bonds with a lower average maturity.
Examples include Dodge & Cox Income, Vanguard Short-Term Investment Grade, and Lord Abbett Short Duration Income, which does include a small percentage of high yield bonds.
UN-CONSTRAIN YOURSELF
The jury is still generally out on unconstrained or nontraditional bond funds, which in recent years have been heavily marketed as a useful tool in a rising rate environment. As the name would suggest, the managers of this relatively new type of fund can own debt instruments of any sortcorporate or government, in any country and currency, and of any quality or durationto try to enhance returns.
So far, the enhancing returns part hasnt worked out so well. The average nontraditional bond fund returned .3% last year and 2.4% in the first half of 2014, according to Morningstar. This improves to roughly 3.5% for three years.
That said, not all unconstrained funds fit into the same box. The returns of these funds vary widely; many are designed to perform best when interest rates rise and are yet unproven. Which means they could do quite well when that scenario arises. Or not. Advisors recommend understanding the organization behind the fund and going with well-known, sizeable firms. Favorites include BlackRock Strategic Income Opportunities, J.P. Morgan Strategic Income Opportunities and Pimco Unconstrained Bond.
When it comes to rising rates, the duration piece is the reason some advisors find these funds appealing.
I use strategic fixed income because they can go negative duration or manage duration with swaps, says Sturgeon, who favors the BlackRock fund. Youre giving up yield potential, and youre giving up upside appreciation if rates go down, but thats going to be your hedge in a rising rate environment.
A portfolio using a negative duration strategya strategy that shorts Treasury bonds with longer duration futures contracts, such as a negative five- or negative seven-year exposurewill increase in value when rates rise, barring other impacts.
Essentially you go in there and short bonds, which means as interest rates rise, youll be able to make money, says Anthony Chan, chief economist at Chase Private Client.
At least thats the plan. But not everyone is convinced. Im never excited to be one of the first people into a new strategy, Reich says. Unconstrained bonds are really a new phenomenon. Folks talk about the ability to have negative durations and engage in these unproven strategies. So they tell me, this bond fund with a negative duration will do this when interest rates do that. And I ask myself, well, how do you really know that? Because it hasnt been around when weve been in this kind of environment.
LET IT FLOAT
While high yield bonds have always been a favorite tool for boosting yield, they also exhibit strong correlation to stocks and add more risk to a bond portfolio than many clients can stomach. So in lieu of this option, and especially in a rising rate environment, floating-rate bank loan funds offer an alternative.
Like junk bonds, bank loans generally have lower credit quality because they are issued by subinvestment-grade companies. But because a bank loan sits at the top of the capital structure, the credit risk is lower than with a bond. Moreover, the floating rate offers a hedge against interest rate risk, so these funds will generally outperform the index when rates rise.
The average floating-rate fund returned just under 2% in the first half of 2014. But if you look longer term the returns improve, rising steadily to 6.65% over five years, according to Morningstar.
Still, these funds are not without risk. They exhibited quite a high level of volatility in 2008. So advisors generally advocate using a floating-rate fund as a partial or complimentary strategy within the bond portfolio, not as a replacement for bonds.
CROSS THE BORDER
A key component to diversification in general, and especially when U.S. rates look poised to rise, is international exposure.
However, most mass-affluent investors dont invest overseas. A study released in January of this year by research firm Spectrem Group, found that just 17% of mass-affluent investors intended to invest beyond U.S. borders this year.
The safest alternative to U.S. Treasuries is the government debt of developed nations with strong economies, such as Germany and Japan. This diversification strategy can be especially effective in guarding against interest rate changes, because rates in different countries dont necessarily rise and fall together.
Case in point: just as the U.S. looks poised for a hike, the European Central Bank recently cut rates in Europe to about as thin as they can go, reflecting the stifled economy there.
To help boost returns as well as add diversification, strategists and financial planners advise investing a portion in emerging markets debt and equities. These funds not only offer stronger returns, but the countries tend to have lower debt-to-income ratios and more rapidly expanding economies than developed nations. Of course, emerging markets do have a higher risk profile, though they are not homogeneous, so strategists advise being selective.
Within emerging markets, there is various potential and you can diversify as well, Chan says. You can look at Latin American emerging markets, you can look at Asian emerging markets, you can look at emerging Europe. We happen to favor the Asian emerging markets right now. Weve been nervous about Latin American because some of the biggest markets there have been having some problems with regards to growth, but that could change.
The average emerging markets debt fund tanked in 2013, posting a 7.27% loss, according to Morningstar. But they raced back on track for the first half of 2014, returning 6.6%. Over five years, the average fund returned nearly 8%.
Theres also the question of convincing leery clients, who might find the emerging markets label a bit frightening.
I think you have to walk them through it and explain the unique opportunities that are available, Reich says. Certainly, there are unique risks there, you have to ask yourself whether youre going to use strategies that hedge against the dollar or do not hedge against the dollar. That introduces another level of risk. I think it takes a little more work and a little more education on the clients part.
TAKE STOCK--ITS NOT JUST ABOUT FIXED INCOME
While much of the conversation about rising rates revolves around fixed income, equities generally make up a larger portion of a clients portfolio and there are issues to consider within the equity portfolio with regards to rising rates.
When the Fed makes its move in an upward direction, it generally means economic indicators point toward a strong or improving economy. And while stocks can lose value when rates jump due to rising debt costs, they typically recover quickly because of strong fundamentals, and they can provide a nice enhancement to returns.
Everything gets hit when rates rise, Sturgeon says. Theres really not a fool-proof method of avoiding rising rates. But equities have the staying power to overcome the damage because rising rates are going to be accompanied with faster growth in the economy. And within, say, six months, the markets will settle down, and equities have the ability to recover.
There are also certain sectors that tend to do better in a growth economy, those being the cyclical sectors best avoided during a recession or stagnant period. These include sectors related to discretionary consumer spending, as well as technology, industrials, and financials. Indeed, the financial sector makes more money when the yield curve gets steepened.
If you look at the average, large-cap bank, their balance sheets look great, but low interest rates are squeezing their margins, says Brock Kidd, an advisor with Pinnacle, who works with Sturgeon. When interest rates go up, their margins should improve.
HEDGE WHERE OTHERS FEAR TO TREAD
Hedge funds may be intimidating to some investors, but strategists and advisors alike say these funds, or mutual funds that use similar strategies, can help reduce risk and offer diversification as rates rise. Hedge fund managers have the ability to be flexible in their positioning, which provides diversity to traditional equity and bond allocations and significant non-correlation.
As interest rates begin to rise, several hedge fund strategies can potentially make money: long/short credit, long/short equity, and global macro, as well as various relative value and arbitrage strategies. Chan favors macro hedge funds that short Treasuries to generate negative duration (as described above with the unconstrained bond funds) and credit hedge funds that aim to hedge out rate risk and focus on alpha.
Moreover, a multi-strategy fund that offers exposure to a variety of these noncorrelated strategies and asset classes can potentially deliver steady performance during a period of rising rates, even if volatility occurs.
The caveat with hedge funds is they tend to be illiquid, so a client has to be in the position to let the money sit to fully take advantage of them. There are now liquid versions of these types of funds, however, the liquidity can undermine a funds ability to execute certain strategies, advisors warn. So it is particularly important to work with a manager with experience, expertise, and a commitment to delivering style purity.
Then theres the question of fear. Much like the emerging markets asset class, hedge funds are often misunderstood and can sound scary.
Hedging is a risk reducing strategy, not a risk enhancing strategy (as some people believe), Sturgeon says. Its just about education. Once you explain that the long/short fund [reduces risk] it usually is not an issue. Plus, I own these in my own account, so I show them that. I give them a copy of my Raymond James statement.
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