While much conversation has focused on the timing of the first interest rate hike, there has been considerably less discussion about what investors should do with their bond holdings. Even in the face of an uncertain outlook for interest rates, bonds can play a role as a diversifying agent and a source of portfolio income. The $64,000 question is: What fixed-income strategy makes sense right now?
Veres wrote an interesting, though lengthy, summary of the feedback for the Advisor’s Perspectives newsletter. He grouped the responses into five main categories: avoid traditional investment-grade bonds or use mutual funds, separately managed accounts (SMAs), bonds and bond ladders or sophisticated and complex bond strategies. Below are highlights of the strategies used and the rationale behind them.
Avoid Traditional Investment-Grade Bonds: One adviser is using a mix of convertible bonds, preferred stocks, closed-end funds, high-dividend exchange-traded funds (ETFs) and dividend-growth stocks until he feels the time is right to get back into bonds. Another is mixing preferred stocks with credit-worthy high-yield bonds to give her clients with high risk tolerances a larger income stream.
Mutual Funds Instead of Bonds: The common rationale for favoring funds over individual bonds was better diversification, more expertise, improved pricing and better liquidity. One Inside Information subscriber wrote, “Advisers simply don’t have the expertise or the staff that mutual funds do” when it comes to selecting individual bonds. A few advisers observed difficulties in getting favorable prices on bond purchases of less than $1 million and/or expressed concerns about potential difficulties for finding an active enough market to quickly buy or sell bonds at favorable prices (liquidity). One adviser said that portfolio accounting software doesn’t properly value bonds at their amortized costs. He further added, “I don’t want to manage [clients’ bond holdings] out of a spreadsheet.”
Separately Managed Accounts (SMAs): This is a moniker for an actively managed account, with security decisions either made by the adviser, the brokerage firm or a contracted third party. Advisers using SMAs say they prefer this method because it allows them to rely on managers and trading desks with expertise in the bond market and can give their clients better pricing on bonds.
Bonds and Bond Ladders: The primary argument for using individual bonds was the return of capital if they are held to maturity. Many of these advisers believe that using actual bonds would do more to calm clients’ nerves than holding bond funds would. A few advisers said they use certificates of deposit (CDs)—holding CDs with differing maturity dates—to meet planned redemptions.
Interestingly, whereas some advisers refrain from using bonds for clients with smaller portfolios, advisers who use individual bonds say individual investors are better situated to find bargains than institutional investors. This latter group of advisers believe individual investors can purchase odd lots, or a considerably smaller quantity of bonds than larger investors can.
Sophisticated and Complex Strategies: This is essentially a catch-all category for strategies not fitting into the four aforementioned categories. One adviser gave an example of a barbell strategy with 10% allocated to a one-year bond and 90% allocated to a five-year bond. Another adviser is buying long-term bonds to lock in a stream of income. He thinks the amount of long-term income will still be higher than what can be earned five years from now because a client may still prefer to stay in shorter-term bonds in the future if he or she expects interest rates to continue rising.
As you can see, there are varying opinions about what to do, with rationale given for each strategy. None of the advisers based their strategies on what might happen to interest rates, but rather on what securities and funds made the most sense for their clients. It’s an important point because the only thing you can control are your decisions, not what may or may not happen with interest rates in the future.
The Week Ahead
The U.S. financial markets will be closed tomorrow in observance of Good Friday. On behalf of everyone at AAII, happy Easter and happy Passover to those of you who are observing the respective holidays.
First-quarter earnings season will “officially” start on Wednesday when Alcoa (AA) reports. Joining the aluminum company will be fellow S&P 500 members Bed Bath & Beyond (BBBY) on Wednesday and Family Dollar Stores (FDO) and Constellation Brands (STZ) on Thursday. Earnings estimates for S&P 500 companies have been falling overall, but on an average quarter, more than 60% of companies exceed profit expectations.
The first economic report of note will be the ISM non-manufacturing survey, released on Monday. Tuesday will feature the Job Openings and Labor Turnover (JOLTS) survey. The minutes from the March Federal Open Market Committee will be released on Wednesday. Friday will feature March import and export prices.
Minneapolis Federal Reserve Bank President Narayana Kocherlakota will speak publicly on Tuesday and Friday. Richmond president Jeffrey Lacker will also speak publicly on Friday.
The Treasury Department will auction $24 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday.
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.
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