It seems as though America is always engaged in a struggle between two opposing forces. Whether it's Republican versus Democrat or "tastes great" versus "less filling," it is often difficult to find the middle ground. This task is harder because over time the middle ground may actually shift. This struggle is evident today in fixed-income investing as clients are caught between the desire to "stay safe" and the desire to generate "more income."
The past few years have coupled high levels of uncertainty and apprehension with an environment of decreasing interest rates, with one perhaps driving the other. At first, clients simply sought a safe harbor from the storm, but now they are increasingly aware of the risk of running low on income to cover their living needs. So maybe it's just the natural progression that they are now exploring fixed-income options outside of the relative safety of the most conservative approaches. This means taking risks, including some that clients may not be aware of or attuned to.
As advisors, it's our job in serving our clients to help educate them about the risks they face as they seek a better balance between safety and higher income. Here are some ideas that your clients may find helpful.
Beware of Concentration
Avoid, as much as possible, concentration risk, where different kinds of assets show close correlations during times of market stress. If a client is worried about the impact of a slowing China, for example, adding a position in the bonds and currencies of a specific country like Australia may not bring the desired results. You may think that the two nations are quite different, only to find that the economies of both are linked to oil, aluminum, copper and other commodities. In other words, it's important to think through global interaction and perhaps seek a wider diversification of global fixed income to offset specific risks.
Be careful about stretching for yield, especially in an environment that has been driven by technical factors. In an economy with 2% GDP growth, we are seeing asset prices in high-yield credits that some would argue are misaligned with underlying economic fundamentals. We should be asking ourselves: Is it more likely that the risk market will come back down in line with today's 2% growth rate or that the GDP will literally double from where we are today?
We may be in a "bond picker's market" over the next few years. Instead of focusing only on a coupon, investors might benefit from a manager who can seek total return by taking advantage of inefficiencies that exist between different bond markets of sub-asset classes. In the global space, diversifying over a wide range of global economies and doing so with different approaches to participation may be something to consider.
Truth in Labeling
While many financial advisors may set up a screener based on yield that offers perhaps 6.5% or 7%, what you really should be asking is, "Where's the true high-yield market right now for the type of paper I want to buy, and how is the distribution rate being made so high?" There is no free lunch in the bond market. It is a very efficient market that typically prices assets very correctly. So before buying, a client should ask, "Why am I being paid? What is behind the higher income?"
Be cautious about credit scales, especially in the global high-yield market, where some companies (and countries) that barely survived the recession are now generating market focus. Consider the results of a recent poll of 1,000 CFOs by BDO, a business consulting firm. A majority said Greece was a riskier bet for investors than war-torn Syria. Really?
Rotation, Rotation, Rotation
Equity investors generally understand that different asset classes perform with differing degrees of success throughout economic cycles. It may be better to own small-cap stocks during early-stage recoveries and large-cap diversified companies when things turn down. In my experience, however, investors are slow to view the fixed-income markets through the same lens.
Take a fresh look at the performance rotation among fixed-income asset classes. It will remind you that the fixed-income market consists of many asset classes beyond core U.S. treasuries. Much as in the equity markets, these classes rotate based on the fundamental environment that affects them over time. Sharing a view of that rotation may benefit clients by guarding against being too focused in their allocation.
Very few investors know just how much more risk they must take today to generate increased fixed income. Can your clients handle the truth about bonds?
I believe they can. I believe portfolio reviews are a great time to educate your clients about how the world of bonds has changed and the right approach for finding the middle ground they seek.
Here are my suggestions for reviewing your clients' fixed-income positioning:
First, be sure they are diversified in terms of increasing rates. Test portfolios to determine the impact of a 100 or 200 basis-point increase over the short term. If it doesn't happen, there is no harm done. If it does, at least they were aware of the potential risk.
Second, examine both their high-yield and core bond strategy. Determine where the credit is allocated in order to confirm that their core bond strategy will provide the riskless ballast to the portfolio in times of market stress, while the high-yield exposure will supplement their income needs.
Finally, look beyond the U.S. borders for exposure to countries that are in different positions relative to their fundamental economic drivers. But in doing so, be sure that the exposure is broad, that research capabilities are deep, and that the manager has the flexibility to take advantage of unique opportunities that may otherwise be overlooked. These three steps can provide a healthy perspective about the impact of unpredictable risks on the "predictable" portion of clients' portfolios.
John Diehl is a senior vice president of the Hartford Mutual Funds.
The views expressed here are those of John Diehl and they should not
be construed as investment advice. They are subject to change.
John Diehl does not offer any financial planner services on
behalf of The Hartford. Clients should contact their own advisors
for specific advice. "The Hartford" is the The Hartford
Financial Services Group and its subsidiaries.