Professional financial advisors know that interest yields on high-quality bonds are historically low. And that can spell disaster for certain clients.
When retired or retiring clients understand the current and likely future state of bond investing, and how it has changed in a way that will deny them the benefits enjoyed by their parents, it will be up to their financial advisor to counsel them.
What you do in that discussion might just be the difference between your practice growing, treading water or sinking.
Here’s how to explain the realities of today’s bond markets to your clients — and help them adjust to new investing realities when it comes to bonds.
The Risks Your Clients Carry by Owning Bonds Today
The bond market used to be a way to balance your clients’ equity portfolios. Now, it’s more like a proverbial game of chicken, making it similar to the equity market with its sky-high valuations.
Yields on U.S. Treasury securities and high-quality corporate bonds — those rated A or better — have been low for a while.
The 10-year Treasury bond yielded well above 4% for decades. Over the past decade, it has rarely crossed above 3%. One reason for that was low inflation, but inflation, as measured at the government level, is picking up. While Federal Reserve Chair Jerome Powell likes to refer to inflation as “transitory,” that word only means “not forever.” Your clients are not planning to live forever. Their concern is the next few decades, a period over which higher inflation is a distinct possibility.
This reality has probably caused some in the financial planning industry to reach for yield by owning lower-quality bonds. But those financial products are only as good as the Fed’s implicit backing.
The number of companies with lower-quality bond issues that cannot make their payments has grown, thanks to rates being suppressed for so long. This may not be a reason to avoid junk bonds, but it should be a reason to change how you classify them for clients. They are not bonds as much as they are equity-like instruments, with equity-like volatility potential and a little more yield.
There may come a day when the market believes that the Fed can’t save bonds rated BBB and lower, preferred stocks and convertible securities. Then, as in past credit market crises, they will blow up without much warning.
Why You Should Care, Even If Your Clients Don’t
When clients figure out that the fee percentage rate they pay makes up most or all of the yield they earn on the bond portion of their portfolio, how will you respond?
For the past few years, financial advisors could hide behind low rates getting lower, which added price return to those paltry yields, producing decent total returns for bonds. And inflation was low, so advisors could position bonds as a value-added feature of their investment work for clients.
But now, with inflation rising and bond rates having fallen, what explanation do you have?
This bond situation may have crept up on clients. After all, the yield on the popular Barclays Aggregate Bond Index has fallen over the past decade. In addition, many bonds owned by active bond managers are rated BBB-, the lowest investment-grade level.
Imagine the chaos that would ensue if Fed support diminished and some of those BBB bonds dropped to BB+, the highest junk level, forcing funds that track the bond benchmark to sell many of their holdings, likely without much interest from buyers. This is just one potential casualty that the state of the current bond market has put on the table for clients.
Creating a Potential Alternative Solution
Before you decide to simply turn your 60/40 portfolio into a 100/0 portfolio, comprised of all equities, consider that there are other ways to replace what used to be your stock market balancing act. It starts with the concept of tactical management alongside your core long-term investments.
Tactical management is a more viable consideration for advisors now. Simply put, tactical investing is where you set out to capture profits over shorter time periods such as weeks or months. This offers the potential to earn investment return through a wide variety of asset classes other than bonds. It may also help stem major declines in value because tactical investors don’t aim to hold investments through the ups and downs as a long-term investor might.
Clients are starting to hear more about the demise of bond investing. But the other major change in today’s markets is how increased volatility and an expanded opportunity create more ways to pursue lower-volatility, noncash, nonbond investments that could beat bond returns. For example, innovation in the exchange-traded-fund space now allows skilled tactical managers to create and rotate portfolios, seeking gains in smaller bites and managing risk proactively.
While advisors have traditionally used that 60/40 framework to buy and hold stocks and bonds, they can decide to allocate based not on asset type, but on the relative speed at which holdings turn over. In other words, a balanced portfolio becomes an allocation based on the expected holding period of the investments rather than on stocks versus bonds. You allocate between long-term investments and shorter-term investments.
If you have ever talked to clients about the “bucket” approach to investing, this is just a different version of it. But instead of the first bucket simply being cash equivalents, which is a loser for your clients, your short-term bucket contains investments that may be more volatile if you held them long term. But you cut down a lot of that volatility by establishing loss thresholds.
Delivering the Message
Once you have created your answer to the bond morass, you can celebrate by describing it to your clients.
If you are offering an alternative to standard bond strategies, there’s a good chance they will be receptive to it. Bull markets tend to make investors think all advisors look the same. This is your opportunity to stand out at a time when they need you to.
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Why Bond Investing May Be Losing Your Clients Money originally appeared on usnews.com