Why Clients Need High-Quality Individual Bonds

Regardless of how quickly interest rates rise, there’s value to be found, says this advisor.

Christopher Baccella

Russia’s invasion of the Ukraine has flooded the financial markets with a lot of confusion and questions, including whether or not the Fed will stay on its projected course of tighter monetary policy by raising interest rates. Concerns about economic growth could encourage the Fed to ease up on anticipated rate hikes. On the other hand, pressure on oil and commodity prices could heat up inflation and necessitate the Fed to act swiftly. But regardless of what happens, income-seeking clients still need that income.

The first conundrum we have as advisors is whether it is better for our clients to sit on cash, waiting for higher rates, or invest now and deal with the market risk.

In our opinion, pockets of the bond market provide opportunity. Late in February, we were finding some value in the 3- to 6-year maturity range.  For example, we are beginning to see 3-year yields touching 2.5% for A-rated corporates, and near 3% for 5-year maturities.

Be Selective

The next decision becomes whether to buy individual bonds or ETFs and mutual funds. And as recent data shows, investing in pooled fixed-income investments may not be the most lucrative approach at this time.

For example, the Vanguard Intermediate Term Bond ETF (BIV) has lost approximately 10.6% from its 5-year high as rates have increased.  Considering that it is currently yielding 2.05%, it could take nearly five years for clients to earn back their market losses through yield.  These losses can be distressing, as clients may have viewed fixed income as their “safe” money, while taking more risk with their equity portfolio.  Indeed, clients may have been overweight in equities to this point, as the paltry yield environment has given them few alternatives.

In this environment, individual bonds they can be relatively beneficial. Unlike ETFs or mutual funds, which are managed in perpetuity, individual bonds have a defined maturity.  So although an individual bond may suffer market losses, typically the bond will converge upon par as it draws closer to its maturity. Until then, the client is entitled to continue clipping coupons (earning interest) along the way.

Mutual funds and ETFs don’t work this way — managers must trade in and out of positions to meet the funds’ cash flows, and thus may not hold positions to maturity.

You would be well-advised to remind clients that as interest rates on newly issued bonds rise, the value of seasoned (previously issued) bonds falls, which can result in existing bonds going underwater. But, if the bonds are high quality and creditworthy, clients will continue to receive interest payments and the return of their principal at maturity. Translation: Clients may miss out on the opportunity to invest at the higher rate, but they have not seen a permanent loss of capital. And they’re likely to find this assuring.

We believe this can be an attractive “King Solomon” approach: Keep the money invested in relatively short bonds with fixed maturities, while anticipating that these funds can be invested later at higher rates. And for older clients who tend to have a greater allocation to bonds in their portfolios, adding in these shorter bonds can be a nice fit.

Overarching Strategies

 Regardless of whether clients buy funds or individual bonds, the following overarching strategies should be followed when managing bond portfolios in a rising interest rate environment:

  • Diversify. In general, no single name should comprise more than 10% of the portfolio.  For larger accounts, a 5% maximum may be appropriate. Typically, Government and Government Agency debt is excluded from this rule of thumb because of their higher safety (creditworthiness).
  • Ladder maturities. Consider spreading out maturities, as opposed to clustering or ‘bulleting’ securities around a specific maturity date. This can help smooth out the portfolio and may allow matured bonds and coupons to be invested at higher rates.
  • Don’t be a yield hog. Stay with investment grade bonds on the corporate or municipal side.  Remember, many clients are already taking risk with their equity investments. Be careful to avoid a double-down that could result from investing in high-yield (a.k.a. “junk”) bonds.
  • Don’t go too far out on the yield curve.Typically, longer-dated bonds have higher yields relative to intermediate bonds. But remember, those longer bonds will have greater interest rate sensitivity. This means they will suffer greater market losses from rising rates, and you may be locking in a low rate for 10 or more years.

So, remind your clients about the difference between a temporary market loss and a permanent loss of capital, and then consider individual bonds for them. But don’t forget those four basics about investing in fixed income.

Income-seeking clients can’t afford to sit on the sidelines as we wait to see how events play out on the national and world stage. They’re no doubt rattled by the economic uncertainty and need your guidance today. Your reassurance and nimble approach to fixed income could help put them at ease.

Christopher Baccella, CFA, an investment advisor with Michigan-based Heber Fuger Wendin, delivers investment management services to the RIA firm’s high net worth and institutional clients. Heber Fuger Wendin has $8 billion in assets under management and has been managing fixed income portfolios since 1934. 

 

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