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Are Clients Taking More Bond Risk Than They Realize?

October 22, 2015

Client portfolios have recently been buffeted by the volatility of the equity and fixed-income markets, due to mostly technical factors and contagion from the Chinese markets. We should see this volatility not as a fundamental deterioration of the market, but rather as a short-term technical deviation: the U.S. economy has moved from strength to strength — in GDP growth, in strong jobs numbers and in corporate earnings reports.

We should expect more of this disconnect between the technical results in the public markets and the fundamental performance of the U.S. economy, as the Fed plans its rate increase. The question is what to do. If clients’ portfolios rely heavily on bond ETFs and fixed-income mutual funds, they may see significantly increased volatility in their portfolios — additional risk that they aren’t getting paid for. However, fixed-income alternatives — including private debt and muni bonds — can be a good complement for clients’ portfolios containing a traditional mix of investment-grade and high-yield bonds. It also gives clients the ability to place money behind some of the very best U.S. middle-market growth companies — with a goal of achieving investment returns with low risk to principal, current income and low volatility.

Advisors today must consistently educate clients on the mechanics driving today’s market volatility. Clients must know yields will remain historically low and bond prices will likely continue to fall, accompanied by higher levels of risk and volatility as investors continue to chase incremental returns wherever they can find them. Overall, the difference in this rising-rate environment is the heavy volume carried by bond ETFs and mutual funds, which have both seen significant flows in recent years. According to the Investment Company Institute, more than $900 billion since 2010 has gone into these vehicles. As a rule, these products seek to match the major fixed-income indexes and offer instant liquidity against a diverse set of securities, some of which are more liquid than others.

But in a rising-rate environment, that promise may break down because pricing on the less-liquid elements of the portfolio will drop more rapidly as risk spreads widen, according to analysts at Barclays and results from the recent market reversal.

For open-ended, high-yield mutual funds, sellers have a perverse incentive to get out first — because net asset values (NAVs) on which mutual funds are priced daily tend to lag in a diverse high-yield fund portfolio with variable underlying liquidity. In other words, the first sellers in a significant market sell-off get the benefit of an inflated price.

With bond ETF exposure, clients will stomach more-significant gyrations on a daily or weekly basis relative to the benchmarked cash index. This is because the tracking error of a given ETF can significantly magnify volatility before returning to normal. For example, when high-yield markets sold off during the summer, the high-yield index dropped 5% and has recovered recently to 3% below its last high at the beginning of June. Correspondingly, the largest ETF, HYG, dropped 7% and remains 5% below its high point.

By most measures, U.S-invested clients have exposure to an economy that is performing well in absolute terms and even better on a relative basis globally, given weakness in China and sluggishness in Europe.

One area of opportunity we have noticed is middle-market U.S. companies. Seventy-five percent of middle-market companies increased revenue growth in the second quarter according to a recent survey and reported an average of 6.6% year-over-year growth. As a result, advisors can talk with clients about investing in the debt of middle-market companies — a strategy that can generate private-equity-like returns, with current income and reduced volatility.

To ensure that clients understand why this approach is relevant today, it can be helpful to address the following three factors:

  • Watch out for stocks in bond clothing. Recognize the volatility in the bond ETFs and mutual funds your clients own, and evaluate whether the yield is sufficient to deserve a slot in your fixed-income portfolio.
  • Buy American. Refocus portfolios on U.S. corporate stocks and bonds (excluding energy), and avoid global funds and troubled geographies like China and Southern Europe.
  • Match potential reward to risk. Selectively seek high-yield products, like private debt, that finance the U.S. middle market but avoid the volatility and technical risks of the corporate bond markets.

Without question, clients face a challenging period ahead in the bond market. Consequently, advisors and clients are well advised to make sure they aren’t underestimating the risk in their portfolios. As part of this due diligence, they should consider alternatives that provide fixed-income opportunities with better risk-reward potential than more “liquid” alternatives.