Bond Volatility: Do the Math
Since early 2016, benchmark 10-year Treasury note yields have dropped by roughly 30%. At the same time, many Wall Street pundits keep forecasting an imminent hike in interest rates.
“Trying to predict the timing and depth of Federal Reserve policy pivots is really difficult to do for clients,” says Randal Golden, cofounder of Vivaldi Capital Management in Chicago, which manages about $1.3 billion.
With uncertainty over when the Federal Reserve will start hiking interest rates, Wall Street analysts are noting that it’s probably smart for advisors to rethink their strategic allocations to bonds.
While that might not be a bad plan of attack, several experienced fixed income experts at wealth management shops are warning that talking to clients in times of heightened volatility needs to be done with a high degree of objectivity.
“With bonds you have an advantage because there’s a defined income stream being paid on a regular basis,” says Golden, whose firm works with both ultra high net worth individuals and family offices.
So even though prices might be volatile, he still finds that “you can sketch out to clients a basic picture of how bonds might react under different interest rate scenarios.”
Start with three very basic patterns, suggests Jason Stuck, director of analytics at Chicago-based consultancy Performance Trust.
Four years ago the indie broker-dealer started working with advisors to supply analysis and trading services related to developing efficient bond ladders.
“With everyone trying to predict how soon the Fed might raise rates, we’re telling advisors that doing some basic math can reduce a lot of the guesswork involved in reassessing clients’ bond holdings,” Stuck says.
In the case of rates moving higher, he points out that FAs can look at someone’s average bond portfolio duration, a measure of interest rate sensitivity.
For example, a client might own a diversified mix of bonds with a five-year average duration. If rates rise 3% over a three-year stretch, then Stuck would multiply that portfolio’s average coupon – or the amount someone is actually going to be paid – by three.
That part of the equation covers income possibilities. But another factor is pricing.
Since fixed income prices move inversely to yields, Stuck says in such a scenario he might recommend subtracting 3% from the current price of a typical bond in a client’s portfolio.
For clients with $1 million, say, he figures a bond ladder of U.S. munis under such conditions could generate a net return of 0.16% – or $1,600 a year. By contrast, Stuck estimates that if rates drop by 3% in that period, a client might realize a total return of 3%, or $30,000 a year.
In the event that rates stay steady, he calculates that someone with such a portfolio could make 2.3%, or almost $23,000 annually.
“With bonds you can really take clients through those three basic scenarios and give them fairly good estimates of where their portfolios will come out,” Stuck says.
Of course, these examples are highly simplified for educational purposes, he adds. At Performance Trust, his team digs down to analyze each portfolio bond-by-bond. The firm’s analysts also take into account specific market values by different fixed-income sectors.
“It’s not exactly rocket science,” Stuck says. “But the idea we’re trying to get across to advisors is that bonds lend themselves to being mathematically analyzed in a way that you can’t do with stocks.”
Nancy Skeans, a partner at Schneider Downs Wealth Management Advisors, is also avoiding complex forecasting models to answer questions about how higher rates might impact bonds.
The Pittsburgh-based advisor, whose firm manages more than $1 billion, warns that even simple number crunching can cause confusion for some clients.
“While we run through some basic scenarios, we’re doing it to complement in-depth and ongoing asset allocation conversations,” she says.
Instead of expecting her clients to gain some sort of specific outcomes from such a discussion, Skeans adds, “we’re really trying to show them that our planning process has taken into consideration all of the different scenarios.”
That point alone, she says, “is a valuable way to let clients know they don’t have to worry that we’re going to drop the ball in monitoring their fixed income investments.”