From the November 2006 issue of Wealth Manager Web • Subscribe!

A New Look

Fixed income used to be so predictable. For two years, the Federal Reserve Open Market Committee (FOMC) ratcheted up short-term interest rates 0.25 percent at every meeting and signaled higher rates to come. Meanwhile, the economy prospered, and the default rate in high yield corporate bonds sank to just 1 percent. Advisors and money managers kept durations short, reinvested maturing bonds at ever higher rates, and dabbled in high yield bonds to take advantage of tightening credit spreads. That game came to an end earlier this year when credit spreads began to creep up in the corporate market. Merger and acquisition activity was booming, which often undermines credit quality--sometimes dramatically when the buyer is a private equity group. Then in August, the FOMC left the target Fed Funds rate unchanged at 5.25 percent. If short-term rates are close to a peak, fixed income portfolios deserve another look.

The knee-jerk reaction among advisors and bond managers is to extend duration. For Acropolis Advisors, a $750 million wealth management firm based in St. Louis, Mo., that means targeting three to five years instead of the one- to two-year duration it maintained while rates were rising, according to general partner David Ott. The firm's clients are typically retired (or close to it) and wealthy; they don't rely on cash flow from their fixed income portfolios to meet living expenses. "Most of the fixed income is taxable bonds held in tax-deferred accounts," Ott explains. "Equities--where you can control the timing of capital gains, and the dividends are taxed at 15 percent--go into the taxable account." His asset allocation strategy minimizes taxes, but isn't appropriate for clients who need current income.

Acropolis avoids credit risk by focusing on government agency bonds and mortgage-backed securities (MBS); the firm does not own any corporate bonds. Pre-payments from mortgage pools shorten duration, of course, so Acropolis met its new duration target by adding callable agency bonds to its existing MBS portfolios: The mix is now 50/50. Ott believes fixed income expertise gives his firm a competitive edge in the local market.

In its private client portfolios--about $425 million--Acropolis allocates 40 percent to fixed income in the aggregate. The precise figure depends on a client's circumstances, but most fall in the 30 percent to 50 percent range. Acropolis sets this allocation during its annual portfolio review, and market conditions don't alter it. "It's less a decision about stocks versus bonds than a reflection of how much risk the client is willing to take," Ott explains.

Other financial advisors take a similar approach, even if they have a different target allocation and client base. At Welch & Forbes, a $4 billion wealth manager in Waltham, Mass., President Richard Young says representative clients have about 25 percent in fixed income, depending on their need for income and risk tolerance. "We manage that within constraints that are set up at the time people become clients and then review periodically," says Young.

Welch & Forbes specializes in family offices. It advises 400 to 500 families. The typical client is a taxable trust with multiple beneficiaries--about 2,000 accounts in total. The firm tolerates a wide range of fixed income allocations (0 percent to 50 percent) as it tries to balance current trust beneficiaries' need for income against future remainder interests' preference for capital growth.

Half of its fixed income portfolios are in high-quality general obligation municipal bonds in a tax jurisdiction appropriate for the client. The rest includes treasuries, corporate bonds rated AA or better and government insured agency bonds. Young shuns lower quality credits because his clients are looking for reliable income and capital preservation. "I'd rather take risk with stocks," he says, "You don't want to impose a risk on a client that is counterproductive to why you have fixed income in the portfolio in the first place." Young is willing to push out duration beyond five years in the high-quality market, however, even if the yield curve is flat.

Tom Carstens, partner and president of Lenox Advisors, a $1 billion New York-based wealth manager, is doing the same thing for some of the smartest money around: Investment bankers and hedge fund managers, his firm's core clients. Lenox doesn't manage money itself; it looks for the best outside managers it can find for separately managed accounts, hedge funds and funds of hedge funds. At about 18 percent today, the fixed income allocation is lower than most, although Lenox also invests in market neutral hedge funds and private real estate investment trusts, which Carstens views as bond surrogates.

Lenox started moving from "high three-year" duration toward "five to five-and-a-half" years at the end of the first quarter, according to Carstens. He won't go out further while the yield curve is flat, but he reaches the new target through a barbell strategy, reinvesting cash flow from maturing bonds into long-term bonds until the mix is 80 percent short-term and 20 percent in 20-year bonds. "The only reason to sell any of the short-term bonds would be for a tax loss if we needed an offset," Carstens says.

His clients are not looking for excess returns from their fixed income portfolios, but to reduce risk. Taxable accounts--which make up the majority at Lenox--hold almost exclusively high quality AAA or AA municipal bonds. "Most clients, specifically the hedge fund managers, want a portfolio that has a lot of downside protection," says Carstens. He looks for 10-year call protection on the long-term bonds so clients can sit back and collect the income.

Lenox uses mutual funds only for tactical moves, such as its play on high yield bonds. Three years ago, Carstens recommended that clients put 50 percent of their 401(k) money in high yield mutual funds, a "no-brainer" trade as the economy strengthened and default rates fell. "We let the spreads narrow," he says, "Clients made 13 percent annually for two years, and then we reallocated out of it." The mutual fund format gave clients diversification they could not have achieved in an individual high yield bond portfolio.

Some financial advisors prefer to use mutual funds exclusively. Litman/Gregory Asset Management, an Orinda, Calif. wealth advisor, has $800 million in private client money and handles another $2.4 billion on a contract basis for other advisors--all of it in mutual funds. Fixed income comprises about one third of total assets, according to co-chief investment officer Jeremy DeGroot. Litman/Gregory doesn't customize individual allocations, but based on clients' circumstances and risk tolerances selects one of four model portfolios. The conservative balanced portfolio has 60 percent fixed income and 40 percent equity, while its most aggressive portfolio is 100 percent equity. Most clients fall in the middle ground, with either a 40:60 or 25:75 ratio of fixed income to equities.

DeGroot makes core strategic allocations, but will take tactical positions in other funds to take advantage of compelling "fat pitch" return opportunities, like high yield bonds in the early 2000s. Core holdings include the PIMCO Total Return Fund managed by Bill Miller and the Loomis Sayles Bond Fund run by Dan Fuss. He also likes the PIMCO Developing Local Markets Fund, an emerging markets ultra-short duration bond fund denominated in local currencies. "We are not really taking on interest-rate risk," says DeGroot. "It's a dollar hedge. You have a yield advantage from these currencies, and there is currency risk, but we see a risk of secular dollar decline."

Litman/Gregory takes a three- to five-year view when looking at prospective returns, a horizon that makes allocations less sensitive to movements in interest rates. If rates drop, capital gains in the portfolio will be offset by a lower reinvestment rate, and vice versa if rates rise. "Over a five-year period, it doesn't matter that much if your total return goes from 5 percent to 5.5 percent or to 4.5 percent on an annualized basis," says DeGroot.

Money managers operate under different constraints than financial advisors, but they share many of the same views. Mary Miller, director of fixed income at T. Rowe Price in Baltimore, believes that short-term interest rates are close to a peak but anticipates higher default rates as the economy slows. She worries about event risk to corporate bonds from the flurry of leveraged buyouts and mergers, and if late cycle inflationary pressures emerge, she believes long-term rates could rise--particularly in the taxable market.

In tax-exempt bonds, Miller says the long end should hold up better because municipal bonds typically have a 10-year call, and most coupons are higher than today's market rates. As a result, the bonds trade on yield to call date rather than yield to maturity--a shorter duration. That will offer protection if long rates go up, at least until market rates exceed coupon rates and remove the incentive for issuers to call.

Although Miller feels "more constructive than we have been for two years on short- and intermediate-term rates," T. Rowe Price doesn't make big bets on duration. Miller has moved progressively from 10 percent below benchmark a year ago to "neutral to 5 percent above" today.

Howard Greene, a senior vice president and portfolio manager at Boston-based Sovereign Asset Management LLC, an MFC Global company, agrees that short rates have peaked and expects the yield curve to steepen over the next 12 months as the FOMC begins to ease next year. Like Miller, he sticks close to benchmark duration, but has moved out from 4.3 to 4.9 years. Greene points out that "this time, the Fed didn't break anything," as it raised rates, which may explain why today's 350-basis point high yield spread over treasuries is only half what it was at the top of the last credit cycle.

Greene's portfolio includes floating rate notes, short-dated callable agency bonds and adjustable rate MBS at the short end as well as long treasuries and high quality investment grade corporate bonds. He prefers banks, brokers, insurance companies and utilities, which need a solid credit rating to conduct their business and are less susceptible to event risk. "Management and the board are beholden to the shareholders, not the bondholders," says Greene, "We are a bunch of geeks who just want our money back, but we like our valuations to hold steady during that time frame."

PIMCO--the 800-pound gorilla of fixed income managers--believes the fixed income markets are set for a two-year bull run, according to Mark Kiesel, an executive vice president and portfolio manager who heads the Newport Beach, Calif.-based firm's investment-grade corporate desk. He expects a hard landing in the housing market where unsold inventories have soared and homebuilders' order books are shrinking from cancellations--up to 45 percent in some cases.

Kiesel favors the short end of the U.S. bond market in defensive sectors like media, cable, utilities and telecoms where consumers pay the bills even in tough times. He believes the burgeoning federal deficit will force Congress to raise tax rates, so municipal bonds look attractive for individuals. The trade deficit, meanwhile, will put pressure on the dollar and may prompt foreign investors to sell long treasuries, which is why Kiesel prefers two- to five-year maturities.

Among professionals, the consensus seems to be, no matter who your clients are or how much fixed income they own, it's time to move quality up and duration out.

Neil A. O'Hara is a financial writer with intimate knowledge of domestic and international markets from an earlier career in money management. A native of England, he resides with his wife in Lincoln, Mass.

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