Financial advisors know boomers need a diversified selection of bonds if they want them to generate a long-term income stream with moderate volatility. However, selecting the types of bonds and tailoring that mix to economic conditions is no simple matter.
Although financial advisors can manage interest-rate risk using either a laddered approach or a barbell strategy, the emerging intricacies of bond investing make it worthwhile to consider placing a portion of client retirement portfolios in a multi-sector bond fund.
Selecting bonds requires considerable expertise in five key areas: duration management, yield curve strategy, currency management/international exposure, sector allocation and security selection.
Managing duration -- Duration is a measure of a bond portfolio's sensitivity to interest rate changes. The art and science of a duration call is in the ability to forecast interest rates. When interest rates decline, bond prices tend to rise and longer durations are more desirable. Considerations include:
- Business cycle analysis: Longer durations usually are preferable during periods of slowing growth and recession.
- Value indicators: Consider the extent to which yields reflect the current business cycle and how accurately the market has priced in what is expected over the next six months.
- Global attractiveness: At any given period, some foreign economies and yields may be more attractive than those of the U.S.
Yield curve strategy -- Decision factors include valuation indicators that identify specific areas of value along the curve, regardless of the direction in interest rates. Price/yield trade-off analyzes the relationship between bond prices and bond yields and considers the investment trade-off between the two. Anticipating federal reserve policy will help you consider the prospects for interest rates increases or decreases based on the for inflation and economic growth outlook.
Currency/international exposure -- Key factors in determining currency outlook are expectations for the U.S. balance of trade and government spending. When deficits in either or both are expected to rise, the dollar typically weakens. Currency swings are notoriously volatile and unpredictable. Other factors affecting this decision include the relative strength of the U.S. economy versus those of its major trading partners, as well as relative levels of interest rates across the globe.
The sector allocation decision -- Key considerations include historical spread analysis or the relative attractiveness of a sector based on current yield relative to treasuries vs. the typical historical yield spread. Also, consider the various sectors' performance history over several market cycles in order to estimate their likely volatility relative to each other. Lastly, consider the sector's suitability in relation to current the business cycle.
Security selection -- Individual security analysis typically includes a determination of risks related to default, call, prepayment and interest rates. Sector-specific considerations include:
- Corporate: Detailed, fundamental analysis determines the best securities within specific credit quality constraints; diversify by company and industry.
- Mortgage-backed: The portfolio manager should have in-depth knowledge of pool-specific characteristics, including the structure of the security, the effectiveness of the mortgage servicer, the borrower's credit score and the loan-to-value ratio.
- High yield: Credit concerns are paramount. Consider each company's competitive position and management expertise. Diversify by company and industry.
- International: Analyze credit risk, interest rate risk, security risk and currency risk.
- U.S. Treasury/Agency: Backed by the full faith and credit of the U.S. government, these securities require relatively little credit analysis.
For all of these reasons, the case for expert, professional management of a bond portfolio has never been more compelling.
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