August 15, 2013

How Investment Gurus Are Fixing Fixed-Income Portfolios

Envestnet|PMC, PIMCO and Guggenheim show how to make portfolios less vulnerable to interest rate shifts

When traditional fixed income yields began their stomach-churning rise in May, strategists started to field calls from advisors looking to get out of their buy-and-hold bonds and into more flexible investments.

During the 30-year secular bull run in fixed income, the conventional wisdom had been that portfolios comprised of anywhere from 70% to 100% bonds enjoyed dependably low volatility and low risk. But when the bond bubble burst in May, advisors and their retiree clients suddenly realized they would need to get into new investments — and fast.

Tim Clift, chief investment strategist, Envestnet|PMC“They were afraid, because typically, fixed-income investors aren’t jumping around in the markets,” said Tim Clift (left), who as chief investment strategist for Envestnet|PMC was one of those people who started to field calls. “Income is the biggest issue that advisors have had questions about this summer, and we’re helping advisors get past buy-and-hold and into flexible opportunities.”

With wealth management and tech software firm Envestnet serving 25,415 advisors, Clift said his Portfolio Management Consultants group had already been warning advisors for a long time that the bond market was a ticking time bomb. When it exploded, PMC was ready with risk diversification strategies that didn’t involve alternatives such as commodities or hedge funds.

“The risks are much higher now because we’re at the end of this 30-year secular trend in fixed income,” Clift said. “We’re at a turning point. There’s no telling how long this ‘new normal’ will last, but it’s not a short-term phenomenon."

To be sure, other wealth and asset managers with deep knowledge of the bond market have joined Envestnet in proposing new strategies that focus on curtailing interest rate risk. Here’s a roundup of what strategists believe are the best fixed-income investment opportunities this summer:

Tim Clift, Chief Investment Strategist, Envestnet|PMC

1) Bank loans. These 60- to 90-day short-term floating-rate loans are benchmarked against LIBOR and have almost no interest rate risk because the price and yield resets every 60 to 90 days, according to Clift.  They’re currently yielding an average of 4% to 6%, but they’re risky because these are lower rated corporate credits, and they can go into default. However, the default rate is currently less than 2%, and if they do default, they’re the most senior securities in the capital structure.

2) High-yield corporate credit. These fixed-income securities are currently yielding a return of 5% to 6%, but the downside is that high-yield credit is closely correlated to the relatively risky equity market.

3) Emerging-markets sovereign debt. “Currently, the debt of emerging markets is better than the debt of developed countries, although there is country and currency risk attached to them,” Clift said. “There’s always a tradeoff.” Rather than buy EM debt of a specific country, PMC recommends buying a basket of EM debt.

4) Unconstrained bond portfolio. Not tied to a benchmark, unconstrained bond portfolios are go-anywhere portfolios that involve closely timed buying and selling strategies. The risk of the unconstrained strategy is that it is a new strategy, and any unconstrained strategy is heavily dependent on a specific manager.

Bill Belden, Managing Director of Product Development, Guggenheim Investments

Guggenheim Investments, an exchange-traded fund (ETF) provider, says that investors who may be too cautious to jump into equities, but are still looking to maximize their fixed income return, should consider the following:

1) Consider defined maturity ETFs. Similar to bonds, these ETFs make periodic income distributions and have a pre-determined date upon which the NAV of the fund is liquidated and returned to investors.

2) Avoid minimum maturity requirements. Investment-grade and high-yield corporate bond ETFs have been more affected by the bond market’s volatility and have higher turnover rates among investors.

3) Use duration to safeguard portfolios. Investors should shorten their duration of bond holdings.  Advisors should look for liquid, easily accessible tools so their clients can generate monthly income.

 “Obviously, interest rate volatility is creating fixed-income anxiety,” William Belden, managing director of product development with Guggenheim Investments, told ThinkAdvisor on July 25. “In the fixed income ETF space, an ebbing of inflows was seen and even outflows as investors wondered if rising rates portends a trend in and of itself.”

Jennifer Bridwell and Sabrina Callin, Managing Directors, PIMCO

In a PIMCO interview published in July, Callin and Bridwell argued in favor of alternatives for investors, saying that most alternative strategies benefit by being free from the constraints of conventional benchmarks and having the flexibility to diversify across asset classes and geographies on either the long or short side.

“Alternatives incorporate different sources of return and risk than those provided by traditional stock and bond strategies,” Callin said. “They may also capitalize to a greater degree on the manager’s investment experience and skill in risk management because they allow managers much greater discretion to select and manage exposures over time.”

Chris Dialynas is manager of PIMCO’s $29 billion Unconstrained Bond Fund (PUBAX), and was named a “rising star” by Bloomberg in April.

Callin and Bridwell name these advantages of alternative investment strategies:

1) Diversification enhancement and the potential for alpha, or risk-adjusted returns, because returns from traditional asset classes in coming years may be lower and more volatile than those realized historically.

2) Potential in markets where large financial institutions are stepping back, including the provision of residential credit, commercial credit and corporate lending, as well as in liquid, outcome-oriented fixed income and equity strategies such as absolute return, market-neutral and long/short.

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Check out What’s a Fixed Income Investor to Do? Try Alt Asset Classes by Gib Watson on ThinkAdvisor.

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