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Bonds in Client Portfolios: What Advisors Need to Know

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The expression, ‘Markets climb walls of worry’ certainly rings true today. Though political, economic and interest rate uncertainty marked much of 2017, the stock market remained strong, reaching record levels and creating significant wealth.  As we enter 2018 with these same uncertainties still present in the markets, financial advisors have two important opportunities: to reinforce for clients the value of their expertise in navigating a complex environment, and to potentially grow their business by capturing an incremental portion of a client’s asset portfolio through fixed income investing. Here’s how.

For many investors, a relatively strong stock market like we see today can create a blind spot in planning long-term investment goals and targets for risk-adjusted returns. For some, there has been a temptation to lean too heavily into equities as a way to maximize returns. Therefore, talk to your clients about creating a more balanced portfolio with investments in fixed income. While most high-net-worth individuals understand the benefits of fixed income in offering protection from fluctuations in the stock market like we have seen recently, many lack the resources and/or a deeper understanding of the fixed income markets necessary to make the right choices for their investment goals. Use this market opportunity to expand your client base and to capture incremental business from existing clients by demonstrating the value of working with an advisor who can take a holistic, tailored approach to helping clients achieve their investment goals.

Once you’ve initiated a discussion about fixed income investing with your clients, you have an important opportunity to provide education and guidance on the implications of the current rising interest rate environment in the U.S. economy. Should interest rates continue to rise, as many financial analysts believe they will, the differences between an investment in individual bonds versus bond funds or ETFs becomes increasingly significant.

For example, if a client buys an individual bond at par value, barring any default or premature call, and holds the bond to maturity, its worth remains exactly what he or she paid for it, in addition to its annual interest. This is a key reason that individual bonds are an attractive vehicle in this market for investors who don’t anticipate having to liquidate their investment for a near-term capital event. However, it is important for clients to understand that if interests rates rise, the market value of the bond may be negatively impacted after purchase in the event that a client wishes to sell the bond before maturity. This occurs because as interest rates rise, existing bond prices will fall as newer bonds are issued with higher coupons, assuming equal structural and credit characteristics. One downside of investing in individual bonds is that they often have minimum investment amounts (or denominations), usually of $5,000 or more. This can make diversifying a portfolio of bonds challenging for smaller portfolios.

On the other hand, bond funds and ETFs, which can contain hundreds or even thousands of individual bonds, generally have the benefits of liquidity, as well as the mitigation of default risk of any individual bond within the fund through diversification. However, in a rising interest rate environment, these funds can carry other risks that can negatively affect the bond fund’s net asset value (NAV). For example, given the inverse relationship between interests rates and bond values, shareholders in bond fund may choose to liquidate their shares as interest rates rise and bond prices decline. When this occurs, the fund manager may be forced to sell bonds prematurely in a declining market in order to raise enough cash to meet its redemption requests. This could have a detrimental effect on the value of the fund.

The bottom line is that both vehicles can provide diversification, and both can yield positive results. What makes one a better choice for a client depends on the client’s investment objectives and financial and tax situation. You can play an important role in helping clients make more informed decisions.

Should a client choose to invest in individual bonds, a thorough evaluation of a bond’s structural characteristics and credit profile, and its pricing with similar bonds is important. The good news is that technology is beginning to lift some of the opacity that has characterized the bond market since its inception. New and improving platforms can ease the due diligence process, and provide new levels of pricing transparency. This can give you more confidence as you buy and sell bonds.

In the current financial environment, expertise becomes even more important in navigating market changes. Use this opportunity to further increase your value to your clients and grow your business at the same time.

Josh Rasmussen, 280capmarkets Josh Rasmussen is managing director and head of Advisor Solutions at 280 CapMarkets.


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