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Fewer Financial Advisors Investing in Fixed Income Securities

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bondsquadwebbannerIn our travels this year it has become increasingly apparent that fewer and fewer financial advisors are investing in fixed income securities. You might ask: How can this be? After all, capital flows show that demand for fixed income has been strong in 2014. However, it has been our experience that little of the retail flows into fixed income has gone into actual bonds.

You Belong to the Munis

Advisors and investors have been encouraged to adhere to prefabricated models and packaged products. Feedback from the field indicates that even SMA accounts are falling out of favor on the retail side. This is concerning to us, not just because we manage SMA portfolios, but because investors and advisors might be setting themselves up for anxiety and disappointment. An example of this is the performance of municipal bonds during the past two years.

To see a list of high yielding CDs go here.

According to BAML data, year-to-date total return for AA-rated state G.O.s is just over 5.00%. Since the beginning of 2013, AA-rated state G.O.s have returned 4.00%. Since the lows of June 2013, AA state G.O.s have a total return of about 8.00%. This performance has many investors and advisors scratching their heads. How is one supposed to invest in municipal bonds with that kind of volatility? The fact is: Investing in municipal bonds was (and continues to be) quite easy. Investing in vehicles which gain exposure to the municipal debt market is more difficult. Being able to hold to maturity is what makes fixed income a capital preservation tool. Gaining exposure to fixed income without the protection of a stated maturity is like buying a well-constructed vehicle while foregoing a braking system. By doing this, you would be putting your safety in the hands of your fellow drivers and the authorities.

In the Presence of a Lord

Bond Squad friend and MBS pioneer, Ethan Penner, posted the following on LinkedIn:

“A great example of this could be found in my field of finance where much faith and hope has and continues to be invested in math modeling to deliver us greater certainty. I teach a business school class at USC where we focus on mortgages and the capital markets, and even my young students all figured out pretty quickly that the output of the math models to value mortgage products can only be as good as the assumptions input for the future of interest rates, the defaults and the prepayment choices made by the pools borrowers. None of these can ever be input with any certainty or real long term accuracy, which by definition renders any math model based upon these assumptions nearly worthless and surely unreliable in a vacuum. This was painfully evident in 2008/9 when the rating agencies and the market participants mistakenly ignored the obvious and instead placed blind faith in math models.”

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We have expressed similar opinions. However, the investment industry continues to encourage an almost fanatical devotion to financial and investment models. We have said it before and we will keep on saying it: Following models without gauging prevailing conditions and adjusting for the specific needs of you or your clients is dangerous. If you choose not to heed our warnings, please consider the opinions of Mr. Penner as he has a very in depth knowledge and understanding of models, their benefits and their shortcomings.

We have seen the shortfall of models in recent times. If one was following models, one would have positioned portfolios for rising long-term interest rates, a fairly aggressive Fed tightening and mounting inflation pressures. If one looked around to see which way the economic winds were blowing, one would have positioned portfolios quite differently. If one owned actual municipal bonds one probably doesn’t care all that much about what interest rates and inflation might do.

Building an actual bond ladder can be a hedge versus both credit and duration risk. By spreading exposure across the yield curve, one has higher-yielding longer-dated bonds one can hold until maturity should interest rates fall or remain low. If interest rates rise, one has shorter maturity bonds which can be reinvested when they mature at higher rates. All the while, investors receive coupon payments which can also be reinvested if so desired. Price volatility is a mere nuisance to a laddered portfolio because, unless investors panic and sell into price weakness, any losses are unrealized. Profits too would be unrealized should interest rates fall, unless of course investors sold their holdings (something which runs counter to the objectives of a laddered bond portfolio).

We believe that during the past decade, investors and advisors have been taught a bad trick. This bad trick is the idea that fixed income investments should be judged on price performance. However, the core objective of most fixed income portfolios is income generation and capital preservation. Most investors who desire total return investments should probably look outside the fixed income market. Investors who own fixed income investments labeled as “total return” for diversification versus their equity holdings clearly do not understand what a total return fixed income strategy involves. For certain, capital preservation is rarely a core goal of a total return fixed income portfolio.

We believe that part of the anxiety among retail investors is that they are constantly chasing return. Rather than creating a strategy with their financial advisor and sticking with it, they chase performance, often statement-to-monthly statement. This usually serves to only shoot oneself in the foot. This is true of municipal debt investors as well. Stephen Czepiel, senior portfolio manager at Delaware Investments, summed it up well when he told the Wall Street Journal:

“We don’t buy yield for yield’s sake. Even in a limited-supply atmosphere, don’t deviate from the credit fundamentals.”

Can’t Reach You

We have warned readers against chasing yield, even in a low-rate friendly Fed environment. Credit fundamentals matter. When choosing a fixed income investment or fixed income manager, one should be comfortable that the investment or strategy is consistent with ones or ones clients’ goals and objectives. One size does not fit all.

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At the end of May (2014), we advised readers to “pull in their reach.” In terms of credit risk, this tactic has served us well. Fixed income strategists from around the industry continue to move into our camp.  Janney Montgomery Scott corporate credit strategist Jody Lurie states:

“Given the inflows into high yield over the past few years, the exposure to loss surpasses the potential gains currently available in an upside scenario, particularly at the lowest rung of the ratings spectrum. More investors would likely fare better foregoing some high yield for higher ratings. High yield bonds can be attractive investments as part of a diversified portfolio and can decrease exposure to rising interest rates over many other types of bonds, but investors should weigh the risk over the reward on a longer-term basis, and not just seek out the highest yield.”

Lift Us up where We Belong

Investors were slow to take off some risk, but it appears that they are now pulling in their credit risk reach. Investors were also slow to re-enter the municipal bond market, but by the third-quarter of this year, retail money was flowing back into municipal debt. In fact, municipal asset values had become somewhat richly-priced. In the past few weeks, value has slowly (and modestly) returned to the municipal bond market. Our suggestion for investors seeking exposure in the municipal debt markets is to not wait on the sidelines. We see the following conditions persisting:

*    Demand for municipal debt from an aging investor population should increase.

*    Municipal new issuance should be light versus demand.

*    Interest rates on all portions of the yield curve should remain fairly stable for the foreseeable future.

The key is to ladder or barbell and to resist selling at the first sign of volatility. If you know what you own this should not be a problem. If you don’t know precisely what you own you must ask yourself this question: Should I own it?

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By Thomas Byrne – Director of Fixed Income – Investment Consultant

thomas bryneThomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.

Employment

  • November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
  • December 2011 – November 2012 – Bond Squad, Kunkletown, PA
  • April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
  • June 1986 – March 1988 – E.F. Hutton, New York, NY

Thomas Byrne
Director of Fixed Income
Wealth Strategies & Management LLC
570-424-1555 Office
570-234-6350 Cell

Twitter: @Bond_Squad

 

All trading carries risk. Views expressed are those of the writers only. Past performance is no guarantee of future results. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.
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Thomas Byrne

Thomas Byrne serves ad the Director of Fixed Income for Wealth Strategies Management LLC. Thomas brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets. High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

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