Defined contribution plan participants are notoriously bad about changing their 401(k) allocations, but retirement advisors and wealth management companies are nonetheless preparing their plan sponsor-clients for an inevitable rise in interest rates.
Fixed-income investors may find this annoying, of course, because they embraced the long-term bond market after repeatedly hearing assurances from the Federal Reserve that it planned to hold rates down to record lows, which drove up bond prices and yields.
But that was then, and this is now.
The Fed this year has clearly signaled it plans to gradually taper off its Treasury buying spree as the economy recovers. That will spur a rise in interest rates over the next couple of years, which won’t help portfolios that are heavily weighted to long-term fixed income assets.
So, many are doing what they can to prepare for that inevitable day – including issuing white papers, reports and news releases filled with prognostications, guesses and, they hope, a dash of wisdom about what happens next and how best to deal with it.
“We do not expect to see a violent, sustained move in interest rates, as this would be destabilizing to the economic recovery that the Fed has worked so strenuously to promote the past five years,” Janus said in a recent report. “Rather, we believe there will be a general upward trend in rates punctuated by periods of headline-driven volatility.”
Of course, no one really knows, so all that anyone can do is try to cover their bases as best as they can.
Among other things, doing so means shifting to shorter-term bonds, boosting positions in Treasury Inflation Protection securities and seeking more actively managed bond funds.
Michael Temple, senior vice president and director of credit research, U.S., for Pioneer Investments in Boston, said his firm advocates for “shorter duration fixed-income, like high-yield bonds and bank loans that I think some people felt were too risky.”
“I understand people saying they had a bad experience with high yield in 2008,” Temple said. “The reality of the next phase of the market is the risk associated with high-yield and corporate credit is less risky than long-duration (bonds).”
Temple isn’t alone in his thinking. Many wealth managers are moving clients away from long-term fixed income assets and bonds in anticipation of rising interest rates.
“Fixed-income still has potential, it should be in your portfolio, but cut back on it a bit and buy short and intermediate-term security. Nothing over a five-year maturity at all,” counsels Steven Kolinsky, managing member and founder of Kolinsky Wealth Management in Woodcliff Lake, N.J. “Treasuries are not a good bet.”
“This is not the time to buy bonds,” he adds. “A lot of people think municipal bonds are a great investment because they are yielding 2 to 3 percent. They will be hard hit if interest rates go up.”
That’s why the firm is trying to reposition clients into traded and non-traded real estate investment trusts and business development funds.
Investors shouldn’t freak out about the impending rise in rates, according to Janus. The U.S. has experienced 21 periods since 1970 in which the benchmark 10-year Treasury bond yield rose by at least 100 basis points.
“Also, interest rates generally rise in a nonlinear fashion that creates opportunity for active investors who have the flexibility to buy and sell during market dips and peaks, minimize exposure to the most rate-sensitive segments of the yield curve, and use individual security selection to benefit from market dislocations,” Janus said in its report.
Active 401(k) investors, however, are in the minority.
That’s why they and their plan sponsors might turn to people like Steve Blumenthal, founder and CEO of CMG Capital Management Group Inc., in King of Prussia, Penn.
Blumenthal says he looks at all of the options, including Treasury bills, corporate bonds, long-term corporate bonds, emerging market bonds and international sovereign bonds and ranks them against each other.
It’s not an especially unique approach but Blumenthal is keeping close tabs – something participants rarely do. He does this on a weekly basis to see what is gaining or losing traction and then he lengthens or shortens clients’ exposure based on his analysis.
Blumenthal posits that most advisors and wealth managers haven’t made a move yet in this direction, but “their lights are starting to turn on.”
“The shot across the bow was the temper tantrum on May 22, when (Fed Chairman Ben) Bernanke said we may exit (qualitative easing) and then didn’t,” he said. “We’re early in doing this. We are sharing with other advisors why we’re doing it. A lot of advisors don’t have a process in place. There’s a race to learn how to be more tactical.”
Blumenthal’s biggest fear at the moment is that the Fed will wait too long to start tapering and that interest rates could spike much higher than many anticipate.
“That’s the real risk behind that. If you start at such low interest rates, even if you go up 1 to 1.27 percent, that’s an incredible, exponential hit in the way bonds are priced and valued,” he said. “Investors are completely uneducated about what that means to their portfolio. If you go from 2.6 percent for the 10-year today and move to 4.6 or 6.6 percent, the losses in those bond funds won’t recover. They will panic and sell out.”
Which is why developing new investment options is getting so much attention at the moment.
Chris Petrosino, who heads up the quantitative strategies group in the equity research department at Fairport, N.Y.-based Manning & Napier, said that over the past several quarters his company has decreased its exposure to U.S. Treasuries, especially those on the long end of the curve.
“It is not so much that we were fearful of a significant surge in yield, but that we weren’t finding good value there for our investors,” he said. “Instead, what we are able to do is move assets into some of the corporate bond space where there are still reasonably attractive credit spreads and better opportunities there to generate pretty good risk-adjusted returns for our investors.”