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Stay the Path or Bail on Bonds? Removing Emotion from your Decision.


Investing with intelligence, not emotion is something we hear all the time; however, sometimes it might be hard to tell the difference. The recent volatility within the fixed income markets could be a prime example of this challenge. We saw record outflows in bond mutual funds in June, and we know rates must rise sometime in the future. Is it emotion or intelligence telling us to bail and run? What about those investors who need exposure to bonds, what should they do in this environment?

 

Some investors have decided to go it alone for years in fixed income investing and have most likely seen success in their portfolios. The long-term bond bull market has helped investors realize gains and income with their portfolios, but as we approach a secular market shift, the traditional style of investing could be doomed. Bond prices can and do go down. Those investors who decided to go it alone may want to consider teaming up with a financial advisor and professional portfolio manager.

 

There are many tools that can be deployed in a fixed income portfolio to help protect principal and still deliver income to investors. Advisors and portfolio managers specialize in seeking out these tools and helping their client navigate volatile markets. There are many benefits to hiring a financial advisor and portfolio manager, but maybe one of the biggest advantages is helping to remove the emotional aspect and focus more on the logic behind investing.

 

The role of the financial advisor:

Financial advisors are typically the front line for their clients. Every client that we meet is unique and has their specific objectives to meet with their investment portfolio. Advisors take the time to understand each client’s specific needs and craft a plan to help them meet their objectives. Their work doesn’t stop there, they are also tasked with tracking and ensuring that the plan continues to work as designed and make changes along the way based on changing objectives or changing market conditions. Summed up, advisors are the sounding board for clients and stand ready to give guidance or answer questions on market conditions.

 

The role of the portfolio manager:

If your car needs windshield washer fluid or has a flat tire, you typically handle this yourself; however, you probably don’t want to pop the hood and rebuild your engine or replace your transmission. This is similar to advisors leveraging a portfolio manager. Advisors must be knowledgeable about the broad markets and know when changes are needed, but nobody can be a specialist in every asset class. Advisors typically partner with portfolio managers who can give in-depth guidance in specific areas of the market. Once your financial plan has been outlined, advisors can team up with professional managers who specialize in specific asset classes. These managers spend each and every day watching their area of the market, seeking out tools, and tracking trends to help portfolios meet objectives. Advisors typically have direct access to these managers and work with them to ensure they continue to meet the objectives of the client.

 

A great example of this benefit is highlighted in a recent InvestmentNews article which spoke to the lack of liquidity currently present in the fixed income markets. The article stated that broker-dealers are starting to lower their market exposure with estimates that today they are holding roughly $40 billion in corporate bonds, down from $250 billion earlier this year. Portfolio managers who specialize in corporate bonds typically have a wide network of dealers and traders with whom they have worked with over the years. Their network can help bid out paper and source bonds, even with market volatility.

 

Tools to benefit the investor:

Some of the tools advisors and portfolio managers have at their fingertips include ways to “stress test” a portfolio for a rate move higher or lower, professional analytical reviews, and access to broad market data and resources.

 

“Stress Testing” is a tool actively used by AAM. This is a tool that looks at all of the positions within an investor’s account and gives our portfolio managers an estimate of what a possible return could be if rates moved up or down during a specific period of time. This is especially useful during today’s market conditions when the traditional “buy a bond and clip coupons” style of investing could become obsolete. With this tool, our portfolio managers can get an idea of how a specific security allocation could impact the overall portfolio.

 

Active tactical portfolio management is another tool that could benefit investors. As an example, AAM’s portfolio managers continually meet to discuss market conditions and areas of opportunity for our investors. These meetings allow us to invest in areas of the market that might be oversold, and leave areas of the market that might be overbought. For example, at the beginning of 2011, AAM’s portfolio management team made a decision to exit the U.S. Treasury markets and move the allocation to higher coupon bonds within the taxable municipal and corporate space. They determined that the low yield that treasury bonds were paying investors was a rewardless trade and the higher coupon bonds would help improve income and provide added protection from higher rates. Even though the U.S. Treasury markets had a few rallies since our allocation removed them from portfolios, the rallies were not enough to offset the performance from the other asset classes. This doesn’t mean that every asset allocation call will provide similar results, but demonstrates how at a time when investors were seemingly running to the U.S. Treasury markets, the logical move may have been to exit that market and move to other asset classes.

 

Most investors are probably used to the traditional bond ladder for fixed income investing. This style seeks to control duration by buying maturity dates that are laddered out over a set period of time. The logic behind this is simple: as bonds come due you invest the principal back into higher rate securities. Bond ladders are an effective way to invest a fixed income portfolio; however, they typically provide low yields to the investor as people flock to specific areas of the market. AAM’s portfolio managers take a different approach to controlling duration called, “tactical duration management.” Rather than buying short-term securities, they seek higher coupon bonds, many with embedded call options on the intermediate-to-long area of the market. The higher income that these bonds provide helps lower the portfolio’s overall duration as the portfolio is receiving higher cash flows back into the account.

 

Investors don’t need to go it alone, there are professionals ready to assist you to meet your objectives.

 

To learn more about AAM’s fixed income offerings or the benefits of professional portfolio management, please speak with your financial advisor.

 

 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog. 


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