As interest rates rise, advisors must balance the trade-off between investing in core bonds to maintain stability in client portfolios and allocating a portion of the portfolio to riskier corporate bonds and other fixed-income instruments that could bring higher yields.
“The trade-off is very real. The key is to be strategic within the comfort guidelines of your clients,” says Terrance Martin, principal at Tranquility Financial Planning in McAllen, Texas.
The firm uses a core-satellite approach to investing — within the core, short to intermediate fixed-income only. Within the satellite, “there may be opportunities to participate in the riskier fixed-income sector,” he says.
“If we look at emerging market and other developed foreign markets, there may be opportunities for alpha,” Martin says. “It’s a cost-versus-client-benefit decision.”
Mark Paccione, director of investment research at Captrust in Raleigh, North Carolina, says that his firm has minimized clients’ exposure to intermediate-term high-yield and investment-grade corporates, as the risk reward seems “skewed to the downside,” given tight credit spreads and rate risk.
“Currently, we see the best opportunity with shorter dated bonds in non-traditional fixed-income sectors like non-agency mortgages, structured credit, and alternative lending,” he says. “We believe this strategy should hold up, well regardless of the direction of interest rates.”
At a time when equity valuations are at the high end of their long-term range, clients should not be overly exposed to credit and high-yield instruments, says Kevin Meehan, regional president, Chicago, at Wealth Enhancement Group of Itasca, Illinois.
“We definitely realize U.S. corporations are arguably in their best position in many years, post the corporate tax cuts, yet spreads are not overly attractive, as the rest of the market sees it, too,” he says.
Anjali Jariwala, founder of FIT Advisors in Chicago, says that the bulk of fixed-income allocations should be to high-credit-quality bonds across the U.S. and developed markets.
Any allocation to riskier fixed-income strategies should be smaller, she says.
The terms of fixed-income investments should also be shorter, says Michael Stritch, chief investment officer and national head of investments at BMO Wealth Management in Chicago.
“As the [Federal Reserve] has forced rates higher, short-term bond yields have become quite compelling relative to those available only a few months prior, he says.
As an example, two-year investment-grade corporate bonds now offer close to 3.4%, while 10-year corporates land only marginally higher at 4.3%, Stritch says.
“Staying short duration also allows for quicker reinvestment at potentially higher rates as the Fed keeps tightening,” he says.