Portfolio managers of balanced mutual funds are re-evaluating their portfolio allocations to fixed-income investments. The increasingly volatile market poses new risks for fixed-income, an asset class that traditionally has offered stability in mixed portfolios.
Vulnerability to losses in fixed-income is a new experience for financial advisors and their clients. Until this year, investors had enjoyed a 30-year bull market in bonds as interest rates trended downward, allowing clients to reap a mix of interest and capital gains with relatively little risk.
When the U.S. Federal Reserve Board hinted this past spring that it would soon be tapering off its quantitative easing (QE) program of US$85 billion in monthly bond purchases, bonds and other income-paying securities were sold off in the market, triggering a dramatic drop in prices and causing bond yields to rise.
In September, the Fed said it would delay its tapering plan, which stimulated a rally in bonds but not a full recovery. Bond-watchers remain nervous as they await the end of the massive QE stimulus program and the expected rise in interest rates.
“Bond yields have only one way to go – and that is higher, ” says Alex Sasso, CEO of Calgary-based Hesperian Capital Management Ltd. and manager of Norrep Income Growth Fund. “The risk/reward balance has moved in favor of equities.”
The Fed, he says, by delaying its tapering program in September, “has given investors a mulligan.” The resulting bond mini-rally has created the opportunity to reduce fixed-income exposure at better prices.
Here’s a look at how four portfolio managers are adjusting their portfolio allocations:
– As a balanced fund, Norrep Income Growth Fund’s mandate allows it to hold between 10% and 40% of its assets under management (AUM) in fixed-income. Sasso has moved the portfolio toward the low end of that range, with 12% of AUM in fixed-income.
Not only has Sasso reduced the Norrep fund’s fixed-income exposure, but the focus of the fixed-income portfolio has been adjusted to make it less vulnerable to rising interest rates: government and investment-grade corporate bonds have been reduced, with a greater focus on floating-rate senior loans and high-yield corporate bonds.
The interest rates on senior loans will move in lockstep with any upward movement in interest rates, while high-yield bonds are less vulnerable to rising interest rates than are lower-yielding government bonds because the latter’s yields are high already.
“If investors and advisors are worried that interest rates will go higher,” Sasso says, “they should investigate what percentage of their balanced fund portfolio is in fixed-income. And [they] also should know how much flexibility there is to increase or decrease that exposure.”
– Greg Peterson, director and portfolio manager with Calgary-based Mawer Investment Management Ltd. and leader of the asset-allocation team for balanced products, has reduced fixed-income to 30% of AUM in Mawer’s balanced portfolios during the past year. Fixed-income now is at the low end of the 30%-50% targeted range.
“It’s not too late for bond investors to sell off a bit,” Peterson says. “Bond yields could go higher and bond prices lower.”
Peterson expects to see the yield on the bellwether 10-year U.S. treasury bond in the range of 3%-3.5% next year, compared with about 2.6% currently, as the economic recovery takes hold and the U.S. cuts back on its QE program.
“Having a set range for equities and fixed-income keeps us from thinking we’re too smart and that we’re able to predict what’s going to happen tomorrow,” he says. “Bonds play an important role in portfolio stability. They can be a source of capital protection and liquidity, should equities go lower.”
A bad year in bonds could see a drop in market values of 3%-4%, Peterson says, and that “is nowhere near as bad as a bad year in equities.” Most people are unable to tolerate the extreme volatility of a portfolio that’s invested entirely in equities, he adds, hence the appeal of a balanced portfolio with exposure to fixed-income as well as stocks.
– Tom Bradley, president and founder of Vancouver-based Steadyhand Investment Funds Inc., who makes the asset-allocation decisions for Steadyhand Founders Fund, has whittled fixed-income to its minimum level of 25% of AUM in that fund, which holds a higher than usual level of cash (15%). The maximum allocations permitted under the Steadyhand fund’s mandate are 60% for equities and 40% for fixed-income; the fund holds the maximum in equities.
Despite near-zero yields on cash, the cash cushion provides protection against rising interest rates and is a ready source of liquidity if market moves present buying opportunities, Bradley says: “In this fund, we don’t make tilts in our asset mix easily, but when I see extremes, I will act. Yields in the bond market are dramatically below historical levels and, relative to inflation, investors are barely eking out a real return. Interest rates are unsustainably low, and that creates downside risk in bonds.”
– Tyler Mordy, president and CEO of Toronto-based Hahn Investment Stewards & Co. Inc., manages portfolios comprised solely of exchange-traded funds (ETFs). He believes that a tapering off in QE may be further off than the market anticipates, and that interest rates will be “lower for longer.”
The economy needs to see a sustainable recovery before there will be any pullback in the Fed’s QE program, Mordy says. The extreme reaction in the bond market after the Fed signalled in the spring that it would soon begin tapering will lead policy-makers to move cautiously. “The market had a violent reaction to taper talk starting in May, and we were buying into weakness,” he says. “It’s not a normal economy, and the Fed has cornered itself. The mere mention of tapering caused bonds to sell off and yields to rise.”
Mordy favours an “eclectic” approach to creating income in his international balanced portfolios, moving away from sovereign debt by scouring the world for less traditional sources of income. For example, ETFs can provide exposure to out-of-favour market sectors or geographical regions that offer high dividend yields, such as the Russian stock market, which currently is yielding 4%.
Mordy also is shifting from ETFs that represent traditional dividend stocks, now richly valued, and into less defensive companies that pay lower dividends but are in a position to raise them, such as U.S. technology firms. He also has taken advantage of recent price drops to buy ETFs focusing on real estate investment trusts, mortgages and top-rated emerging-market debt. “[These sectors are] a happy story – you can build a portfolio with decent yield,” he says. “We’ve replaced much of our bonds with income-paying equities.”
Mordy maintains about 15% of the AUM in his international balanced portfolio in high-quality corporate and government bonds, with another 30% in high-income equity.
“As far as bonds, we’re not throwing the baby out with the bathwater,” he says. “There is a place in asset allocation for lower volatility, and bonds can be great shock absorbers during inclement periods in the stock market.”
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