The Fed has finally made its move. The long anticipated "taper" has begun as the Federal Reserve announced that it would begin slowly reducing its bond-buying stimulus program that has served to prop up the American economy. While short-term interest rates remain hovering near zero, longer-term rates have already begun to rise – impacting bond values held in fixed-income portfolios.
Income investors should now be well aware of the "see-saw" relationship between interest rates and bonds: as rates go up, bond values go down.
How are financial advisors helping investors protect their investments during the taper transition?
It's a 'risk-on' market
"I still think that it's a 'risk-on' market. That's what my technical trading services tell me, too," says Steven J. Stanganelli, a fee-only financial planner in Amesbury, Mass. "So that to me means staying invested in equities and keeping exposure to fixed income — albeit in the lower end of the allocation and with a shorter duration of about 3 to 4 [years]."
Duration is the weighted-average of cash flow repayments from a bond – in a sense, its effective maturity.
Charles G. DeNormandie III, a wealth manager in Alpharetta, Ga., says the writing has been on the wall for interest rates for some time.
"We all recognize that interest rates have basically nowhere to go but up," he says. "In fact, as we saw the interest rate trend start to change in June we made quick changes to reduce interest rate sensitivity in our portfolios. While we made that change months ago, I would suggest that opportunity is still there. In fact, with lots of longer-dated bonds still trading at significant premiums I would suggest it might be akin to malpractice to not do so."
Consider floating-rate and high yield
Based in Braintree, Mass., Timothy Shanahan works with business owners and executives, and has also been proactive in preparing client portfolios.
"We have allocated to the shorter end of the maturity curve and have taken positions in floating-rate bank loan funds which should behave well in a rising rate environment," Shanahan says. "We have also taken fixed income positions in areas where we feel there are compensated risks such as high yield and emerging market debt."
Stanganelli agrees with the floating-rate and high-yield recommendations.
"Floating-rate funds get to pass along higher interest rates which minimize the impact on the fund," he notes. "High yield funds offer higher coupons and in an expanding economy there is less operational risk, which should translate to lower overall credit risk. That, and the fact that the higher rates mean that the bonds are impacted to a lesser degree than other lower-rate bonds when interest rates rise, means that investors get a bonus on yield."
Bad time for bond funds?
If the goal is to keep maturities on the shorter-end of the scale, to reduce the impact of rising rates, does that mean this is a bad time to buy a bond fund – which by its very nature has no fixed maturity?
"As to buying a bond fund now, I would ask why one owns bonds or bond funds," DeNormandie says. "In my mind, you should own them to play defense against equity markets misbehaving. As one of my colleagues often says, the only instruments that aren't correlated to equities are Treasuries. With that in mind, he utilizes 7-10 year Treasury ETFs as his only bond holding. So, in short, if you are trying to protect your portfolio against equity downturns, I think you can still make a strong case for buying bond funds. Just be prepared that as tapering begins in earnest this part of your portfolio will likely underperform."
Consider master limited partnerships
Stanganelli believes another way to offset interest rate risk is through energy master limited partnerships (MLPs).
"MLPs can pass along higher costs and insulates them in a way from the impact of inflation as well. These are now accessible in ETF and mutual fund formats without the tax headaches of K-1s. So I'll recommend an allocation to higher yielding options like AMLP and YMLI," he adds. "While I believe that strategic allocation has long-term value to an investor, I'm not inclined to simply 'buy, hold and pray.' So I couple this core with a good dose of cash as one way to hedge market risk. Depending on the client's risk profile this may range from 5 percent to 15 percent in cash."
DeNormandie offers a final note on taper time tactics.
"All of this in my mind goes back to managing risk — the real reason we own bonds to begin with," he says. "I firmly believe that one must know how much risk they are willing to assume within their portfolio and continually monitor those holdings, stocks and bonds, to ensure they are maintaining appropriate risk management measures."
Hal M. Bundrick is a Certified Financial Planner™ and former financial advisor and senior investment specialist for Wall Street firms. He writes about retirement accounts and personal finance for NerdWallet. Follow him on Twitter: @HalMBundrick