Active Management Is Essential

It’s time to rethink your fixed income investments,” says John W. Donovan, head of fixed income and trading at U.S. Trust. “In the rising interest rate environment we’re expecting, the approaches of the past few years simply won’t get the job done.”

Donovan thinks bond investors will need to shift from buy-and-hold, long-duration and passive strategies, and move toward more rigorous active strategies. “A selective approach and investors’ agility to take advantage of shifting opportunities will be key to achieving their goals.”

Portfolio Positioning 

• Slightly underweight duration. As interest rates have declined to record lows, governments and other entities are issuing longer-maturity debt to lock in low rates. However, Donovan adds, the prices of longer-maturity bonds are more sensitive to rate changes. As the average maturity of the index has lengthened, duration — a measure of interest rate risk — has increased for large portions of the global bond market. “Active portfolio managers have the ability to construct lower-duration portfolios that should outperform passively managed funds as rates rise.”
  

• Keep your eye on the curve. Donovan believes the yield curve will flatten — the increase in short-term rates will be greater than that of long-term rates — as we approach year’s end. “In such an environment,” he says, “we favor a barbell strategy. This entails owning both shorter- and longer-maturity bonds, while underweighting medium-term bonds, which tend to underperform in these periods.” This positioning is most likely to outperform a laddered strategy — purchasing bonds with staggered maturities — or bulleted strategy — purchasing bonds with the same maturity at different times. The long end of the strategy provides excess yield, while short-maturity positions provide frequent reinvestment opportunities as rates rise.  

• Leverage volatility. You can use volatility to advantage by rotating from expensive to cheap sectors, Donovan says. “Be aware that volatile environments tend to result in big divergences between the performance of sectors.”  

• Slightly underweight high yield. “Expect defaults to accelerate, particularly in the energy sector. We do not believe current spread levels are, broadly speaking, sufficient for the risk.”  

• Focus on the municipal market. By concentrating on the higher-quality issues in the municipal market, Donovan says, investors can avoid the knock-on effect of Puerto Rico, Chicago and “other troubled headline-grabbing areas.”  

• Keep your options open with U.S. Treasuries. “While we continue to prefer credit over treasuries, with an emphasis on corporate bonds, municipals and commeuries for liquidity and relative safety makes sense,” Donovan says.rcial mortgage-backed securities, some allocation to treas

Prepare For Volatility

Interest rates are expected to rise. The Fed has been signaling a hike in the federal funds rate, and guidance currently points to a modest pace that will be dependent on economic conditions and inflation. However, Donovan says, “the market hasn’t seen an increase in the federal funds rate in nine years, and the likelihood of post-hike volatility is high.”

And it’s not only interest rates that could jostle the bond markets:

• Low yields. Currently low bond yields offer little cushion to offset declines in bond prices. 

• Reduced liquidity. Sweeping financial regulations have led to reduced trading liquidity and increased volatility. This is compounded by quantitative easing programs, which can distort valuations, reduce global bond market liquidity and increase volatility during periods of market stress. 

• Widening spreads. This year’s massive corporate bond issuance has resulted in steadily widening spreads. 

• Corporate credit. The Fed’s increasingly tight monetary policy could have a negative effect on certain overleveraged corporate credits.  

• States and municipalities. State and local governments are not immune to liquidity and volatility risks, particularly those that have taken on a significant increase in unfunded pensions and other post-employment benefits that could have a negative impact on their credit quality.

No Need to Flee Fixed Income

Donovan expects a marginal rate increase, a flattening yield curve (historically, a regular response to rate hikes), low single-digit returns (negative in some sectors) and higher market volatility overall.

“We believe the 30-year bond rally is over,” he says. “But that does not mean you should rush to sell your fixed income investments.” Bonds remain essential to a diversified portfolio. They offer selective opportunities and can help offset equity market volatility. However, popular passive investment approaches of the past few years are expected to underperform actively managed portfolios given the emerging regulatory and interest rate environment.

“We continue to see value in diversified, actively managed portfolios,” says Donovan. “Even with rising rates and the volatile market we’re anticipating.”