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Flexibility: The Antidote for Interest Rate Uncertainty

Much of our latest due diligence and fund research has focused on bonds, and that research recently led us to make a fairly dramatic change to our clients’ bond allocations.  Three funds have been eliminated from our portfolios and two new ones added in their place.  Before we get into the changes in detail, let me provide some perspective by looking at where we’ve been, both over the past 30 or so years, and then more recently, over the last couple of months.

For a long-term perspective, take a look at the chart above from J.P. Morgan’s July 1st, 2013 Guide to the Markets.  Focus on the blue line, which represents the yield (or interest rate) on the 10-year U.S. Treasury bond.  Beginning in the early 1960s, interest rates rose dramatically until they peaked in Sept. 1981 at 15.84%.  Many of our clients will remember mortgage rates and CDs in the double-digits during the late ‘70s and early ‘80s.  However, after that peak, a decline in rates commenced which has continued in a steady downward path until it hit about 1.6% on May 2nd of this year.  What is the significance of this persisent downward trend?  As you know, bond prices go up when interest rates go down.  So this continual decline in interest rates over the past 30+ years has led to siginficant increases in bond prices over that timeframe.  In other words, bond investors have experienced a supportive tailwind of declining rates to help boost bond returns.

Now for the more recent perspective.  From May 2nd to the time of this writing (July 15th), the 10-year Treasury yield has risen from 1.6% to nearly 2.6%.  While a one percentage point move doesn’t seem like much, it represents an increase of almost 63% in just over two months.  And, as we know, when interest rates go up, all things being equal, bond prices go down.  This sudden spike in rates, while not unprecedented, made waves in the bond world and led to losses by most bond managers over that short period.  The spike in yields was caused primarily by hints from Fed Chairman Ben Bernanke that the pace of “quanititative easing” (QE) may slow later this year as the economy appears to be on firmer footing, reducing the need for stimulus by the Fed.  While the Fed hasn’t actually reduced QE, the mere anticipation of a possible reduction caused the bond market to react.

As we can see above, interest rates tend to move in prolonged cycles, potentially as long as 20 or 30 years.  While we don’t profess to have the ability to call an interest rate bottom, we saw opportunities in our bond investments to improve our chances of success in what could be a prolonged rising rate environment.  Now, onto the changes themselves…

We eliminated three bond funds from our portfolios entirely: T. Rowe Price Institutional International Bond fund, BlackRock Inflation Protected Bond, and T. Rowe Price Short-Term Bond fund.  (Not every client owned all of these funds, depending on the risk profile of your portfolio.)  All three of the funds represented very specific sectors of the bond markets: foreign (primarliy governmeny) bonds, Treasury Inflation Protected Securities (TIPS), and short-term bonds, respectively.  While all of these funds are stand-outs in their corresponding categories, we saw a need to expand the investment mandate within our bond portfolio to give our managers the best opportunity to navigate a rising-rate enviornment. In that vein, the new additions to our portfolio include JPMorgan Strategic Income fund (JSOSX) and PIMCO Income fund (PIMIX).

Flexibility: The Antidote For Interest Rate UncertaintyJPMorgan Strategic Income fund is managed by Bill Eigen, a 23-year veteran of bond management.  Eigen has free range in this “go-anywhere” fund, meaning he and his team can exploit opportunities in any sector of the bond market they find attractive.  It also means he will sit on a pile of cash until such opportunities present themselves.  We recently spoke with Eigen as part of our due diligence on the fund.  He started our conversation by saying, “Well, the good news is that volatility is back!”  Volatile environments provide Eigen the opportunity to take advantage of “indiscriminate selling.”  He expects continued “spurts of volatility” in the months and, potentially, years ahead as interest rates find their way back to normal historical averages.

With 21 years of investment experience, PIMCO Income fund is managed by Dan Ivascyn at PIMCO’s Newport Beach office.  The fund’s objective is to target a steady income stream from multiple areas of the global bond market.  In Ivascyn’s words, the fund’s “flexibility allows us to pursue the most efficient and attractive sources of income across the global bond markets and shift exposures from one country or sector to the next, moving to wherever we believe the most attractive yields can be generated, while actively managing portfolio risk.”

In addition to these two new funds, we have been investors in BlackRock Strategic Income fund, which also boasts a “go-anywhere” investment mandate, since 2010.  Together these three funds now represent 75% of our bond allocation for most clients, and with proven expertise and great flexibility, we are confident in their collective ability to exploit opportunities and mitigate interest rate risk in the months and years ahead.

Bryan Zschiesche

Bryan is a CERTIFIED FINANCIAL PLANNER™ and Senior Financial Advisor. He uses his expertise to develop investment strategies to protect and grow clients’ retirement savings. Bryan is a proponent of Elegant Simplicity, the idea that we can work through complex issues surrounding a financial problem and arrive at a sophisticated but simple solution.   Read Bryan’s Profile HereRead More Articles by Bryan

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