While everyone else is watching the stock market, savvy advisors will monitor the bond market.
YOUR CLIENTS MAY FEEL thrilled at how their S&P 500 index fund and "story stocks" keep climbing. The election is over, vaccines are here and the Federal Reserve has their backs. What could possibly go wrong?
Unfortunately, the danger is out there lurking, just like the villain in a Hollywood horror film.
Quietly, long-term interest rates are threatening to pounce. Based on recent analysis, there is potential for rates to rise much faster than analysts expect.
If that occurs, financial advisors will have to speed-learn something they haven't had to do often: Explain to clients why their bond portfolios and bond funds are down. And they won't just be slightly down. They could experience potential 10% to 20% losses or more.
A Rise in Interest Rates
The last time interest rates moved up in a sustained manner – June 2016 to October 2018 – the 10-year U.S. Treasury yield rose from about 1.5% to 3.15%.
That was more like a fire drill than an actual fire for bond investors and their financial advisors. But even that modest rise in rates was enough to drop the price of a couple popular exchange-traded funds, representing long-term Treasurys and investment-grade corporate bonds, by more than 18% and 8%, respectively.
Advisors may be quick to point out that these are only the price returns. The income paid by the bond is excluded. Throughout most of bond market history, this matters. After all, it represents more than two years of interest left off these returns.
In today's environment, however, what your clients will care about is the price decline. With rates so low, large price changes in bond investments will be felt much more than in the past.
That's true for two reasons. First, it's because the coupon interest clients get on bonds is so paltry that it barely moves the needle on total return.
Second, price changes will be felt intensely because most brokerage statements and investor reports do not include the income received from bonds and bond ETFs in a convenient place. They are counted in the total income section of the report, but the unrealized gain-loss column likely excludes the positive performance impact of the interest income. This is, in part, because it allows you to track capital gains separately from income.
The financial advising industry doesn't always present information to clients in a way that makes it easier for advisors to explain what's really happening. However, as the advisor and fiduciary, you'll have to handle it.
Right now, there are low rates on bonds, and that puts the spotlight on the ability of bond mutual funds and ETFs to continue to deliver strong price returns. For that to happen, yields need to continue to fall. But they have a ton more room to rise than fall these days.
For your clients, however, the possibility of enduring losses on bonds is somewhere between unnatural and unfathomable. Who can blame them, given that the bond market was essentially in a bull cycle since 1980?
There is plenty of historical precedent for major price declines in bonds from a sudden jolt upward in interest rates. But if your clients haven't seen or experienced it, that precedent might as well not exist. That lack of experience can lead to overconfidence – and later to shock and disappointment.
As an advisor, it's important to address, educate and cut off that cycle of emotions – before they stop blaming the market and start blaming you.
When secular conditions change, the worst thing an advisor can do is to blow them off and hope they get better. Instead, confront what has changed and use it as a teachable moment for your clients. You and your clients may conclude that it's worth sticking with the current plan. Or you may draw a line in the sand, such that if rates rise to a certain level, and their bond funds' value falls to a certain level, a strategy change will initiate.
Or you can take this strategy: Reclassify high-quality bonds within portfolios. Once a part of the core, long-term portion of a portfolio, they are now simply one of many tactical tools you can use within the strategy. The rationale is simple: Interest rates, and therefore bond prices, are too low to produce a favorable, long-term reward-risk trade-off.
Bond funds can still be used to pursue client objectives. But you will consider if – and when – there is a compelling reason to "rent" them for months or even weeks, not own them for years. They will be relegated to being a tactical tool until rates have risen enough to comfortably restore their "core" status.
When will that be? Perhaps, when the U.S. tackles its long-term debt issues, when the Fed has a plan to combat hyperinflation and when the interest rates on speculative bonds are not priced as if they have no risk.
Basic Bond Math: A New Challenge to Understand
This bond market boogeyman has been around for years. If the headline stock indices were producing more modest returns, your clients would likely be focused on how to complement the long-term portion of their stock portfolio, with something that won't act like stocks when stocks crash. Bonds can do that.
Here is a quick way to figure out the potential risk without resorting to a spreadsheet or fancy financial terminal. The 10-year U.S. Treasury bond has a duration of about nine years. The 30-year U.S. Treasury bond has a duration of about 21 years. That means if interest rates rose by 1%, the price return on such bonds would decline by 9% and 21%, respectively.
That's a big move in rates. The 10-year rate has moved up by about 0.6% from Aug. 4 to Jan. 15, in less than six months. Based on ongoing tracking of the return-risk trade-off for many asset classes, there's potential for rates to grind higher.
That probably won't be in a straight line. But the stage is set for a potential wild card: investor sentiment.
Again, while everyone is watching the stock market, it helps you to watch the bond market. Rates are creeping higher, relatively unnoticed by your clients. But, as is often the case, there will come a moment when rates are front-page news. Then, before you know it, prices have moved dramatically and quickly against you and your bond-fund-owning clients.
So, watch out for that scenario. You are better off being proactive and providing clients with much-needed perspective. You want to be the client's personal expert, not an excuse-maker-in-chief.