Advisors Find a Road Less Traveled in Fixed Income

by Venk Reddy of Zeo Capital Advisors, 6/19/17

Experienced investors know they can’t control what the market is going to offer. While it’s not unusual to find an asset manager targeting a specific return, actually achieving that goal is sometimes as much a matter of luck as skill. The simple fact is that no one, not the best stock picker or bond buyer in the world, can accurately predict returns in one year, let alone consistently year-over-year – no one knows the future. There has to be a better way for individuals and advisors to select the managers with whom they entrust their financial well-being.

There is a small but growing community of advisors who are leaving behind the old ways of picking managers in an effort to give their clients something they can’t get on their own or from a robo-advisor. These advisors pay as much, if not more, attention to potential risks as they do to potential returns. After all, fund managers invest in risks, not returns, when they select the securities in a fund, even if they are just rebalancing an index. Returns are nothing more than the result of a portfolio’s risk selection, whether deliberately chosen or passively accepted.

When the market is greedy, indiscriminate buying means that the return-focused manager will have to take on more risk than was necessary before the market greed kicked in. When the market is fearful, indiscriminate selling means that the return-focused manager can take on less risk than was necessary before the market sold off. But an emerging group of risk-minded advisors recognize that if a manager is always focused on returns, he is unlikely to be consistent in how he selects risk. Meanwhile, an index offers no control over the risks in the portfolio. In both cases, a lack of focus on risk makes their job of achieving client goals much harder.

A fund manager may reduce the dependence on luck by deliberately focusing on selecting risk in an effort to have a consistent investment process regardless of what the market is doing. Managers who adopt this approach make it easier for advisors to draw a straight line between their investment strategies and suitability for a client’s goal of steady performance. This is especially true when it comes to investing in fixed income, where capital preservation is usually the highest priority.

Recent bond market swings have put many advisors in the tough position of trying to explain how their fixed income portfolios are expected to preserve capital when interest rates go up. But the answer to today’s fixed income market isn’t to give up on capital preservation entirely because it’s “too hard”. Some call capital preservation an absolute return goal, which means the portfolio aims to always be positive over some timeframe, but there is more to it. To preserve capital, an advisor must also seek lower volatility because she never knows when her clients need to access their money. Having confidence that a portfolio will always be positive in a three year timeframe means little to the client who has a medical emergency in year two. Having confidence in absolute returns within one year with low volatility is much more meaningful.

There are three key characteristics specific to fixed income for advisors to look for when evaluating whether managers are selecting risks to preserve capital. First, volatility is most effectively managed by keeping a low sensitivity to interest rate moves, also referred to as having a short duration. Second, a portfolio should have a high enough yield that any income earned will be able to compensate for price movements. Third, to earn higher yields without losing sight of the capital preservation goal, security selection can often matter more than any other factor when building a portfolio.

The interdependence of the three key characteristics of fixed income capital preservation shows why cutting corners and addressing just one or two of them might have failed in previous market disruptions. Bonds with short durations may naturally be less sensitive to interest rate movements, but declines in bond prices will still cause unrealized losses if the bonds don’t earn enough income to overcome the price moves or if bonds aren’t carefully selected to reduce the impact of indiscriminate selling. And even though a higher yielding portfolio is necessary, not just any portfolio of higher yielding bonds will do if an advisor is concerned with preserving capital.

Fixed income capital preservation is something that an advisor may have difficulty bringing to clients through a fixed-income ETF or index-related strategy, which by its very nature will contain bonds with less-than-stellar credit since better credit quality isn’t a criteria for inclusion. Experience has shown that, when it comes to fixed income, investors must not forget this truth: to buy a bond is to lend money to an issuer, and a good lender is careful and diligent in choosing who to lend to. This requires a fundamental research process which has a clear emphasis on selecting risk, not just return.

Fortunately, risk changes with duration. For any issuer, regardless of its credit rating, there will be a difference between the risk of a default in one year and the risk of a default in seven years. The difference in risk due to time is true whether the issuer is rated investment grade or high yield and whether the bond is corporate debt or government debt. But credit ratings don’t usually distinguish between the bond maturing in one year and the bond maturing in seven years. The confidence a manager has in security selection can increase if the timeframes for analysis are shorter.

Many investors try to cut corners by simply limiting their core fixed income portfolios to investment grade strategies. But since credit quality varies across the time spectrum within the same issuer, the bonds with the best risk/return profiles are not always investment grade. A sharp-eyed advisor can find managers willing to do the research to find bonds from shorter duration higher yielding issuers with a credit quality and expected income which is not far off from what most investors think they’re already getting using investment grade, but without the same interest rate risk.

But the manager who focuses on managing risk may appear to “underperform” when the markets rise and “outperform” when the markets decline even if they reach the same place over time with lower variability. This approach tends to get a two-star rating from Morningstar when markets are going up and a four-star rating from Morningstar when markets are going down – not because the manager has changed, but because the markets have. No manager can control how the markets behave, but they can control their own behavior, the amount of risk they are willing to take on, and most importantly which goals their portfolio is managed to achieve – high ratings or consistent risk.

Advisors who seek out managers who focus on risk selection may be able to more easily assemble a portfolio which is directly aligned with client goals and, as important, may be easier to explain. Choosing a bond fund that meets the three key characteristics of fixed income capital preservation – short durations, higher yields and careful security selection based on deep fundamental issuer analysis – gives the emerging movement of risk-minded advisors an option they had been sorely missing in their effort to find like-minded managers. But, in order to make it work, the advisor must make sure they’ve done their homework and fully understand the portfolio they’re buying and the managers they’re hiring for clients.

Advisors Find a Road Less Traveled in Fixed Income

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