Time to Rethink the Love Affair with Bonds?

David Fabian, money manager at FMD Capital, cautions long-term investors against becoming too complacent about bonds. Here, the editor of the Flexible Growth and Income Report suggests three prudent steps for investors to consider to cushion risk against a potential rise in rates.

Steve Halpern:  Joining us today is David Fabian, money manager at FMD Capital and editor of the Flexible Growth and Income Report.  How are you doing today David?

David Fabian:  I'm wonderful, Steve.  Thanks so much for having me back.

Steve Halpern:  Well, thank you so much for taking the time.  You recently published a fascinating report entitled "Rethinking the Love Affair with Bonds".  As background can you explain why investors have been so attracted to the bond market?

David Fabian:  Yes, certainly.  One of the things that we've seen over the last 18 months is the stock market has been extremely volatile.  You've had two big drops over that period of time. 

More than 10% correction type moves in the stock market, and over that same period of time we've seen just a slow steady decline of interest rates, which has pushed bond prices higher. 

People are looking at their stock allocations, they are looking at their bond allocations, and saying why I am going to take all this risk in stocks when the market really isn't going anywhere.  I'm just going to stick with plain old vanilla bonds that continue in a slow, steady, low, volatility up trend. 

When you look at the S&P500 that's up 2% or 3% this year, and then you look at just even an aggregate bond fund that's at 4% or 5%. 

People start to swing more of their portfolio towards the bond market in an effort to kind of jump on some of that recent performance.  That's why we've seen some of the enthusiasm and exuberance within the bond market over the last six to 12 months.

Steve Halpern:  With that as background could you explain why this "Love Affair" is starting to raise some concern for you?

David Fabian:  Certainly.  One of the things that I pointed out in the article is that bonds move very similar to stocks in that they can get to a point where they're very much over loved in the market, and when that happens you get all these people piling in, piling in, piling in, and suddenly there's no one left to buy. 

Then you start seeing the boat shift back to the other direction.  You start seeing interest rates rise, you start seeing bonds become less and less attractive so then the assets pile back out a gain. 

Many people think, hey, we've been in a long-term bull market for bonds for a number of years, for decades really, and so this has been a slow steady easy trade to be a part of.  Especially because they've been so low volatility.

Over that period of time we have seen fluctuations in interest rates that you can actually take advantage of if you're a little bit more active with your portfolio.  Another reason that started the love affair with bonds, when I kind of look at the sentiment data out there, I really pay attention to the Bank of America, Merrill Lynch Asset Management Survey. 

They talk about how bonds are the most loved, the most owned in their investor's portfolios in the last 3.5 years, and stocks are the most under owned in 3.5 years.  

If you go back on the calendar and look at what happened 3.5 years ago in 2013 we had that taper tantrum situation where the 10-year Treasury note yield got as low as 1.5%.

And within a period of about six months it shot all the way up to 3% so again that caused a massive repositioning in the bond market.  Investors have really kind of gotten back all those gains, now they're excited again at bonds, and that could potentially represent a short-term peak.

Steve Halpern:  You offer your subscribers some strategies that could help insulate long term portfolios from this type of back up in rates.  The first recommendation you make is to shorten duration.  Can you explain what you mean by this?

David Fabian:  Absolutely.  One of the things that, the longer duration that you have the longer effective direction in your bonds, the more sensitive your portfolio is going to be to interest rates. 

People that own an ETF like iShares Barclays 20+ Year Treasury Bond (TLT) are going to have a very high sensitivity to interest rates. They're going to see that position fluctuate quite rapidly. 

If you were to transition out of a higher duration fund into a lower duration position something that doesn't have an effective duration of over 10 years.  Maybe it has an effective duration of under-five.  You're going to be much less sensitive to changes in interest rates. 

That could potentially insulate your portfolio more.  Also there are  =a couple of funds that I pointed out in the article that I wrote.

The Vanguard Short Term Bond ETF (VSB) is a very big, very liquid fund that many people use. Another fund I use for my Wealth Management clients is the Vanguard Short-Term Corporate Bond Fund (VCSH). 

Just another couple of different options people have if they want to look, and potentially look to reduce some of their longer duration positions.  These can potentially be short-term holding patterns that they used for a short period of time if we see a rebalancing in the interest rate markets.

Steve Halpern:  You also highlight the SPDR DoubleLine Total Return Tactical ETF (TOTL).  Could you explain how this fund fits in with your strategy?

David Fabian:  Certainly TOTL is an actively managed bond fund, it's actually managed by Jeffery Gunlock who runs DoubleLine Capital. 

He’s a very famous bond manager; a lot of people see him on CNBC.  He's on TV quite a bit.  We've owned this one for quite some time for our Strategic Income Portfolio for our Wealth Management clients. 

The way it fits into our strategy is TOTL is more of a multi-sector bond fund.  Because it's an actively managed fund, Jeff Gunlock is able to do a little bit more with this portfolio than you would just too passively kind of core type of bond index.

You can see him, he has a much shorter duration than an iShares Core Bond ETF (AGG).  It has a duration of about 5.5 years.  The total position has a duration of about 3.5 years so again, we're talking about less sensitivity to interest rates. He's also got the ability to position himself in other areas of the bond market outside of just the US. 

He can go with emerging market bonds or he can add or reduce exposure to high yield bonds.  I think having some of these actively managed fixed income positions in your portfolio.  It's certainly going to add value over the next rears. 

I really belief active management is the way to go for fixed income because you'll bounce in the interest rate market, there's going to be bumps in the credit market, and you have to be able to have somebody that's going to weave you through these area with a great deal of expertise, and is kind of looking over your money for you.

Steve Halpern:  Another strategy you suggest for investors is simply to move some of their holdings to cash.  Yet many people seem to avoid this, can you explain that.

David Fabian:  Yes, you know I always recommend for diversified portfolios you need to have some core bond exposure.  I'm not telling somebody that if you have 50% in bonds go out and sell everything right here, and think we're going back to the 3% on the 10-year Treasury note or anything like that. 

Certainly if you do have 5%, 10%, or 15% of your portfolio exposed to a high duration positions or more tactical positions that are very interest rate sensitive. 

You could potentially look to reduce some exposure to that.  Simply move to cash, and really, cash gives people a little bit of clarity, and the ability to have some capital to deploy for other opportunities. 

Maybe you see a stock that you want to purchase that's going on sale, maybe you just wait two or three weeks, and even buy back the same position at a much more attractive interest rate level. 

Something along those lines, but just having a little bit of flexibility, having cash is just sort of a short term place holder in your account can be very beneficial so that you're ready to deploy that money at a moment's notice. 

You're then not having to sell something in a stressful situation or something like that, and then look to immediately put it back to work in the market.  Again don't have cash for too long a period of time, but it can be a useful tool as you transition your portfolios to some other areas showing value.

Steve Halpern:  The third suggestion you offer is making a directional bet on rising rates. How would you invest or follow that advice. 

David Fabian:  Well, certainly with using ETFs there are a number of funds that allow you to bet on rising interest rates.  A very popular option for that is the ProShares Short 20+ Treasury Bond ETF (TBF).  That's a fund that I point out in my article. 

For the majority of investors, I don't recommend going long interest rates, and shorting bonds because if you get the timing wrong, you're actually going to do more damage to your portfolio than good.  It's also very expensive to short bonds, and so they're just not good holding vehicles for long periods of time. 

If you're a more aggressive trader, if you have more short term holding period, you have a discipline risk management approach with stop losses and the like, there is opportunity to actually play the interest rate game with rising rates through a fund like TBF. 

That's kind of what I was pointing out as another opportunity, but is really more for either aggressive income investors, somebody who wants the hedge of position that they don't want to sell necessarily, but use with caution certainly.

Steve Halpern:   Interestingly, you're not necessarily expecting a very sharp rise in rates, rather is it fair to say that you're just being prepared for this possibility as part of your ongoing active management strategy.

David Fabian:  I'm not forecasting that we're going to go all the way back to 3% on the 20-year or 4% or 5% anything like that.  I'm not expecting any kind of a blow up in the bond market, but I am just saying I think bonds are a little bit over loved. 

We got all the way down to 1.5% on the 10-year.  We've actually since I wrote the article, we've snapped back to about 1.7%.  Again we're already seeing some of that retracement since I've written about my concerns. 

Again it's just making some tactical shifts in your portfolio, hanging on to the important core positons that provide you with stability and income, and offset some of the stock volatility in your portfolio. 

Making some small actively managed shifts I think can really add some value over the next couple of years, and just kind weave you through some of these mine fields in the interest rate and credit markets. 

Steve Halpern:  Again our guest is David Fabian of the Flexible Growth and Income Report.  It's always fascinating to talk with you.  Thank you for your time today.

David Fabian:  Thank you for having me Steve, have a great day.

By David Fabian, Money Manager at FMD Capital