The Case for Strategic Income

02/07/2014 10:00 am EST

Focus: BONDS

Following a 30-year bull market in bonds, investors need to prepare for a long-term rise in rates, cautions Anton Bayer. The CEO of Up Capital looks at this transition and highlights several strategies and positions for the next stage of the interest rate cycle.

Steve Halpern: We're here today with Anton Bayer, Founder and CEO of Up Capital Management. How are you doing, Anton?

Anton Bayer: I'm doing great, thanks very much, Steven.

Steve Halpern: First, could you tell our listeners a little about Up Capital Management?

Anton Bayer: Yes, we're a registered investment advisory firm with about $160 million under management and we manage four model portfolios that are comprised of individual stocks, ETFs, and mutual funds. They are risk-based, so there are four of them; income, balance, growth and income, and growth model portfolios.

Steve Halpern: Now—as a smaller firm—you mentioned that you're not one of the big guys and that gives you some added flexibility. Can you tell listeners a little about how that allows you to react a little more quickly to markets?

Anton Bayer: One of the key aspects that large firms are handicapped with is they have an investment policy that dictates all of the advisors as to how to manage money and, for the most part, it requires the advisors keeping the investors in the risk category that, when they sign the original application, that is what they need to stay in, regardless of market conditions.

If you sign up with a large firm and you identify yourself as a growth and income investor, you will stay predominantly in an overweighted equity position and the advisor doesn't have, typically, the flexibility to increase cash positions or reduce risk, even in situations like 2008, and 2000, and 2002, because the compliance requirements are to keep the client in the category that they sign up for.

As a smaller firm, we write our own ADV—a disclosure form filed with the Securities and Exchange Commission—and our own investment policy.

So, in our ADV, we have established that all four portfolios can go 100% to cash anytime, so even if you're in our growth portfolio, if it is a high-risk scenario, as we believe it is, we can increase the cash position, which, even though it typically doesn't represent a growth portfolio, in our opinion, it is the best allocation at the time.

Steve Halpern: Let's look at the current environment. With the Fed beginning to taper, you see some challenges ahead for Janet Yellen. Could you expand on that?

Anton Bayer: Yes. This market has been so sensitive to Federal Reserve monetary policy since 2007, on both sides of the equation, which adds to our level of confidence that it is a key barometer and influencer to the market.

The best recent example is 2012, when Ben Bernanke ended QE2 June 30, immediately, the first day of the market in July and all the way through August, the market fluctuated significantly and, in the first four days of August, fluctuated 2,000 points in that first week.

It wasn't until Ben Bernanke introduced what we now have as quantitative easing, in October, that the market resumed the rally that we are in right now.

Our concern is that the emerging markets are exposing the dependency on Central Bank monetary policy, as the feds continue to slowly wind down and taper their quantitative easing, and then that is going to eventually start bringing the exposure into the US economy, as they continue tapering from $85 billion at $10 billion a month, continue reducing that.

Currently, we have an economy that is growing a meager 2.5% to 3%. We still have a high 7% unemployment and we've had trillions of dollars invested from the Federal Reserve and the federal government index, in spending and stimulus, and we have a lackluster economy.

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So, we feel that the Federal Reserve policy that Janet Yellen has to strategically try and navigate is reducing the quantitative easing, but at the same time, paying attention to economic events and whether or not she has gone too far, so it is going to be a challenge, I think, for Janet Yellen. It is quite a baton that Ben Bernanke is passing on to Janet Yellen.

Steve Halpern: Now, with that as background, you also note that on a long-term basis, we could be shifting from a 30-year bull market in bonds to perhaps many years of rising interest rates. How concerned should investors be about that?

Anton Bayer: This is a huge issue, in our opinion, and we are very focused on history as an indication to future events.

When you look at the 10-year Treasury chart, starting in 1958, when the 10-year Treasury bottomed at 2.6%, 2.67%, and then it rallied all the way to 15% in 1981, and then, since 1981, it has now gone back and reached a bottom of 1.62% last year, and now, we're just under 3% and in the 2% range.

When you look at that mountain chart of rising interest rates from 1958 to 1981, you look at what made money during that time period as an indication.

We believe investors need to look at an indication of what will make money going forward, because, with money market rates at zero, the 10-year Treasury at 2.6% to 3%, a rate that was in 1958, we don't see the option of interest rates dropping like they have for the last 25 or 30 years, at this rate.

There are only two places interest rates can go, in our opinion, stay the same for the rest of our life, or go up, and so, investors need to pay attention to what made money from 1958 to 1981.

The biggest mistake investors will make is look at past performance of bond funds for the last one, three, five, ten, or 15 years, which will look very attractive, but that is only relevant if they feel that the future represents the past, and the past can't be represented because interest rates are at zero, so they can't decline like they have since 1981.

The same mistake investors made in 1970 to 1981, when prime lending rates soared, and interest rates soared, and owning bonds, I think it is going to be the same mistake conservative investors are going to make again now.

Steve Halpern: For investors who want protection from rising interest rates, you would suggest strategic income or conservative allocation funds. First, before we look at individual funds, could you explain what this broad sector is?

Anton Bayer: Yes, so, this is a case that, I believe that active managed funds will outperform inactive index funds, and so, the key here is that mutual fund companies can hedge against rising interest rates, whether they own Treasury protected bonds, whether they own floating rate bonds, or simply derivatives that hedge against rising interest rates and actually include shorting the bond market and hedging against it with futures and options.

There is sophistication of being able to do this. It is very, very inexpensive when you compare what an individual investor would have to do on their own, not only the research, but then the cost of buying options or other investment instruments that would hedge against rising interest rates.

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So, a strategic income fund and conservative allocation fund—the reason why I think they are going to be a better play for investors—is they have a much bigger selection and a prospectus that allows them to diversify their portfolio.

If you own strictly a term bond fund, a five-year term bond, intermediate bond fund, short-term bond fund, that is all they are going to own and that is per the investment prospectus, but a strategic income fund, by design, is allowing the portfolio managers to broaden their investment options and include the ability to hedge against rising interest rates.

A conservative income fund has an additional component with a little more exposure to stocks and dividend paying stocks and, if you look at 1958 to 1981, the S&P 500 outperformed the Barclays Aggregate Bond Fund by almost 300%.

So, again, we would consider a conservative income fund where the portfolio manager has a little more to work with to try and address a rising interest rate market for the next 15 to 20 years, versus just a term bond fund that has very little options.

Steve Halpern: Before we leave, could you highlight a few examples of strategic income funds that investors could consider?

Anton Bayer: Yes. What is terrific for investors right now is, we have immediate data as to what worked and what didn't work, so what I would suggest investors do, which is the same thing that we're doing, is we're looking at what worked last year.

So, on May 22, Ben Bernanke made his announcement and immediately, the institutional conservative investors withdrew billions of dollars out of bond funds and the bond market collapsed, as you know, in May and June.

What we want to do, and what investors should do, is look at what worked last year because that is going to be, potentially, the indication of what will work for the next three, five, ten, 15 years.

We were very pleased with the performance of several funds and include the BlackRock Strategic Income Fund (US:BASIX). It has a nice dividend yield in the 2% to 3% range.

Goldman Sachs Strategic Income Fund (US:GSZRX) also performed last year and then in the conservative income fund area, the Hartford Balanced Income Fund (US:HBLAX) did very well.

Part of the methodology that we would share with investors is, look at what worked last year, go to a Morningstar database, do your research, look at that fund compared to other funds.

The beauty of what we have now is just three quarters ago, in 2013, we saw the transformation of a declining interest rate market trend to a rising interest rate market, and we now have immediate data to see what's working and what's not working.

Steve Halpern: Well, thank you for joining us today. We appreciate your insights.

Anton Bayer: Yes, thank you very much, Steven.

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