Bond Investments Don’t Have to End Badly

At ICI’s Annual General Membership Meeting held several weeks ago, a number of session panelists and speakers raised concerns about an eventual rise in interest rates and the potential adverse impact of higher yields on retail investors. To be sure, retail investors have been plowing new money into bond funds over the past several years, and the trend has remained unabated through this year. Morningstar data indicates that approximately $95 billion of the $106 billion in long-term mutual fund net flows over the first quarter went to taxable and municipal bond funds, with intermediate bond and high yield leading the way.

The Conundrum
While our crystal ball is not any better than others in the asset management industry, there’s no question yields must rise at some point over the next 1-3 years from the current near-historic lows, as global economies strengthen and secular inflation takes hold. At that point, many retail investors could be caught holding interest sensitive fixed income funds. However, since the Federal Reserve appears determined to keep rates at current levels over the immediate future, there is time for fund companies and their financial advisors to prepare investors.

Education and Alternative Solutions
At a very basic level, fund companies and financial advisors need to continue to educate retail investors about the interest rate risk of long maturity bonds and bond funds. We believe the industry has been diligent in warning retail investors of the pending risk of rising interest rates, but much more needs to be done. Moreover, with the proliferation of new alternative investment solutions developing over the past several years, financial advisors are better equipped to offer yield alternatives without exposing their clients to significant interest rate risk. The development of maturity-date bond ETFs by Blackrock, Guggenheim, and others is one such example. These ETFs track an index of bond issues that mature in a specific year. As such, they allow investors to hold a fund to maturity in a similar fashion to owning an individual bond, thus eliminating interest rate risk. However, by holding several securities in the underlying index, these ETFs also diversify the credit risk of individual fixed income holdings at a relatively low cost. With the diversity of maturity-date bond ETFs now available, advisors are now able to build higher yielding corporate ETF portfolios, tax-advantaged municipal ETFs, or Treasury ETFs, and build traditional bond ladders for retirees by spreading assets across a number of maturity-date ETFs.

There are also a number of other products and strategies now available to advisors to address yield-curve risk, including unconstrained bond funds, in which duration may be positive or negative, a variety of floating rate funds which benefit from rising rates, and global-advantaged funds, which provide exposure across multiple international markets and interest rate environments. So the eventual rise in domestic interest rates does not have to end badly for retail investors, if our industry continues to push its clients to make the right investment decisions.

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