Chicken Little could be right: Are your clients sitting on a ticking time bomb?Article added by Jason Kestler on July 17, 2013
Jason Kestler

Jason Kestler

Leesburg, VA

Joined: August 15, 2009

Advisors are paid to manage people’s money, but we don’t have crystal balls. Instead, we conduct a thorough examination of the client’s needs. We analyze assets, risk tolerance, time horizon and goals, and we make recommendations that are in the best interest of the client. Or do we?

In 1952, Harry Markowitz won the Nobel Prize in Economics for Modern Portfolio Theory. Markowitz's theories emphasized the importance of portfolios, risk and the correlations between securities and diversification. His work changed the way that people invested and the way we advised our clients.

In simplest terms, Markowitz stated that for any given risk tolerance, there is a specific combination of asset classes (small cap, mid cap, large cap, bond, international, etc.) that will provide the highest expected return with the lowest associated risk. This is known as the Efficient Frontier.

Although there is quite a bit of fine tuning within each sector, an efficient portfolio is some combination of equity (stocks) and debt (bonds). The bond portion would increase as the client’s risk tolerance decreased.

Modern Portfolio Theory has been the backbone of the investment community for over 60 years and it has done a very good job. Now, look deeply into your crystal ball. On second thought, just look around you. What do you see?
  • FINRA issues an investor alert, “Duration — What an Interest Rate Hike Could Do to Your Bond Portfolio.”

  • Bill Gross, arguably the most successful bond manager ever, tweets “the 30-year bull market in bonds likely ended April 29.”

  • Warren Buffett, the “Oracle of Omaha,” was recently quoted as saying, “Right now, bonds should come with a warning label.”
For the last 60 years, we’ve been telling clients that a bond position adds safety to their portfolio — and it has. Until now. Clients who own bonds today may be sitting on a ticking time bomb.
Consider this: The value of any given bond is driven by the bond coupon (interest rate) and duration (time to maturity). In a falling interest rate environment, bond values will tend to rise. Since the Fed has been keeping interest rates abnormally low, clients who have held bonds for the last 10 years have done very well. On the other hand, a rising interest rate environment will depress the value of bonds.

In case your crystal ball is on the fritz, the chart below is what it’s trying to show you.

Do you have any doubt that we will see interest rates rise over the next five to 10 years? Now, imagine your clients who are desperate for yield and have purchased long-term bonds. If we see just a 2 percent increase in interest rates, their bond will fall in price by 23 percent! In other words, their $100,000 bond portfolio just lost $23,000. Are they aware of this risk? Are you telling them about this risk?

I don’t mean to be a Chicken Little, but let’s take my hypothetical one step further.

Interest rates rise by 2 percent. Clients see their bond holdings devalued by 23 percent. What will they want to do? Sell! What happens to any item where there is a high supply and a low demand? The price is depressed even more. Chicken Little could be right.

So, why would you recommend that a client should buy (or hold) an asset that you know will lose money. Where else can you go?

Why not consider a new asset class with the following characteristics?
  • No downside risk in a rising interest rate environment

  • In fact, no chance of ever seeing a negative return

  • Daily price availability, just like bonds

  • A fixed asset that effectively shifts the efficient frontier
What is it? A fixed index annuity (in this example, an FIA known as the Balanced Allocation Annuity). To prove our point, we asked Ibbotson to run Monte Carlo simulations to see how blending just a small amount of this investment into a client’s portfolio could affect the anticipated outcome.
In the chart below, we took a conservative investor sitting on the Markowitz efficient frontier with an allocation of 20 percent in stocks and 80 percent in bonds. We made a minor adjustment to the bond portion by substituting the FIA for 20 percent. This changes the overall allocation to 20/20/60. The upside remains the same, with a corresponding reduction in risk. By increasing the allocation to 20/40/40, we can shift the the efficient frontier even further.

So, what’s the take away?

1. As you meet with clients who have bonds in their portfolio (401(k), investment accounts, variable annuities, managed money), consider repositioning all or a portion of the bond to an FIA. Same asset class, lower beta (volatility).

2. Examine your current book of business. Are there clients with assets currently sitting in bonds or bond funds?

3. Have the conversation with your clients. Do they have friends or loved ones at risk?

You can see the storm brewing. Your crystal ball is tuned in perfectly. The big question is, will you act on the information?
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