Should I Sell My Fixed Income?

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

Now that we’re able to look back with the benefit of hindsight, it’s pretty easy to pick on the mistakes that investors made during the financial crisis of 2008. For instance, as equity markets sold off, emotion took over, and many investors that entered the crisis with a well balanced portfolio abandoned their plan and made wholesale changes to fixed income or, even worse, cash. At the time, it seemed like a rational reaction—Wall Street institutions that had existed for decades were insolvent, and each day seemed to bring a new, ineffective government program to stabilize the credit markets, along with yet another triple-digit loss in the stock market.

7.18.13_Raupp_FixedIncomeWe know now that what had started as an economic slowdown and then recession extended into a full-fledged market panic, where investors sold indiscriminately of price. In the years that followed, those that kept their heads recovered and reached new highs with their investments; those that joined the panic are, in many cases, still hoping to recover their 2008 losses.

Today, many investors are considering a question that could very much have the same negative long-term consequences, namely, “Should I abandon fixed income altogether?”

The question comes up after interest rates spiked in reaction to Federal Reserve Chairman Ben Bernanke’s May testimony in which he outlined a scenario where, with the right economic growth in place, the Fed could start lowering the level of bond purchases they’re making as part of the quantitative easing (QE) program. Over a two month period, the yield on the 10-year Treasury jumped from 1.6% to 2.8% and at -2.3%, the Barclay’s Aggregate Index had its worst quarterly return since the second quarter of 2004 when it fell 2.4%.

To answer the question, first let’s look at the downside potential. It’s been a long time since we went through an extended rising rate environment. As our research indicates, from 1945 to 1981 the yield on the 10-year Treasury rose from 1.5% to over 14%. Over that 36-year period, the return an investor in the 10-year Treasury received was actually a positive 2.8%, with 75% of the calendar years in that period having positive returns. The worst one-year loss, 5.0%, was in 1969, and the worst multi-year losing streak happened twice—1955-1956 and 1958-1959 (1957 was a strong year and the five-year period 1955-1959 was close to flat). Compared to a stock market bubble, the downside on fixed income is extremely tame.

7.18.13_Raupp_FixedIncome_1Secondly, you have to think about the role fixed income plays in your portfolio. In heavy stock market sell-offs, fixed income is often the only asset class with positive returns and therefore can act as a hedge against market volatility. Since 1945, there has only been one year (1969) where both stocks and bonds had negative returns. In today’s world, a global flight to safety results in demand for high quality fixed income, driving yields down and bond prices higher. No other asset class plays the low volatility hedging role quite as well. Responding to the threat of low rates by greatly increasing equity, or even alternative exposure, can prove disastrous if markets crater.

Finally, fixed income comes in many varieties. At any given point in time, there are areas of fixed income that provide opportunity and/or protection. By broadening your universe beyond simple treasuries to take advantage of these you can get a better end result.

Let’s be clear, core, investment-grade fixed income doesn’t provide a great investment opportunity right now. With yields still at low levels and likely to rise in the coming five to ten years, we’ll likely see muted returns at best with fits and starts of performance along the way. Inflation is currently in check below 2%, but if we started to see it flare up, investors, especially those with longer horizons, would need to consider the impact rising prices would have on their purchasing power. But even in an adverse environment, fixed income still plays an important role in portfolios.

Behavioral Finance 101: Framing

DanielCrosbyDr. Daniel Crosby, Ph.D., IncBlot Behavioral Finance

As we’ve discussed in the first two parts of this series, economic decision makers are not the cold, detached, decision makers they have historically been painted to be by efficient market theorists. Quite the opposite, human behavior is marked by irrationalities and fuzzy logic based more closely on mental approximations than hard and fast rules. We have already touched upon the impact of heuristics and irrational behavior and today will turn our gaze to the third pillar of behavioral finance – framing.

7.10.13_Crosby_Framing_2Simply put, framing is an example of a cognitive bias in which people arrive at a different decision depending on how the question is framed. While homo economicus would weigh all decisions equally and disregard framing effects, actual behaviors indicate that the lens through which we view a decision has everything to do with the eventual outcome. Frames can take a number of shapes; it could be the physical place where we make a decision, whether a question is positively or negatively framed, and even the way we mentally account for the options from which we are selecting.

Consider a real-life framing example with a huge cost to the U.S. taxpayer. Twice in the past few years, the government has tried to stimulate the economy by offering tax rebates to the hardworking citizens of the U. S. of A. Both times, these efforts have met disappointing ends, and behavioral finance may just be able to tell us why.

Belsky and Gilovich lead us toward the answer in their excellent primer, “Why Smart People Make Big Money Mistakes.” They describe a study conducted at Harvard wherein 24 students were given $25 to spend in a lab store as part of their participation in a research. Any unspent money, they were told, would be returned to them shortly via check. But wait, there’s a rub (there always is when psychologists are involved)! Half of the students were told that the $25 was a “rebate” and the other half told that it was a “bonus.” Could such a minute difference in cognitive framing have a measurable impact on spending behavior? It turns out, it could.

7.10.13_Crosby_Framing_1For those whose earnings were framed as a bonus, 84% spent some money in the lab store, a behavior mimicked by only 21% of those whose money was framed as a “rebate.” Now consider the decision of the U.S. government to give “tax rebates” to help stimulate the economy—an action that ultimately failed, probably at least in part due to framing effects. Irrational decision makers that we are, we fail to grasp the fungible nature of dollars and account for them differently based upon how they are framed in our mind. As Nick Epley, the psychologist who conducted the Harvard study, said more forcibly, “Reimbursements send people on trips to the bank. Bonuses send people on trips to the Bahamas.”

One of the most profound forms of framing effect plays on our fear of loss in times of fear or risk, or the related fear of missing out in times of plenty. This tendency, demonstrated most powerfully by Daniel Kahneman and Amos Tversky is known as “loss aversion.”[1] The basic tenet of loss aversion is that people are more upset a loss than they are excited by an equivalent gain. Consider the comical demonstration of loss aversion that resulted from a survey conducted by Thomas Gilovich. Mr. Gilovich asked half of the respondents to a questionnaire whether or not they could save 20% of their income, to which only half said yes. The second half of the respondents was asked whether they could live on 80% of their income, to which 80% replied in the affirmative. To-may-to, to-mah-to, right? So why are the responses so different?

7.10.13_Crosby_Framing_3The first phrasing frames it as a 20% loss of spending power (there is a large body of research that indicates that saving is viewed as a loss. Silly people), whereas the second frames it more positively. Thus, equivalent financial realities are viewed through entirely different lenses that lead to decisions with profoundly different outcomes.

One of the benefits of behavioral finance is that it shines a light on the little peccadilloes that make us the flawed but lovable people we are. But irrational as we may be, we can turn the tide on ourselves and use these quirks to our personal advantage. Framing is only disadvantageous inasmuch as the frames we are applying to our money are reckless. Viewing money through the frame of a charitable contribution or a child’s college fund can impact your financial decision positively just as surely as framing it as disposable can have a negative impact. At Brinker Capital, our Personal Benchmark system accounts for the human tendency to mentally account for and frame dollars, and does so in a way that helps ensure an appropriate allocation of assets across a risk spectrum. As we hope you’re aware after taking part in this behavioral finance survey course, you are not as logical and dispassionate as you might have guessed. Whether or not you use that irrationality to your benefit or detriment is now up to you.


[1] Kahneman, D. and Tversky, A. (1984). “Choices, Values, and Frames”. American Psychologist 39 (4): 341–350.

Monthly Market and Economic Outlook – June 2013

Magnotta@AmyMagnotta, CFA, Senior Investment Manager, Brinker Capital

Financial market performance diverged in May. Despite selling off in the second half of the month as investors began to worry about the Federal Reserve tapering its asset purchases, U.S. equity markets delivered solid returns, with the S&P 500 gaining +2.1%. In the equity markets, high dividend oriented sectors (utilities, telecom, staples) delivered negative returns, as did interest rate sensitive sectors like REITs and MLPs. International equity markets declined in May and were negatively impacted by a stronger U.S. dollar. Emerging markets continue to lag developed international markets.

Interest rates moved higher in May, attempting to return to more normal levels. In the U.S., both the 10-year Treasury note and 30-year bond climbed over 40 basis points resulting in negative returns for all major income sectors. Year to date, U.S. fixed income markets (Barclays Aggregate Index) have declined -0.9% while U.S. equity markets (S&P 500) have gained over 14%.

06.07.13_Magnotta_MarketOutlook_1The fear of the Fed tapering its stimulus as early as September has continued to weigh on investors as we move into June. While equity market indexes are just 3% off the recent highs, we’re experiencing more volatility. The last two occasions when the Fed has attempted to pare stimulus, the equity markets experienced double-digit declines. However, if the Fed does follow through with reducing the amount of asset purchases, it will do so in the context of an improving economy. More recent economic data has been mediocre, the recovery in employment will continue to be slow, and inflation is falling and now well below the Fed’s target. Market participants will be focusing on every data point in an effort to predict the Fed’s actions.

Interest rates have come down slightly from recent highs, but the 10-year note remains above 2%. We expect to see more bond market volatility as interest rates attempt to return to more normal levels. However, with growth still sluggish and inflation low, we expect interest rates to remain range-bound over the intermediate term.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we move through the second quarter. A number of factors should continue to support the economy and markets for the remainder of the year:

  • 06.07.13_Magnotta_MarketOutlook_2Global Monetary Policy Accommodation: The Fed remains accommodative (even if they scale back on asset purchases), the ECB has pledged to support the euro, and now the Bank of Japan is embracing an aggressive monetary easing program in an attempt to boost growth and inflation. This liquidity has helped to boost markets.
  • Housing Market Improvement: An improvement in housing, typically a consumer’s largest asset, is a boost to net worth and, as a result, consumer confidence. However, a significant move higher in mortgage rates, which are now above 4%, could jeopardize the recovery.
  • U.S. Companies Remain in Solid Shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.
  • Equity Fund Flows Turn Positive: Equity mutual fund flows turned positive in 2013, and while muted compared to flows into fixed income funds, remain a tailwind after several years of outflows. Investors experiencing losses on their fixed income portfolios could also be a driver of flows to equity funds.

However, risks facing the economy and markets remain, including:

  • Europe: The risk of policy error in Europe still exists. While the ECB is willing to act as a lender of last resort, the region has still not addressed its debt and growth problems.
  • Sluggish Global Growth: Europe is in recession while Japan is using unconventional measures to create growth. China is showing signs of slowing further, as is Brazil.
  • U.S. Fiscal Drag: While we achieved some certainty on fiscal issues earlier this year, drag from higher taxes and the sequester will weigh on personal incomes and growth this year.

06.07.13_Magnotta_MarketOutlook_4Because of massive government intervention in the global financial markets, we will continue to be susceptible to event risk. Instead of taking a strong position on the direction of the markets, we continue to seek high conviction opportunities and strategies within asset classes. Some areas of opportunity currently include:

  • Domestic Equity: dividend growers, housing related plays
  • International Equity: Japan, small & micro-cap emerging markets, frontier markets
  • Fixed Income: non-Agency mortgage backed securities, emerging market corporates, global high yield, short duration strategies
  • Real Assets: REIT Preferreds
  • Absolute Return: relative value, long/short credit
  • Private Equity: company specific opportunities

06.07.13_Magnotta_MarketOutlook

Beginning of a ‘Great Rotation’?

Joe PreisserJoe Preisser, Brinker Capital

As the share prices of companies listed in the United States rose this week, to heights last seen in October of 2007, speculation has run rampant that a so called ‘Great Rotation’ from fixed income to equities may have commenced.

The continued easing of Europe’s sovereign debt crisis, combined with positive corporate earnings surprises and the temporary extension of our nation’s borrowing limit, has helped to quell a measure of the uncertainty that has plagued market participants during the course of the last few years. Tangible evidence of this phenomenon can be found in the marked decline of the Chicago Board Options Exchange Market Volatility Index (VIX), commonly referred to as the “fear gauge”, which is currently trading far below its historical average. The steep drop in expected market volatility suggests that investors believe to a large degree that many of the potential problems facing the global economy are already priced into current valuations, and as such have set expectations of the possibility of any external shocks to be quite low. This state of affairs has led directly to an increased appetite for risk within the market, which has culminated in strong inflows into equity funds. According to the Wall Street Journal, “For the week ended January 16, U.S. investors moved a net $3.8 billion into equity mutual funds. That followed the $7.5 billion inflows in the previous week, along with another $10.8 billion directed to exchange traded funds. Add it up and you’re looking at the biggest two-week inflow into stocks since April 2000” (January 24, 2013).

Although the movement of money into equities this year has been quite strong, whether or not this is the beginning of a significant reallocation from fixed income remains to be seen. Despite the flight of dollars into stocks, yields, which move inversely to price, on both U.S. Treasury and corporate debt have risen only moderately, and bond funds this year have not experienced the type of drawdowns that would be expected if investors were truly rotating from one asset class to another. In fact, what has transpired speaks to the contrary, as although inflows to the space have slowed from last year, they remain robust. According to an article in Barron’s published this week, “Bond funds, meanwhile, attracted $4.63 billion in net new cash. Bond mutual funds collected $4.21 billion of that sum, compared to the previous week’s inflows of $5.45 billion” (January 18, 2013). One possible explanation for the hesitation to exit the fixed income space is the lingering concern among investors over the looming fiscal fight in Washington D.C. and the potential damage to the global economy if common ground is not found. According to a recent Bloomberg News survey, “Global investors say the state of the U.S. government’s finances is the greatest risk to the world economy and almost half are curbing their investments in response to continuing budget battles” (January 22, 2013).

If begun in earnest, a rotation by investors from fixed income to equities would certainly present a powerful catalyst to carry share prices significantly higher; however caution is currently warranted in making such an assertion, as a potentially serious macro-economic risk continues inside the proverbial ‘beltway’. If the budget impasses in the United States is bridged in a responsible way, and the caustic partisanship currently gripping Washington broken, the full potential of the American economy may be realized and this reallocation truly undertaken. David Tepper, who runs the $15 billion dollar Apoloosa Management LP was quoted by Bloomberg News, “This country is on the verge of an explosion of greatness” (January 22, 2013).

Dealing with Fear in Clients

Bev FlaxingtonBev Flaxington, The Collaborative

These are difficult economic times. Add the current economic climate to a market that hasn’t cooperated for some years, and you have investors with angst. Anyone with money saved, or looking at retirement, is feeling a bit worried and ill at ease. When investors are worried, it impacts the advisor. Sometimes a client will not make a decision out of fear. Sometimes referrals are impacted because clients hesitate to recommend friends and family until they see what happens with the markets. People often simply sit on the sidelines when they are fearful, because doing nothing always seems better than taking a risk.

Do advisors just have to wait out this period of angst? What if it doesn’t go away for some time? Are advisors doomed to live with fearful clients? Let’s look at some strategies for managing clients through fearful times, and perhaps even benefiting from the difficult conditions.

bev blog 12.13.12

(1)    Manage your own fears first. If you, as an advisor, are worried, this will impact your clients too. Remember, most of us recognize the “smell of fear.” We know when someone is scared or worried. If you aren’t managing your own reactions, it will be noticeable to your clients. Practice meditation or deep breathing. Go to the gym. Read books that make you laugh. Whatever you have to do to feel more upbeat and less worried, do it. And watch the way you speak. Your words should be balanced and realistic, but overall optimistic and connoting a sense of “in control” to your clients.

(2)    Stay proactive. Many of the fears come from the unknown. What will happen if our politicians can’t reach an agreement? What if they decide to do one thing over another? The news is filled with worst case scenarios. Stay on top of what’s being discussed, and provide education to your clients about what you will do in different scenarios. Show them you are paying attention and thinking about your responses based on different outcomes.

(3)    Provide education. This might be a great time to hold a client event or seminar on the things we do know about. Can you speak about long-term care? Can you talk about living well during the aging process? Can you examine 529’s and the college savings options? Find things that are more known and that may be impacting your clients now or in the future, and educate about them. Keep the focus on you and your expertise, while taking it off – even for a short time – the things that are distracting your clients.

(4)    Talk about the fear that clients and prospects have. Acknowledge that you are hearing about it from many people. Talk about how much having an advisor can put fears to rest. Instead of reading the paper every day and wondering what strategies they should take, your clients can depend on you to do this. It’s really the best time to have someone else looking out for them. Remind them of this whenever possible, and acknowledge the circumstances. You want to stay confident in your approach, but it can be helpful to let them know you understand their fears and concerns and that you are there to look out for them.

In many ways, times of uncertainty offer an opportunity for those who are confident and experienced in approach to be the beacon, or comfort, for worried investors. See what you can do to be that confident supporter during these interesting times.