The Federal Reserve decides to hold tight on interest rates, and advisers are reacting accordingly.
The Federal Reserve announced Wednesday it will reduce its quantitative easing program by another $10 billion a month, down to $15 billion, but that the market should not expect a hike in interest rates anytime soon.
The U.S. equity markets immediately spiked more than a quarter of a percentage point on the 2 p.m. ET announcement that included no indication that interest rates would be adjusted prior to next year.
For financial advisers, it means more anticipating and adjusting for the inevitable start of a rising-rate cycle, whenever it comes.
In a world of unprecedented interest-rate patterns since the 2008 financial crisis, financial advisers have learned to get creative, and are anticipating more of the type of innovation as the economy inches closer to a rising-rate cycle.
“We made several different changes to our fixed-income allocations starting in 2001, including dipping a toe in the water of the nontraditional bond fund space,” said Chad Carlson, director of research and wealth manager at Balasa Dinverno Foltz.
Like most advisers, Mr. Carlson reduced the risk in his bond allocations by shortening the average duration to around three years from a typical neutral duration of four years.
Even though he does not anticipate the Fed will make any sudden moves with regard to interest rate hikes, he does not want to get caught flat-footed in a rising-rate environment that will cause bond price to fall.
“We are already planning for an eventual rate hike and we're positioned for that outlook, but we're not reducing any of our bond allocations, we're just moving things around,” he said. “We don't like to make huge duration calls, because if you get too short you can get burned.”
Most advisers acknowledge they are participating in a guessing game as to exactly when the Fed might decide the U.S. economy is healthy enough to absorb a small interest rate hike, but they also recognize the Fed is striving to be as transparent as possible to avoid surprising the markets.
That mindset lends a certain degree of comfort to advisers who have been forced to wander into brand-new fixed-income territory over the past half-dozen years with the Fed holding short-term rates at near zero.
Patrick McDowell, an investment analyst at Arbor Wealth Management, said his firm has been navigating the low-rate environment by diversifying across floating-rate, convertible, high-yield and bank-loan funds.
“Just about everything except for corporates,” he said. “And we are slowly phasing out of high-yield bonds because we anticipate some increased selling pressure as rates start to rise.”
Mr. McDowell is keeping the average bond duration below four years, but he isn't really worried about income right now because he remains very bullish on the equity side of the portfolio.
“We're not doing anything to try and achieve outsized returns in fixed income,” he said. “We just want consistent and reliable returns from bonds, because we think equities will continue to outperform.”
Regardless of the Fed's best efforts to be transparent about its monetary policy plans, most advisers are not prepared to make any portfolio adjustments until the tightening actually begins.
Bob Kargenain, president of TABR Capital Management, placed a best-guess estimate that the Fed would start raising rates at some point during the second half of next year. But he confessed: “I honestly have no idea.”
One thing Mr. Kargenain does feel certain about is that even when the tightening cycle begins it will be very slow and subtle.
“There is so much debt in the system right now, the Fed can't afford to raise rates,” he said. “If we get continued low inflation, I think the Fed will continue to hold off on raising rates, and it may be a long time before we see any kind of inflation or employment pressures.”
In terms of how he is allocating bond positions for his clients, Mr. Kargenain said he has not altered his tactical ways.
“We use timing models and focus on price trends whether we are taking an aggressive or a more defensive approach,” he said. “Last year when we saw a sudden uptick in rates, that took us to cash, and when we go to cash now, we are going to short-term bond funds.”
Tracy Scott Burke, an investment consultant at Conrad Siegel Investment Advisors, anticipates the Fed will start raising rates next year, and he expects the overnight rate to be increased by three-quarters of a percentage point by the end of next year.
“People have been saying for a couple of years that rates will start rising soon, and we may have jumped the gun a little in keeping our duration exposure short,” he said. “We anticipated rates would go up sooner rather than later.”
Mr. Burke said the average duration of bonds in client portfolios is around two years, which is down from two and a half years 12 months ago.
“Interest rates have been the No. 1 topic for a while with our clients, because the writing is on the wall,” he said. “We're not tactical, but it's tough to take a long-term approach right now.”
