Stick with the Intermediate Bond Strategy

As we near the fifth anniversary of the collapse of Lehman Brothers and the ensuing financial crisis, it is reassuring that year by year, while slow and bumpy at times, we have a come a long way from the fears of complete national financial ruin and the days when some even feared that ATM machines would not be able to dispense cash. After years of massive fiscal and monetary intervention by the US Government, the crutches are gradually being taken away and, although very early in this process, so far the economy has not fallen on its face. A certain normalization in financial markets is taking place as they factor in less intervention. One result has been a shift upward in longer-term interest rates this year as represented by the ten year Treasury note whose yield has roughly doubled from 1.5% to almost 3%.1

What happens next to interest rates? Should we change our approach to investing in fixed income? The answer to the first question is that we do not know. Predicting the direction and magnitude of interest rates is notoriously difficult…it makes predicting the stock market seem easy. Which makes the answer to the second question a definitive NO. Intermediate bond strategy managers are generally committed to holding a portfolio of bonds whose average maturity and sensitivity to interest rate changes (known as duration) is neither short-term (with maturities of less than three years) or long-term (maturities of more than ten years). This approach constrains the managers to not make big bets on interest rate movements but rather focuses on maximizing returns within a boundary that historically represents the best risk/reward profile in the bond market.

In a steady or declining interest rate environment the intermediate strategy extends far enough out to capture the higher coupons that bonds in the five to ten year maturity range offer, and, in times of rising interest rates, the strategy has a large allocation to maturities with less than five year maturities whose prices are much less vulnerable to decline as rates rise. In addition, as those shorter-term portfolio holdings mature or are sold, the manager is then able to reinvest in newer holdings that offer higher coupons since rates have been rising.

Placing too much conviction on which way rates are going is misguided. Investors who have aggressively shifted their allocation to shorter-term only fixed income portfolios or even cash are making an implied statement that they or their advisors will know exactly when interest rates are peaking in order to extend their maturities at that moment. The odds are heavily stacked against their success. It makes much more sense to allow a fixed income manager to be in a position to continuously take advantage of opportunities to add to positions as rates are rising rather than wait for some magic moment that will alert them to shift back to owning longer-term bonds. Already, especially in the municipal bond market, many intermediate-term managers are taking advantage of what they perceive to be excellent values that are offering yields that have not been available for a number of years.

The bottom line is that we at Hewins Financial Advisors believe that the intermediate strategy is as sound as ever. One of our key roles as effective advisors is to maintain investment discipline that can well withstand the vagaries of the markets. Regardless of which way interest rates go over the next few years, we continue to maintain very high confidence in the intermediate approach that focuses on taking advantage of opportunities rather than being beholden to fear.


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Stick with the Intermediate Bond Strategy

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