NEW YORK, July 15 (Reuters) - Last month, Houston-based financial adviser Gene Theobald picked up the phone and began making calls to clients, telling them to expect a reality check in their June account statement.
Theobald, who was the No. 2 bond salesman at Morgan Stanley before moving to RBC Wealth Management last year, estimates roughly 98 percent of his clients are invested in fixed-income, with average portfolio allocations of 90 to 100 percent.
“Your next month’s statement is going to look ugly,” Theobald told many of more than 200 clients.
The downward spiral in the bond market, which for the past few decades had long been considered a safer, more conservative place to invest, has led to tough conversations with clients, according to more than a dozen veteran financial advisers interviewed by Reuters.
Customers who favor bonds tend to be on the conservative end of the investing spectrum, so they are especially sensitive to price declines. Advisers, on the other hand, find it disconcerting that some of these investors are asking to increase their equity holdings as a hedge against bonds.
“I’d hate to see clients hopping out of the frying pan into the fire,” said Michael Kitces, a financial adviser and publisher of the popular financial planning industry blog Nerd’s Eye View.
Some advisers say they are reaching out to customers who are heavily invested in bonds, reminding them that such fixed-income assets remain less volatile than stocks, and if they are in shorter-duration bonds, their portfolio may not even take a hit. Duration measures a bond’s sensitivity to interest-rate moves.
Other advisers who didn’t contact clients before June statements hit the mail are now hearing from anxious clients worried about the impact of declining bond prices.
In May and June, the bond market suffered its worst two months period in a decade as prices for the 10-year tumbled amid expectations that the U.S. Federal Reserve may begin to taper its $85 billion monthly bond purchases as the U.S. economy improves.
While investors added $257.8 billion to bond funds in 2012 and another $109.9 billion through the end of May, according to Lipper, in June, there were unprecedented outflows of $40 billion.
The yield on 10-year Treasury notes climbed 46 basis points during May and rose another 36 basis points in June, hitting a near two-year high of 2.75 percent in early July on the back of a strong jobs report. On Tuesday, the 10-year hovered around 2.54 percent, up roughly 42 basis points since the end of May.
Yields move inversely to the price of bonds, so a sharp rise in yields means a decline in prices.
“Even people that have bought bonds for 20 to 30 years of their life still forget what happens when interest rates go up,” said Tampa, Florida-based Greg Ghodsi, an adviser with Raymond James Financial Inc.
Ghodsi, who said he has received more calls from clients than usual over the past few months, is gradually moving his them into shorter-duration bonds, which would have less of an impact on a client’s principal if interest rates rise.
“Anybody that has those long-term bonds is going to have a little bit of shock, down 10 percent, down 15 percent,” Ghodsi said. “We have to slowly prepare clients for that volatility in the marketplace that’s going to happen if interest rates go higher.”
Ghodsi, whose clients have roughly 40 percent to 60 percent of their assets in fixed-income, is shifting them into bonds with average maturities of one to two years, from average maturities of 10 years to 12 years back in 2010. He is also cutting their bond allocations, replacing them with dividend-paying stocks, such as regional banks or insurers.
Bank of America Corp’s Merrill Lynch Private Banking and Investment Group Chief Investment Officer Christopher Wolfe said the firm is counseling advisers whose clients have longer-term bond portfolios to rein in durations and shorten maturities, at least over the next six to 12 months during what he expects will be the biggest portion of the potential interest rate rise.
Wolfe expects the yield on the 10-year Treasury to reach 3 percent by year end and 4 percent by the end of 2014. The yield is currently hovering at 2.5 percent.
“You really may need to keep things on a much shorter leash than you had in the past, meaning maturities of five years or less,” Wolfe said.
It is important to give clients some historical perspective, advisers say.
“A bad bear market in stocks still loses way more money than a bear market in bonds,” Kitces said.
Drew Zager, head of a six-person team that runs $7.5 billion in high-grade, fixed income for Morgan Stanley Private Wealth Management in Los Angeles, said the fears about the bond sell-off are overdone.
“It’s not like investors are saying, ‘OK, let me do the math...and see if this makes sense.’ They’re just selling their bond funds,” Zager said, who runs money for sophisticated investors, such as founders of bond funds and hedge funds.
Zager, whose minimum account size is $10 million, said nearly all of his 87 clients are content with keeping the current durations on their bond holdings. And some customers are asking to extend duration a bit to take advantage of cheaper prices. Some are moving from a 3.5-year duration to a 5-year duration, while others are moving from a 5-year to a 7-year duration. They don’t have an appetite to go farther out than that, and Zager doesn’t recommend it.
Zager is concerned about bond funds, too. His advice if you already own one is to hold on, because the sell off has gone too far. Money will flow back into bond funds when people realize this is an overreaction, but perhaps not for a month or two, he noted.