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Breaking Bad Habits of Bond-Addicted Clients

Bond investors are licking their wounds with prices of U.S. Treasuries and corporate debt having recently dropped precipitously. The volatility, while being hard to stomach for many investors, is providing an attractive opportunity for advisors to strengthen client relationships by highlighting the risks associated with fixed-income investments and the need to maintain diversified portfolios. In doing so, advisors can help reverse a trend of retail investors continuing to miss out on potential equity gains.

Investors have redeemed nearly $400 billion from stock mutual funds during the past five years while flocking to the perceived safety of government and corporate bonds, according to estimates from Morningstar. In doing so, investors have missed out on substantial gains with equities as measured by the Russell 3000 Index, which has shown an average annual gain of 23% from March of 2009 until early June of this year.

Bonds issued by highly regarded tech giant Apple have recently become the poster child for risk associated with fixed-income investing. Apple issued $17 billion in debt on April 30, 2013 and the bonds have since declined 9%, making the securities more volatile than Apple stock.

Shortly after the bond issuance, Federal Reserve Chairman Ben Bernanke suggested that the Fed consider reducing the size of its quantitative easing program if economic conditions appear to be improving. Fears that the end of quantitative easing is approaching has caused prices of other bonds, including those from Vodafone, Diageo and Petrobras, to also decline. U.S. Treasuries weren’t immune from the fears, with the Bank of American Merrill Lynch U.S. Treasury Index generating a negative 1.27% return in May, including interest.

Quantitative easing refers to the Fed purchasing $85 billion in mortgage-back securities and U.S. Treasuries each month to keep interest rates low. It is believed to have keep mortgage rates lows, which has helped fuel the ongoing real estate recovery.

For advisors, recent bond volatility is an opportunity to illustrate to investors that fixed-income investments, contrary to popular belief, do present risk. Advisors should ask prospects and existing clients to discuss their views on risks associated with bonds and equities. If investors respond that they prefer the lower-risk associated with bonds and say they are averse to risk associated with equities, advisors should be prepared to compare the performance of Apple bonds and Apple stock.

At the same time, advisors should illustrate how U.S. Treasuries, as measured by the Bank of American Merrill Lynch U.S. Treasury Index, lost value in May. During discussions, advisors should explain that no one can forecast with utmost certainty how soon the Fed will curtail quantitative easing and how quickly interest rates will rise, but the recent bond volatility illustrates how fixed-income investments are highly vulnerable to monetary policy.

The goal should be to illustrate that bonds can subject investors to considerable declines in portfolio values. Advisors should then proceed to illustrate how bonds, over the long term, have underperformed equities and show how most investors will need to generate equity-like returns to reach their retirement goals or other savings targets. As part of the presentation, advisors should also illustrate how bond yields may trail inflation and how investors face re-investment risk, or the risk that they will have to settle for lower yielding investment when their current bonds mature.

Advisors, of course, should acknowledge that equities are also subject to substantial price declines that have generally proved to be temporary. Rather than focus on the potential for either asset class to lose value, however, advisors should focus on how combining bonds and stocks can reduce volatility over the long term. Advisors can also show how the risk profile of portfolios change based on the allocation of bonds and stocks.

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