Investors should be wary of risk as they reposition their portfolios to navigate the 2016 interest rate environment, according to asset management firm Baird Advisors.
Investors should avoid riskier sectors, while increasing liquidity and credit quality to protect their holdings from added stress that may result after the Federal Reserve started raising interest rates, Baird senior portfolio manager Warren Pierson said in a press release last week.
"We believe many investors – individuals and institutions alike – may have higher risk exposure than may be appropriate," he said. "The Fed's exceptionally accommodative policy has led to a risk-on mentality for many investors, but it is probably not a time to take on a lot of risk."
He noted that the current rate climate is unique after several years of unprecedented liquidity and a zero interest-rate policy, but investors should be prepared to insulate their portfolios from risk nonetheless.
"We think investors should be very cautious about sectors that are intrinsically less liquid, like high-yield or bank loans," Pierson warned.
"We may be at an inflection point where some investors with increased exposure to higher risk areas of the market may realize they aren't as comfortable and cut back on exposure," he added.
Following the Federal Reserve Board's 25 basis point rate increase in December, Pierson said liquidity is still satisfactory, but any increased outflows from the bond market would trigger concern.
"We do not view the Federal Reserve's current policy as tightening, but rather relaxing policy to a more normal interest rate posture," Pierson said.
"In 2008 and early 2009, the Fed's zero interest rate and quantitative easing policies were completely appropriate in the midst of the crisis. But it is hard to argue that we are still in that same crisis mode, and the Fed needs to normalize rates."
Pierson said to buffer its own portfolios in anticipation of the Fed's recent widely expected rate hike, the firm made adjustments to sector and yield curve positioning, while maintaining a duration-neutral strategy.
Doing so "keeps our portfolios tied to the durations of their respective benchmarks," he said.
In addition, the firm is focusing on investment-grade bonds, and is currently favoring corporate bonds due to the presence of solid balance sheets and earnings, according to Pierson.
"Even though we see value in some sectors of the bonds market, we remain constantly vigilant and focused on risk," Pierson said. He noted the firm is keeping a cautious eye on the bond market, including municipals, to prepare for any potential trouble.
While he said the firm tries to seek out a yield advantage in the current environment, "we aren't banging the table about opportunities at this time."
Analysts, like Jim Colby, senior municipal strategist at Van Eck Global, have said high-grade municipals with low volatility and attractive ratios to Treasuries offer good value on the heels of outperforming U.S. Treasuries for most of 2015 and the international and domestic volatility that spooked investors in the weeks leading up to 2016.
On Wednesday, generic, triple-A general obligation bonds due in 30 years and tracked by Municipal Market Data were unchanged from the previous session at 2.72%, which is a taxable equivalent yield of 1.63% for taxpayers in the highest 39.6% tax bracket, according to MMD.
Meanwhile, Pierson said investors should adjust their expectations in the current climate.
"The longer we are in a slow-growth, lower rate environment, the harder it is for people to meet their return expectations," he said. "In a 2% to 3% rate environment, you can't expect 7 to 8% returns on investment-grade bonds."
"We are clearly in a time like no other," Pierson said. "While pundits analyze past cycles, we think it may be very different this time."
"We don't expect the Fed to move quickly to normalize rates," he said, "but the markets could still move quickly in anticipation of the Fed or in reaction to other news."
