WealthManagement.com: Do you think advisors are prepared for the negative returns in bonds, much like we saw in the second quarter?

Steven Young: No, advisors haven’t prepared their investors for the potential for negative returns. You only need to look at the flows into bond mutual funds over the last four years. It’s over $1 trillion. Investors are not thinking about negative returns if you have that kind of massive inflows.

 

WM: How do they make up for those losses?

SY: It’s tough to make up for them, unless interest rates come back down and the bond values go up.

It’s almost like, ‘What do you do now to prevent another second quarter of 2013 going forward?’ The most extreme action is to get completely out of bonds and go to cash. You have no interest rate risk, but you have essentially no return either. For the longer term, you can look to complement your bond portfolio with things that provide better return potential—some of those are alternative-like. It could be adjustable rate bond funds, otherwise known as bank-loan funds. They certainly fared better in this downturn in the bond market in the second quarter. Bank–loan funds are essentially adjustable rate securities within the funds, so when interest rates rise, in fairly short order, the interest payments on those loans will also adjust upward. So the cash flows increase as interest rates go up.

You can look at bond managers that have the flexibility not only to own bonds, but also to sell those bonds short, where they’ve essentially zeroed-out your interest rate risk. An unconstrained manager, while it might introduce some volatility, has the ability not only to shorten duration, but he or she can go negative duration and actually make money if interest rates rise further. Shorting Treasuries is probably the most efficient way to do that because of their duration sensitivity.

 

WM: Do you think the equity market has reached a peak?

SY: A bull market can continue for quite a long time, but it’s dependent on earnings and what investors are willing to pay for those earnings. Earnings have been enhanced and supported by the decline in interest expense for companies, because interest rates have dropped essentially to zero. So this massive decline in interest expense has gone right to the bottom line, and that’s helped earnings and profitability.