While much conversation has focused on the timing of the first interest rate hike, there has been considerably less discussion about what investors should do with their bond holdings. Even in the face of an uncertain outlook for interest rates, bonds can play a role as a diversifying agent and a source of portfolio income. The $64,000 question is: What fixed-income strategy makes sense right now?

Writer Bob Veres asked financial advisers who subscribe to his industry newsletter, Inside Information, about what bond strategies they are using to help their clients emerge unscathed if interest rates spike or to avoid opportunity costs if rates don’t spike. He received 178 pages of responses.

Veres wrote an interesting, though lengthy, summary of the feedback for the Advisor’s Perspectives newsletter. He grouped the responses into five main categories: avoid traditional investment-grade bonds or use mutual funds, separately managed accounts (SMAs), bonds and bond ladders or sophisticated and complex bond strategies. Below are highlights of the strategies used and the rationale behind them.

Avoid Traditional Investment-Grade Bonds: One adviser is using a mix of convertible bonds, preferred stocks, closed-end funds, high-dividend exchange-traded funds (ETFs) and dividend-growth stocks until he feels the time is right to get back into bonds. Another is mixing preferred stocks with credit-worthy high-yield bonds to give her clients with high risk tolerances a larger income stream.

Mutual Funds Instead of Bonds: The common rationale for favoring funds over individual bonds was better diversification, more expertise, improved pricing and better liquidity. One Inside Information subscriber wrote, “Advisers simply don’t have the expertise or the staff that mutual funds do” when it comes to selecting individual bonds. A few advisers observed difficulties in getting favorable prices on bond purchases of less than $1 million and/or expressed concerns about potential difficulties for finding an active enough market to quickly buy or sell bonds at favorable prices (liquidity). One adviser said that portfolio accounting software doesn’t properly value bonds at their amortized costs. He further added, “I don’t want to manage [clients’ bond holdings] out of a spreadsheet.”

Separately Managed Accounts (SMAs): This is a moniker for an actively managed account, with security decisions either made by the adviser, the brokerage firm or a contracted third party. Advisers using SMAs say they prefer this method because it allows them to rely on managers and trading desks with expertise in the bond market and can give their clients better pricing on bonds.

Bonds and Bond Ladders: The primary argument for using individual bonds was the return of capital if they are held to maturity. Many of these advisers believe that using actual bonds would do more to calm clients’ nerves than holding bond funds would. A few advisers said they use certificates of deposit (CDs)—holding CDs with differing maturity dates—to meet planned redemptions.

Interestingly, whereas some advisers refrain from using bonds for clients with smaller portfolios, advisers who use individual bonds say individual investors are better situated to find bargains than institutional investors. This latter group of advisers believe individual investors can purchase odd lots, or a considerably smaller quantity of bonds than larger investors can.

Sophisticated and Complex Strategies: This is essentially a catch-all category for strategies not fitting into the four aforementioned categories. One adviser gave an example of a barbell strategy with 10% allocated to a one-year bond and 90% allocated to a five-year bond. Another adviser is buying long-term bonds to lock in a stream of income. He thinks the amount of long-term income will still be higher than what can be earned five years from now because a client may still prefer to stay in shorter-term bonds in the future if he or she expects interest rates to continue rising.

As you can see, there are varying opinions about what to do, with rationale given for each strategy. None of the advisers based their strategies on what might happen to interest rates, but rather on what securities and funds made the most sense for their clients. It’s an important point because the only thing you can control are your decisions, not what may or may not happen with interest rates in the future.

• Liquidity: The Hidden Risk in the Municipal Market – Fund manager Nicholos Venditti of Thornberg Investment Management discussed the concept of liquidity and how a lack of trading activity can make it difficult to sell muni bonds.
  
• Bond Strategies for Those Fearful of Inflation – Bond experts Stan and Hildy Richelson explain their rationale for using bond ladders and purchasing bonds at prices above par value.
  
• What Is Your Bond Strategy? – Tell us what strategy you are using to allocate to fixed income on the AAII.com Discussion Boards.
  

The U.S. financial markets will be closed tomorrow in observance of Good Friday. On behalf of everyone at AAII, happy Easter and happy Passover to those of you who are observing the respective holidays.

First-quarter earnings season will “officially” start on Wednesday when Alcoa (AA) reports. Joining the aluminum company will be fellow S&P 500 members Bed Bath & Beyond (BBBY) on Wednesday and Family Dollar Stores (FDO) and Constellation Brands (STZ) on Thursday. Earnings estimates for S&P 500 companies have been falling overall, but on an average quarter, more than 60% of companies exceed profit expectations.

The first economic report of note will be the ISM non-manufacturing survey, released on Monday. Tuesday will feature the Job Openings and Labor Turnover (JOLTS) survey. The minutes from the March Federal Open Market Committee will be released on Wednesday. Friday will feature March import and export prices.

Minneapolis Federal Reserve Bank President Narayana Kocherlakota will speak publicly on Tuesday and Friday. Richmond president Jeffrey Lacker will also speak publicly on Friday.

The Treasury Department will auction $24 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday.

Pessimism about the short-term direction of stock prices rose to a two-month high in the latest AAII Sentiment Survey. AAII members grew more cautious overall, as fewer members anticipated price increases or flat markets over the next six months. All three sentiment indicators are well within their typical historical ranges, however.

Bullish sentiment, expectations that stock prices will rise over the next six months, pulled back by 3.0 percentage points to 35.4%. The decline puts optimism below its historical average of 39.0% for the fourth consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 4.5 percentage points to 32.6%. This is an eight-week low. Even with the drop, neutral sentiment is above its historical average of 30.5% for the 13th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 7.6 percentage points to 32.0%. The rise puts pessimism at its highest level since February 5, 2015, and above its historical average of 30.5%.

The comparatively higher level of volatility in stock prices this year has contributed to notable swings in the sentiment readings. For example, neutral sentiment has fallen by a cumulative 10.4 percentage points over the past three weeks after rising to a 10-month high of 43.0% on March 12, 2015.

In addition to the recent price fluctuations, prevailing valuations, concerns about the market reaction to a potential forthcoming interest rate hike, worries that an even larger decline in stock prices could occur and the pace of economic growth are weighing on some AAII members’ short-term market outlook. Keeping other AAII members encouraged is sustained economic expansion, still-accommodative monetary policy, a lack of investment alternatives to stocks and the ongoing bull market.

This week’s special question asked AAII members how, and why, their six-month outlook for stocks has evolved since the start of the year. Nearly 44% said they have either turned more cautious or are otherwise currently cautious. Elevated valuations and a general sense that the market is due for a larger drop of a correction were the primary reasons why. Other respondents cited the possibility of a forthcoming rate hike as the reason for their more cautious stance.

More than a quarter of all respondents (26%) said their outlook has not changed, while 18% said they are more optimistic. Sustained economic growth was the primary reason given by those whose outlooks are more upbeat.

Here is a sampling of the responses:

• “Gone from bullish to neutral largely due to the pending increase of interest rates by the Fed.”
• “Remain bullish because the U.S. economy is improving.”
• “My guess is that the market is overdue for a 10% to 20% correction.”
• “Valuation for stocks seems to be on the high side.”
• “Slow, but sustained, economic growth and low interest rates continue to make for a positive market.”

Individual investors’ allocations to stocks and stock funds are now at levels last seen in June 2007, according to the March AAII Asset Allocation Survey. Bond and bond fund allocations rose slightly, while cash allocations declined.

Stock and stock fund allocations rose 0.3 percentage points to 68.6%, matching June 2007’s equity allocation. Stock and stock fund allocations have now been at or above their historical average of 60% for 24 consecutive months, and for 26 out of the past 27 months.

Bond and bond fund allocations increased by a nominal 0.1 percentage points to 16.5%. March was the 10th consecutive month with fixed-income allocations at or above their historical average of 16%.

Cash allocations fell 0.4 percentage points to 14.9%. March was the 40th consecutive month with cash allocations below their historical average of 24%.

Equity allocations are now at their third-highest level in the past 10 years. Only April 2006 (70.3%) and February 2007 (68.7%) had larger allocations. Larger equity allocations have been registered by our survey prior to 2006, with a record 77.0% allocation to stocks and stock funds occurring in January and March of 2000.

A combination of longer-term approaches to portfolio management and a lack of good alternatives may have contributed to the rise in equity allocations. From a return standpoint, the equity markets pulled back last month. Sentiment about the short-term direction of stock prices among our members largely stayed below average last month as well. Yields on the benchmark 10-year Treasury note fluctuated throughout March, ultimately ending down slightly.

Last month’s special question asked AAII members about the biggest mistake they have made over the six-year course of the current bull market. We received a wide range of responses. Nearly 15% of respondents said that they did not hold a large enough allocation to stocks, and an additional 5% said they waited too long to buy stocks or boost their allocations. More than 8% said that they held onto too much cash. Allocating too much to bonds and bond funds was the mistake cited by 7% of respondents. About 15% said that they either invested in the wrong industry or sector (e.g., energy, gold mining, etc.) or failed to invest in the best-performing industries (e.g., biotech, health care).

Slightly more than 11% of respondents said they did not make any allocation mistakes. Many of these AAII members said they stuck to their long-term allocation strategies throughout the current bull market.

• Stocks and Stock Funds: 68.6%, up 0.3 percentage points
• Bonds and Bond Funds: 16.5%, up 0.1 percentage points
• Cash: 14.9%, down 0.4 percentage points

• Stocks/Stock Funds: 60%
• Bonds/Bond Funds: 16%
• Cash: 24%

*The numbers are rounded and may not add up to 100%.