Here's this month's scenario, which was discussed with Erik F. Miller, CFP, of CMC Advisers LLC in Portland, Ore.: The clients are conservative investors in the top income tax bracket who are concerned about the possibility of income tax rates moving higher next year. They're considering repositioning $100,000 from taxable CDs to municipal bond funds.
What research tools do you use to identify prospective funds for clients?
We use Morningstar for initial screens using a list of about 20 criteria such as beta, standard deviation, Sharpe, alpha, fees, manager tenure, etc.
One of the more helpful indicators Morningstar has come out with now is called upside/downside capture where you can get a really good sense of the volatility of the fund within its category and what you can expect the fund to do in certain favorable/unfavorable market environments.
This is particularly interesting for the high yield bond category where a fair portion of funds have a greater propensity to lose badly in down markets than to outperform in good ones. This has helped temper clients and our expectations for that particular asset category.
What specific fund categories would you recommend for the scenario-clients' consideration and why?
Of $100,000, we would place 79 percent in short-term to intermediate-term municipal bond Funds. For yield improvement, we would most likely place 10 percent in a conservative high-yield fund and 10 percent in an un-hedged international bond fund, with 1 percent in a cash money market. If you expect to pay out dividends and income, a portfolio of this nature will yield around 3.62 percent.
A major consideration for a portfolio of this size is how many times the money might be moved around or transacted. Custodial trading fees and internal fund-expenses can really dig into fixed-income returns.
A simple trading fee of $25 on a fund can cause problems for rebalancing, or if there is a systematic liquidation of funds occurring to produce cash.
If the money is going to sit throughout the year and pay income to cash than low-expense funds make sense.
If the money is going to be reallocated or distributed beyond interest only, you are definitely going to want the NTF (non-transaction fee) fund that has 12b-1 fees added in which will make true fees some 25 to 60 basis points (bps) higher.
While there are a lot of concerns about rising rates and their effect on bond funds, we believe that the current environment allows for a buy-and-hold strategy for at least the next nine months.
We also do not know what specific segments of the yield curve that might be affected. Long -term rates could be completely un-phased by an increase or vice-versa.
Many funds will illustrate what has happened to their returns over time in a 2-percent-rate-increase environment.
