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Richard Leeson: Threat to fixed income presents an advice catch 22

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My last article, on the threat to uncapped trail fees, examined the very real risk of highly profitable clients challenging advisers on the amount they charge each year. This is particularly an issue when they are based solely on the value of assets under administration. However, there is a more immediate threat to fees.

Much has been written in both the trade and national press this year about the negative impact of interest rate rises on fixed income investments. How bad that impact will be depends on just how much money moves out of the asset class and how quickly. The Investment Association already reported negative net outflows from fixed income investments for two consecutive months in May and June.

Bank of England governor Mark Carney has been at pains to make clear that volatility in China and its impact on financial markets will not prevent the Bank from tackling interest rates if it needs to.

Not only are there concerns about valuations but also the lack of liquidity in the market. The traditional market makers are no longer around in the same numbers and there are real worries about whether supposedly liquid funds will be easily traded, particularly those invested in corporate bonds. Manager of the Artemis Strategic Bond fund James Foster calculated earlier this year that a 2 per cent rise in interest rates could knock 23 per cent off the value a 20-year bond.

So, what should advisers do? Moving clients away from fixed income is not as easy as it might seem, as it raises the question of where cautious clients should invest. The regulator and Financial Ombudsman Service have strict views about cautious clients being in cautious portfolios. Many bond funds have been forced to invest in more and more non-investment grade assets, which would be classed as high risk. The obvious alternatives seem to be short-term bonds and/or cash but neither of these offer attractive returns to investors at present.

They may offer measures of capital protection but already poor yields suffer even more after accounting for adviser charging. Some clients could find themselves with near zero returns going forward until interest rate rises feed through to higher deposit rates.

The terms of business will determine whether the adviser is liable for ongoing advice on the invested assets of their clients. But even where it is clear there is no ongoing responsibility there will be a self-imposed moral pressure on advisers to take action. Reputational risk alone will compel many to intervene and warn their clients to take action. This, then, is the threat: if advisers place clients in assets that have very low yields then, after accounting for adviser charging, some clients might be better off not being clients at all. It is a predicament that doing what may be right for the client could be bad for the adviser. Of course, in the pre-RDR world of commission this was less of an issue.

In addition to the client/adviser/advice issue, we have a more aggressive regulator in the background. Under former chief executive Martin Wheatley, the FCA introduced a revised set of Threshold Conditions in 2013. One of the new conditions requires the business model “to be in the interests of consumers”.

When the new conditions were implemented they were enshrined in a statutory instrument and have the full weight of the law behind them. This was no mere rule change. One might wonder at the regulator’s attitude to a charging model that leaves clients worse off when invested through an adviser.

Advisers are caught in a catch 22: leave fixed income clients where they are and watch them suffer or move them and potentially watch their business suffer. One solution to this unenviable dilemma would be to increase cautious clients’ exposure to higher risk assets. Sadly, this solution would go against the regulator and FOS expectations of placing cautious investors into so-called cautious investments. It is unlikely we will see any change in attitude or guidance from the FCA any time soon so it falls, once again, on the adviser to find a solution.

Richard Leeson is chief executive of Adviser Advocate

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There is one comment at the moment, we would love to hear your opinion too.

  1. It ultimately depends on the underlying reason behind an interest rate rise and the timing. If, for example, rates rise unexpectedly then equities and corporate bonds (particularly those corporate bonds with high duration) will be hit. Then we are likely to see a shift into relatively more cautious assets which is highly likely to include sovereign bonds. This could conversely cause an improvement in fixed interest investments (specifically government fixed interest) following a rate rise. Whether or not this happens depends ultimately on investor sentiment and the conflicting impacts of the “shock” of higher interest rates causing a flow out of risk assets and the impact a rate rise will naturally have on fixed interest assets. Basically the bigger the shock, the lower the investor sentiment and the bigger the demand for sovereign debt.

    On the other hand, many multi asset managers now talk about minimising duration risk by holding short-dated bonds. If we see steady interest rate rises it will naturally cause a rise in the coupons offered on new bond issues. Managers who currently hold short dated bonds will be well positioned to both avoid the initial dip in bonds following a rate rise and will also be well positioned to move into longer term bonds with a higher coupon rate than is currently on offer.

    Ultimately the biggest losers in this will be large bond funds with an overall long duration who can’t move out of their positions easily (due to low demand and the sheer size of their holdings which need to be liquidated). So why not look for short duration, relatively small bonds funds.

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