Why Custom Bond Portfolios Are Worth Considering for RIAs

Accessing Fixed Income for Clients

In an environment with elevated volatility, ongoing interest rate speculation, and managing client expectations, it may be time for advisors and RIAs to rethink their approach to fixed income. As clients seek more customization, particularly around financial planning and income generation, we think that advisors can provide more customized fixed income solutions.

There has been a tremendous amount of research done on the efficiency of equity ETFs, which we feel has resulted in the bias towards independent advisors using Equity ETFs, often within a structured Model Portfolio that has been created by the ETF provider. We reviewed public data on the S&P 500 ETF (ticker: SPY) as well as public data on popular fixed income ETFs, including the Aggregate (ticker: AGG) and Investment Grade Corporate Bonds (ticker: LQD). We found that Sharpe Ratios for Bond ETFs such as AGG and LQD are substantially lower than SPY. We think this suggests that passive fixed income funds are less efficient than exists for a few reasons.

First, we think passive fixed income strategies are less effective than passive equity strategies, because the constituents of bond market are constantly changing, as new bonds being issued and existing bonds maturing. To add to the complexity, often large public issuers may have a single equity ticker but could also have many bonds issued. In some cases, for companies like Apple, AbbVie and Meta, there may be as many as 30-40 bonds outstanding per issuer.

As a result and due to the complexity of the bond market, we often see advisors rely on passive fixed income strategies via bond ETFs. Passive Bond ETFs like LQD tend to utilize bond selection criteria that does not use fundamental credit analysis, relative value comparison or assess call structures. While this may not be the most tailored approach to client needs or for financial planning, it is convenient and scalable. Leveraging bond ETFs as a fixed income strategy also requires less in-house fixed income expertise.

Second, we think passive fixed income strategies are less effective than passive equity strategies, because corporate bonds are often harder for retail clients, advisors and RIAs to access than institutional investors. When an asset class has a large group of investors effectively not active in the market, it can result in market inefficiencies.

Rethinking Fixed Income for Clients

As we described, the bond market is constantly changing as bonds mature, are redeemed or are newly issued — and so are the potential risks with generic off-the-shelf fixed income solutions. Clients count their advisors to allocate across assets effectively and inline with their financial goals.

Fixed income has always been a bit murky for advisors that excel in client relationship management and allocating via ETF-based Model Portfolios. Creating custom bond portfolios for advisors to utilize in client SMAs has been difficult as times due to access, time and often technical jargon.

With careful bond selection in terms of creditworthiness, we think an astute advisor can better match client cash flows from their fixed income allocations to financial planning goals, by selecting appropriate maturities and yields. But with multiple conventions for calculating yields, this can make client conversations more tricky if these various bond yield conventions are not properly understood.

Understanding Bond Yields

Advisors can help their clients plan better for their financials goals by understanding the difference between yield-to-maturity and yield-to-worst. Being able to communicate this to clients and incorporate an effective methodology or approach in fixed income portfolio construction is critical to effective financial planning. However, often clients can be confused by fixed income jargon such as spread, duration, convexity and … yes also bond yields.

As it turns out there are different ways to calculate bond yields, depending on their expected path until principal is paid back.

Some bonds can be called away from the bondholder at the company or issuers discretion. To protect against this, some bonds have periods where the bonds cannot be called away by the company or are said to be noncallable.

Due to these dynamics, bond yields can be calculated as if they are left outstanding until the bond matures or as if they will be called by the issuer.

What is Yield-to-Maturity (YTM)?

Yield-to-Maturity (YTM) is what most people think of as the bond’s “true yield.” It is the return your client would earn if the bond is bought today and hold it until maturity. This approach is often used with higher quality bonds such as investment grade bonds, because the methodology assumes that (1) all coupon payments will be received on time, (2) the bond is held to its stated maturity, and (3) coupons are reinvested at the same rate. The last assumption is a simplifying assumption that is helpful for relative value comparisons.

The yield-to-maturity approach is often used because it blends (1) the interest payments or coupon income that your client would receive, (2) the price your client paid for the bond, which could be above or below par, and the time remaining until maturity. Think of the yield-to-maturity as the the return that your client would received if everything plays out as expected until maturity — no surprises, no early exits. For bonds without call features — like most Treasuries or non-callable corporate debt — YTM is the relevant benchmark for return expectations.

What is Yield-to-Worst (YTW)?

Yield-to-Worst (YTW) is more conservative. It assumes that the bond issuers will act in a way that is most favorable to the bond issuer and likely least favorable to the bond holder. Usually, this means the bond is called or retired at the earliest possible date. In other words, this means the yield-to-worst reflects the worst of lowest yield that your client would receive based on envisioned call scenarios.

For this reason, YTW is almost always lower than YTM, especially if interest rates have fallen since the bond was issued. The reason why is often because the bond issuer would like to refinance at a lower rate, which results in returning your clients’ principal early and leaving you to reinvest client proceeds at lower yields. So the yield-to-worst reflects the return your client would earn in the least favorable outcome, which is often the first call date or early redemption option. In the world of corporate bonds, callable bonds are with hard call dates are often found within the high yield sector.

Why this matters for financial planning goals?

As an advisor, understanding the differences in Yield-to-Maturity and Yield-to-Worst can make a tremendous difference in client communications. For example, a client could buy a 5% coupon corporate bond trading at $1,050. The bond may mature in 10 years, which the client was counting on for income generation. However, the bond is callable in 3 years at par ($1,000).

YTM might show a 4.4% return if the bond is held for the full 10 years.
YTW might show only a 2.6% return if the bond is called in 3 years.

That difference could have a negative impact on your client’s ability to meet a particular financial planning goal such as college, elderly care or retirement cash flows. It could also shake your client’s confidence in you. So, understanding bond conventions such as YTM and YTW keeps expectations grounded and builds trust through conservative planning.

How we think about modeling fixed income returns and bond yields?

Our investment team typically models client portfolios using YTW as the base case. We do this for a few reasons. First, we can use YTW for risk management, as it helps protect against over-promising yield. Second, we can use YTW for cash flow planning reasons, as it helps prevent shortfalls from early redemptions. Third, we prefer YTW for relative value comparative analysis, as it can handle different bond structures and issuers.

Many portfolio reporting tools display both yields, but often default to YTW in performance reporting, particularly in discretionary bond sleeves.

While there are many things an advisor (or their fractional bond desk) should understand about their clients’ bonds, here are a few basic questions to start the conversation with your fractional bond desk or outsourced fixed income provider. (1) Is this bond callable? (2) What is the YTW relative to the YTM? (3) What are the reinvestment risks if this bond gets called? (4) How are you modeling this in the portfolio — worst case or base case?

About RIA Credit Partners

At RIA Credit Partners, we specialize in helping independent advisors design and implement bespoke fixed income strategies tailored to the real needs of their clients.

Our business is built upon the conviction that custom bond portfolios offer greater control over credit quality, enhanced yield targeting, specific maturity structures, and lower total costs than many passive fixed income alternatives, while helping advisors demonstrate superior value in an increasingly competitive marketplace. We offer Fractional Bond Desk and Outsourced Fixed Income Solutions for Advisors, RIAs and Institutional Investors. Please complete the form below to subscribe to our content.

Disclaimer

RIA Credit Partners is a fictitious name owned by Grayton Beach Capital, which is a multi-state registered investment adviser. Information presented is intended for advisors, RIAs and other professional investment specialists for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

RIA Credit Series - Bond Yield Conventions