As financial advisors, money managers, and investors alike all begin to plot portfolio strategy for 2017 and beyond, one of the biggest questions is what to do about the bond market. For those of you keeping score at home, note that the Barclays Global Aggregate Bond Index had its worst month ever in November. Bloomberg reports that the venerable index saw $1.7 trillion (and yes, that is a "t") wiped off the index's value last month. And with the consensus calling for higher rates, an uptick in inflation, more supply, and less central banker demand, well, the macro outlook doesn't look all that encouraging.

However, as the saying goes on Wall Street, something that everyone knows, isn't worth knowing. As such, it isn't surprising to see that sentiment models for the bond market are currently hitting extreme negative readings. For traders, this means that the current spike in rates and the corresponding dive in prices for bonds and bond proxies is, at the very least, likely in the late innings of the game. And from my seat, it will be how the bond market acts during the inevitable countertrend move (i.e. a bounce in bond prices) that may tell us whether the move has legs from a bigger picture point of view.

At the same time though, investors other than the pure passive types, may want to consider making some strategic tweaks to their holdings as we head into the new year. And no, selling all your bonds isn't the solution.

Remember, a secular cycle - one that lasts for many years - doesn't move in a straight line. So, even if the great bond bull is indeed ending, this does not mean that one should abandon the asset class altogether.

So, I've come up with six things investors and advisors alike may want to consider with regards to the bond allocation in their diversified portfolios.

Understand the Role of Government Bonds

Lest we forget, the current secular bull market in stocks will be entering its 8th year on March 9, 2017. And according to Ned Davis Research, this is now the second longest stretch in history where stocks have avoided a 20% decline. As such, we must recognize that trees don't grow to the sky and that there will be bumps - or more likely, shocks - along the way for the stock market.

What does this have to do with bonds, you ask? Cutting to the chase, history has shown that during a disruption or crisis in the stock market, government bonds are the only game in town in terms of asset classes that don't act like stocks (i.e. government bonds are the best uncorrelated asset class when compared to stocks). The point is that the role of government bonds in a properly diversified portfolio should still be one of a shock absorber.

Reduce Duration Risk

So, now that we've established that it probably isn't a great idea to abandon the bond market in a diversified portfolio, the question becomes, what type of bonds do you want to own. Or better yet, what type of bonds should you avoid?

Feel free to hit me with the Captain Obvious tag here, but long-dated government bonds have the highest risk to a rising rate environment. As such, if you only had one move to make for calendar year 2017, I would consider reducing exposure to 20- and 30-year government bonds. Or as market geeks would say, reduce the risk in your portfolio by shortening up on the duration of the bonds.

Own Stuff That Matures

One of the greatest aspects of owning individual bonds is they mature. Thus, when prices are falling in the bond market, investors can sleep at night knowing that unless the issuer of the bond goes belly up, they are going to get their money back when the bond's term ends.

However, it is important to recognize that this is most definitely not the case with open ended bond funds and most ETF's. As such, one move to consider is to use a portfolio of individual bonds or the new iShares iBonds, which are term-dated ETF's that have a termination date. (Full and fair disclosure, we do own iBonds in many of our investment programs.)

Ladder Up

To be sure, using a "laddered" approach to your bond holdings is Bond Investing 101 stuff. But since it has been a VERY long time since investors and advisors have had to deal with a rising interest rate environment, this is a strategy that makes sense.

So, if you expect rates to rise over time, you want to have a portfolio of bonds (or certain ETFs) that mature at different times. This way, when your shorter-dated securities mature, you can reinvest the proceeds at the now current - and higher, rates.

The bottom line here is laddering up is a strategy worth dusting off.

Find The "Sweet Spot"

In bond vernacular, "carry is king" - especially now. This is a bond trader's way of saying that the interest one earns while "carrying" a bond remains critical. The trick is to balance that "carry" with the associated risks, which include default and interest rate risk.

For example, government bonds generally have very low default risk, but don't provide much in the way of yield. Junk bonds, on the other hand, provide much better yields, but have significant default risk.

So, the trick is to find the sweet spot. And the bond pros I trust suggest that intermediate-term, high grade corporates represent the best combination of risk and reward at this time.

It's Time to Let Managers Earn Their Keep

Perhaps the best way for both advisors and investors to deal with the dilemma in bonds is to utilize an actively managed approach. Yes, I know that active managers have been chastised in the press for a few years now and that everybody and their grandmother is back to passive investing. However, THIS is the type of environment where active bond managers can earn their keep.

So, instead of you trying to figure out what bonds to own and when to make moves, let the "total return" or the "flexible" bond managers do it for you. There are a handful of fund managers out there that are quite skilled at dealing with changing times. So why not let them do their jobs and deal with it?

My closing point is simple. It makes sense (well, to me, anyway) to let PIMCO or DoubleLine deal with the bond market dilemma right now. If they don't perform, fire 'em and move somewhere else. But from my perch, this beats the heck out of you trying to figure out the bond market in what may be a massive turning point.

Publishing Note: I have an early meeting Friday morning and will not publish a report - have a great weekend!

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. The State of the "Trump Trade"
2. The State of Global Central Bank Policies
3. The State of Interest Rates
4. The State of Global Economies

Thought For The Day:

Oftentimes excusing of a fault, doth make the fault the worse by the excuse. --William Shakespeare

Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

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Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

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