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High Yields - Why Your Advisor Suddenly Wants More Risk

Over the past year or so, I've noticed that new clients are coming to me with portfolios, built by their previous advisors, with riskier bond portfolios. By riskier, I mean that they are either longer maturity or lower credit quality bonds. In many cases, I see both.

One might assume that the reason behind the increase in risk is the previous advisors' belief that inflation will remain low, or that junk bonds will continue their rally of 2009. But the truth is that inflation risk has never been greater and junk bonds got creamed only two years ago.

In actuality, the answer is that advisors must take on more risk in order to get paid. Most financial planners now charge on a percentage of assets basis. Say a planner charges one percent of assets. Can they charge you this amount on your cash that is earning 0.06 percent? They would yield the client a -0.94 percent return. Even a short-term high quality bond fund like the Vanguard Short-Term Bond Fund ETF (BSV) is yielding only 1.44 percent. Thus, an advisor charging one percent would be taking about 70 percent of the yield.

The only solution is to go out longer on the yield curve or buy riskier bonds. Both will pay higher yields, making it easier for the advisor to justify his fees. Of course, the problem with this is that the investor can end up holding the bag under two scenarios - inflation or a bad economy where the riskier bonds default.

My Advice
Advisors don't put you in these riskier bonds because they are evil. Incentives are powerful motivators, and the unintended consequences from those incentives can dramatically impact your portfolios. I see more junk in portfolios than ever before, including bonds going out to the year 2039.

I don't know that hyper inflation will happen, but I'm scared enough that I won't recommend anything longer than an intermediate-term bond. My memory is still good enough to recall the 2008 disaster in lower credit quality bonds. Make sure that your bond portfolio is mostly backed by the U.S. Government and your duration is no more than five years.

If most of your yield is going to your advisor, then it's time to renegotiate the percentage take going to him. Always remember that the goal of the fixed income portfolio is to act as a shock absorber. Low-cost diversified bond funds fit the ticket well.

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