Inch By Inch
By Doug Drabik
Yields are climbing… inch by inch. As anticipated, long end rates are outpaced by the short end yield increases prompted primarily by Fed Funds rate hikes. Since the start of year, modest increases can be seen across the Treasury yield curve:
It is not unusual to see investors position for the future, after all, this is the tactical approach common for equity investing. Buy low, sell high. However, the process for fixed income allocation merits its own distinct method and altered thinking process. Many investors utilize fixed income as a beneficial balancing tool. In other words, bonds primary purpose is DIFFERENT than other assets. It is to protect principal while delivering a known income and cash flow, not a tool to gain growth through future price appreciation. The goals of these various asset classes are typically very different yet not always treated as such.
Tactical assessment warns investors that as interest rates rise, bond prices will fall. This is a basic mathematical fact associated with a fixed coupon bond. However, the consequence to heeding this warning, “don’t buy bonds in a rising interest rate environment because their prices will go down”, may produce dismay to long term investment plans. For investors informed on the distinct goal differences between asset classes, isolating only on price may alter a portfolio’s balance away from an ideal allocation. Keep in mind that as interest rates rise (or fall), bonds held to maturity will see absolutely no change to the income or cash flow they produce and face value will be returned upon maturity, regardless of any price fluctuations. Moreover, increasing yields will benefit the net portfolio yield as cash flows and rollovers are reinvested in the increased yield environment.” Different asset classes, different goals… different mindset!
The benefits of this slow rising interest rate environment will deliberately benefit the portfolio’s fixed income allocation. The Treasury curve continues to trade in a very tight range but in a range that has slightly elevated yields versus those experienced at the start of the year. The following graph may help sum up the story:
Don’t allow short-range moments in the market to dictate long term investment planning. In the long run, higher yields will mostly help the fixed income allocation by increasing the predictable income and continue balancing the growth asset allocation.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.