Fixed Income Freebies
Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
“I’m looking for 4.00% yield with no risk and a maturity inside of 5 years”.
Did you know that the odds of winning a Mega Million jackpot are 1 in 302,575,350? No worries because the odds of winning the Powerball jackpot are much better at 1 in 292,201,338. Sadly getting struck by lightning is 417 times more likely than winning the lottery (1 in 700,000). When the 30 year Treasury rate is 1.435%, the odds of an investor receiving 4.00% with no risk and a maturity of inside 5 years don’t even exist. There are no fixed income freebies.
Many fixed income allocations are designed with the primary purpose of protecting principal. How this works with individual bonds is that once purchased, there are only two events that can alter a bond’s performance. One is an outright default. This is managed by purchasing high quality, investment-grade individual bonds. The second event is by selling a bond prior to its maturity. This can be addressed by choosing to hold an individual bond to maturity.
When held to maturity, the cash flow, income earned and return of face value are not altered by interest rate moves, price changes, pandemics, changes by rating agencies or any other event except an outright default. In other words, your income and cash flow are insulated from material outside events.
Investors can be persistent in their pursuit of the “freebie.” Last week, the group addressed one of these pots of gold at the end of a rainbow. In this case, an investor was seeking a high yielding cash alternative. In fairness, these “special” bonds are often wrapped in sheep’s clothing. A fund, which included the words “…Cash Management…” was the magic ticket. Or was it? Although the name implies a cash option and the fund even invests in only 1 year and less maturities, further analysis reveals that nearly 13% of the fund is invested in BB, B (high yield). The fund is taking significant credit risks not typically exhibited by investors interested in a safe short cash position.
If an individual bond or bond fund or managed fund is exhibiting an above market yield, it is very likely that there is risk being taken. That’s the tradeoff. The Cash Management fund was taking more credit risk to achieve higher yield. This is neither good nor bad, it is a tradeoff that should be exposed to an investor in order for them to make a personal decision.
There is neither a magic bond garden producing above market yields nor a fund manager, SMA or individual bond professional that is privy to a collection of superior performing bonds. As a matter of fact, the higher the management and/or annual fees, the potential for more creative ways to provide yields equivalent or above individual bond offerings.
Again, there are no fixed income freebies. Higher yields are sometimes achieved with greater credit risk, higher market risk (higher durations), or leveraging techniques. Taking additional risk is part of establishing one’s own risk profile and as long as there is a clear understanding of risks, fees and differences in quoted yields, an investor can make a fair and comprehensive investment decision.
If something is too good to be true, or seems to be a fixed income freebie, it likely isn’t. It is likely a trade off of additional risk.
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.
Stocks are appropriate for investors who have a more aggressive investment objective, since they fluctuate in value and involve risks including the possible loss of capital. Dividends will fluctuate and are not guaranteed. Prior to making an investment decision, please consult with your financial advisor about your individual situation.