Finding the "Sweet" Spot
Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
There are many uncertainties in our financial world which can result in some unnerving decision making. It may help to establish what we do know and what we feel pretty certain about, which in turn, may help with strategic planning.
As we highlighted last week, we do know that interest rates are near historic lows. This may suggest it is not an ideal time to seek out extended maturities with new money or cash flow reinvestments. It may be beneficial to position newer investments to take advantage of the economic cycle’s turnaround.
What we can be somewhat certain about is that the Fed is not going to raise short term interest rates through 2022. How do we know this? They told us.
Equipped with the knowledge that we are near historic lows in interest rates and also reliably comfortable with the idea that short term rates are not going to be discernably higher for the next 2 ½ years, there may be a window of opportunity to explore.
The demand for high quality short term investments is great. This elevates the pricing and therefore pushes short term yields low. For investors comfortable with the idea that the Fed will keep short term rates low through 2022, you can explore selling high quality holdings inside of 24 months to maturity.
A potential benefit exists. Almost all of the yield that would be received through maturity might be captured immediately with a strong selling price. In other words, the market is willing to compensate many high quality short maturity securities with attractive prices. In bond language, the healthy selling prices are creating low take out yields. The take out yield is nothing more than the yield corresponding to the market price. If you can reinvest the proceeds at the take out yield or higher it may be worth consideration.
If short term interest rates do remain relatively untouched for the next 2 ½ years, then it is like the current 5 year being the new 2 year. The “sweet” spot for reinvestment might be in that 3 to 6 year part of the curve. A trade like this extends duration which means it adds duration or pricing risk to the portfolio since you are moving from a shorter maturity to a longer maturity. However, it is calculated based on taking advantage of (1) the market’s strong appetite for high quality short maturities and (2) the general belief that interest rates will not be significantly higher at the time these investments are structured to mature.
There are several potential reinvestment ideas. One way that duration could be kept low is by going into short floating corporate bonds. There are bonds that mature inside of 5 years that float or adjust periodically to changing interest rates. This keeps duration (pricing changes) low while the short maturity dates ensure staying within the sweet spot of the curve.
Other corporate and municipal alternatives may fit your specific investment profiles as well. The objective is to take advantage of what we know and what we are reasonably certain about in a time of financial uncertainty. Please contact your advisor to explore this potential opportunity.
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.
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