Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Are you in rate shock? Well, snap out of it and make sure you stay disciplined, which includes resisting the impulse to get sucked into the latest investment gimmick. In addition to timely geopolitical events such as trade debates and viruses, there are a lot of underlying actions and/or occurrences generating low interest rates: featured by global central bank intervention. As investors we cannot control interest rates, we can only control how we align our assets to best serve our needs in a given rate environment.
Investors have been very fortunate to be able to reap the benefits of rallying stock and bond markets despite the doomsday headlines focused on lower interest rates. Remember, as interest rates fall, bond prices go up. However, more important is that for many investors, bonds continue to serve their main purpose of capital preservation. Regardless of falling interest rates, once held in the portfolio, a bond’s cash flow, income and date when the face value is returned is not affected by interest rates. This is how bonds protect your principal and it is often the ultimate reason why many investors allocate a portion of assets to preserving capital … regardless of the rate environment.
The following are some common fixed income objectives considered when interest rates fall.
“Investors are picky…”
Yes, investors should be picky. They should be informed so that they can be cunningly picky. Sometimes the current yield on one product is being compared to the yield-to-maturity on another product, a very bad comparison. Current yields are often quoted on products that don’t have a stated maturity. This is because future (holding period) cash flows are unknown so income (yield) is a guess based on coupon and market price. The relevant observation may be whether products without known maturities can provide the capital preservation/protection sought by assets held in the fixed income allocation? If you can’t pinpoint an exact maturity, you won’t know what the future of that investment will return (principal or interest).
“How about replacing bonds with quality dividend paying stocks?”
It is always tempting to seek alternative investments to capture desired income. It’s like being in a casino and losing a hand and doubling down on the next hand to make up for your loss, then doubling down again if the results aren’t favorable. You can get in a heap of trouble faster than you think.
This is not a condemnation on stocks. Growth assets such as stocks are the very instruments that allow you to build your wealth. However, individual bonds are the assets that provide a means to preserve that wealth. Don’t confuse or attempt to substitute the two.
“…hard pressed to reinvest at these rates.”
Investors cannot control rates but they can control asset allocations. Maintain discipline by allowing your growth assets to do their job – grow wealth. Then be disciplined enough to allow the right allocation to protect that wealth by allocating an appropriate percentage of assets to individual bonds. Domestic rates are low but have fared well versus many other global sovereign rates, many of which are actually have negative yields. It is notable that spread products such as municipal and corporate bonds have maintained upward sloping yield curves versus the Treasury curve. This means investors can obtain relatively higher yields by directing investments to the favorable maturities on those curves.
“Money market yields are just as good as going out on the curve.” Or, “It’s hard locking in anything longer term…”
Money market yields may be similar to rates on various Treasury maturities in a flat Treasury curve environment. Consider reinvestment risk which means short maturities must be reinvested into a future unknown rate in a very short time horizon. If you tend to support the future probability outlining two Fed rate cuts by the end of the year, moving out on the curve before the cuts may make sense. As interest rates have been in a general 38+ year decline, duration has been an investor’s best friend.
In addition, consider that income is a far secondary goal to preservation of capital where fixed income is concerned. Longer duration assets are more negatively correlated with growth assets such as equities. This means they will offer better protection should a correction or equity market reversal occur.
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.