Drew O'Neil discusses fixed income market conditions and offers insight for bond investors.
Interest rates have been in a general decline for 40+ years, which has provided much of the fixed income landscape with attractive total returns over this timeframe. After bottoming out during the pandemic, many experts are now calling for higher interest rates over the next few years, dictating that investors reassess their fixed income allocation and consider how it might perform in a rising rate environment. The steps below provide a roadmap for thinking about your fixed income allocation and determining if your investment vehicle of choice aligns with your goals and objectives.
Step 1: Determine why you have money invested in fixed income.
Investors have different objectives which dictates the need for investments that have distinctive traits. Determining the primary reason for a specific investment is important so that you can ensure that priority #1 is always being met. Is your primary objective for investing in fixed income:
Step 2: Consider what characteristics are needed in order for your fixed income investments to achieve the “why” from step 1.
Investors looking to maximize total return may seek high potential price appreciation. Cash flow-focused investors, such as retirees who need a certain amount of cash flow each year to fund their retirement, generally value having a known stream of cash flows that they can plan their life around. Investors who seek to preserve their wealth probably prefer to have a known maturity value and a known maturity date. If balancing out equity volatility is the primary goal, an investment that “zigs” when equities “zag” is most important.
Step 3: Compare your fixed income investment vehicle with the characteristics in step 2 to determine if investments are aligned with goals.
All “fixed income” investments are not created equal. “Fixed income” in the form of a packaged product has very different characteristics than a portfolio of individual bonds. One is not necessarily better than the other, but there are important differences that make them better suited to accomplish different objectives.
Packaged products are often managed with the goal of outperforming a stated benchmark that aligns with investors who are seeking to maximize total return. Funds do not have a known maturity date, maturity price, or stream of cash flows which are important characteristics that investors whose primary objective is capital preservation or a predictable stream of cash flow seek. Individual bonds do maintain these three characteristics and might be better suited for these types of investors. If the main objective is to counter equity volatility, both packaged products and individual bonds could potentially suit an investor’s needs, depending on the specific investments.
Step 4: Given the potential for higher interest rates, consider how your current fixed income investments might react/perform if interest rates do steadily rise over the next few years.
As interest rates rise, bond prices fall. Owning individual bonds provides an investor the option of holding the bonds until maturity and receiving back their known principal value. Price movement during the holding period of a bond does not affect the investor’s return unless they choose to sell prior to maturity. Bonds have a known maturity date and face value that do not change from the time of purchase, regardless of interest rate movement and price changes.
Funds do not have a maturity date or price, which means that investors are subject to market risk. If interest rates rise and the value of a fund falls, investors do not have the option of holding until maturity to keep their principal intact. The principal returned to the investor depends on the price of the fund on the day they choose to sell. In general, fixed income (regardless of the investment vehicle) will have negative returns in a rising rate environment. Investment vehicle choice may be appropriately different in a rising rate environment because individual bonds give the investor the option of holding to maturity and negating any negative price movement, while funds do not.
Step 5: Compare the pros and cons of various investment vehicles to determine if you are currently invested in a way that aligns with your long-term goals and objectives.
As stated above, there is not just one way to invest in fixed income. The various ways to fill out the fixed income portion of a portfolio lend themselves to investments with different characteristics. Ensure that the primary objective of your fixed income investments is being met without sacrificing needed characteristics by attempting to achieve a secondary goal. It is all too common for investors who have a primary goal of capital preservation to “reach” for a secondary goal of maximizing total return, and while doing so, put goal #1 at risk. Don’t sacrifice a primary objective to reach for a secondary one.
Step 6: If you determine that your current fixed income investment vehicle of choice does not align with the primary reason that you are investing in fixed income, consider shifting into a different product that might better align with your goals.
*All statements regarding individual bonds are barring a default and assume a fixed-coupon, non-callable bond.
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.