Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
When investing, determining appropriate levels of risk and reward is a very important balancing act when it comes to portfolio allocation. With regards to fixed income, assessing the risk side of the equation does not only require determining how much risk you want to take, but also what kind of risk. With fixed income, the three main types are: credit risk, reinvestment risk, and interest rate risk. In deciding where to invest on the curve (maturity selection), reinvestment risk versus interest rate risk can be a critical comparison.
Reinvestment risk is the risk that you will be unable to reinvest maturing principal and interest payments at the same rate you are currently earning. Interest rate risk is the risk that if interest rates rise, the market price of the bonds that you own will go down. The higher the duration of your bonds, the greater the price movement.
Given the current state of the global economy and the uncertainties going forward, many investors are inclined move to a “safer” allocation. In many investors’ minds, a shorter duration equals a safer bond. This is because shorter maturity bonds are going to have less interest rate risk. The potential shortcomings with this line of thinking are twofold. First, price movement is eventually rendered irrelevant when it comes to a bond’s return if the position is held to maturity. When a bond is held to maturity, its price moves toward and eventually ends up at par. A bond’s yield, maturity value, and coupon are fixed at the time of purchase, meaning that negative price movement only results in a loss if the investor chooses to sell at a loss prior to maturity. Second, in focusing solely on minimizing interest rate risk, the investor is ignoring (and increasing) reinvestment risk, which arguably could have a much larger impact on return than interest rate risk for buy-and-hold investors.
Reinvestment risk is rearing its head as rates continue to move sharply lower since the start of the year, and more generally for the past 38+ years. In focusing on interest rate risk (i.e. staying in all short-duration bonds), an investor is exposed to reinvestment risk, in that they will have to reinvest their maturing bond proceeds sooner and into a potentially lower interest rate environment. If an investor was to ignore interest rate risk (because as we know, for a buy-and-hold investor, market price becomes a moot point) and focus on locking in current yields for a longer period of time, they will likely benefit in a falling or flat interest rate environment.
So what’s the moral or the story? Stick with your long-term plan when it comes to fixed income investing. The corporate and municipal curves are still positively sloped, meaning an investor can pick up yield by investing in the intermediate part of the curve. Don’t focus on short-term total return and trying to time the market. Ensure that your fixed income allocation does what it is intended to do: serve as the ballast of your portfolio in providing known cash flow and return of principal.
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.