True fixed income: Are you comparing apples to oranges?

Doug Drabik discusses fixed income market conditions and offers insight for bond investors.

Timing has never been a crucial undertaking for fixed income allocations dedicated to asset preservation largely because this is a long-term endeavor dedicated to keeping an investor’s wealth intact. For decades, low yields produced modest income while performing as intended – maintaining the wealth generated through riskier growth assets. Although this concept has not changed, the interest rate environment has, thus providing investors the opportunity to not only keep wealth but potentially grow wealth by locking into higher interest rates.

Bond yields and prices have an inverse relationship; as yields move up, the price of a bond will move down (and vice versa). Now that interest rates have increased, this may create a secondary benefit for income-oriented investors. Locking in for longer sustains investors’ wealth, provides a healthy income, and may result in appreciated assets should interest rates reverse direction and begin falling. When constructing the fixed income portion of your portfolio, not all products that hold bonds have the same characteristics or provide the same features. Characteristics can be quite different in comparison. As the old idiom goes, comparing the two can be like comparing “apples to oranges.”

ARE YOUR BONDS REALLY “FIXED INCOME?”

Although many different investments hold bonds, not all are “fixed income” instruments. Take the example of an open-end mutual fund; by design, each share represents an indivisible piece of an actively managed pool of bonds, cash, and other investments. Other structures such as Closed-End Funds and ETFs may hold bonds as well, but most are not truly “fixed income.” For example, with a bond fund, the price of shares and the income generated will rise or fall based on the activities of the manager, the creditworthiness of the issuers, fund flows, and market conditions including changes in interest rates. A further challenge is that many structures have targeted maturities and/or targeted durations. Meeting these targets in a moving interest rate environment may prevent the Net Asset Value (NAV) from remaining stable. These requirements in turn can potentially affect the original principal value invested and can result in a realized gain or loss. In other words, an investor’s originally invested principal is at risk, especially in a rising interest rate environment. Many investors felt the pain of realizing a loss as interest rates rose over the last year.

INDIVIDUAL BONDS ARE THE ONLY TRUE FIXED INCOME

What is an individual bond, and why is it important? Simply stated, a bond is a loan agreement between a borrower and an investor. Not surprisingly, a bond is also referred to as a “fixed income” instrument, as it provides the investors with exactly what you’d expect; a stated amount of income at constant intervals for a defined period. This allows an investor to customize his/her holdings to meet specific needs while providing predictability of income and transparency. The stated maturity date is another distinct, ‘fixed’ characteristic of individual bond ownership which can be a benefit. After all, bond prices will move toward par value as they near the maturity date. Regardless of the path of interest rates, whether they go up, down, or even sideways, an individual bond will behave exactly as intended until its specified maturity/redemption, subject to the creditworthiness of the issuer. Put another way, if you intend on holding a bond to maturity, it doesn’t matter what interest rates do along the way. The bond pays the agreed-upon interest at the agreed-upon intervals, and the losses from market price declines remain unrealized as the par value is returned at maturity.

INDIVIDUAL BONDS ARE A PREDICTABLE ASSET CLASS FOR PRINCIPAL PRESERVATION IN ANY INTEREST RATE ENVIRONMENT

Not all bond investments are “fixed income.” Be careful not to blur the lines. There is a distinct difference between individual bonds and packaged securities that hold bonds. Simply put, the two are not interchangeable and, are very different investments. Provided that you have sufficient capital to properly diversify, investors who seek income in this environment should consider a portfolio of individual bonds customized to suit their needs, goals, and risk tolerance. A packaged investment with active management that holds the same instruments is not likely to hold those bonds to maturity. Investments lacking a stated maturity date simply do not have a par value to return. Instead, the value of an investor’s shares is subject to the value of NAV which may be more or less than the price they paid. In contrast, the “fixed” nature of individual bonds gives investors a choice to simply hold their bonds to the maturity date and receive par value. Bond proceeds can then be reinvested at higher rates to put the investor on a path to higher income. Should interest rates fall from here, investors will further have the benefit of price appreciation on bond holdings, whether they choose to realize it or not.

NOTE

Investors should consider the investment objectives, risks, charges, and expenses of mutual funds carefully before investing as these expenses may be on top of fee structures on the account where they are held. The prospectus contains this and other information about this investment. The prospectus should be read carefully before investing. Individual bonds purchased may have commissions or held on a fee basis but will not have management fees.

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.

Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.

To learn more about the risks and rewards of investing in fixed income, access the Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.