Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
First and foremost, one of our primary goals is protection of principal. We harp on this quite a bit because as part of the Fixed Income department, our asset class represents one of the essential tools adept in achieving this goal. Many of you, through your own perseverance and toil, understand how hard it is to build, earn and accumulate wealth. It is far easier to preserve wealth than it is to create it.
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Sources: TradeWeb Direct, Raymond James.
Protecting your accumulated wealth entails asset allocation discipline. In uncertain times, with historic lows in interest rates, it can be unfortunate when an investor abandons long term planning in an attempt to capture short term gratification. Leave the speculation/risk to your growth assets and permit your fixed income allocation to protect what you’ve already earned.
Fixed income planning is a long term discipline and therefore certain characteristics such as credit and duration matter. Economic conditions can dictate bond characteristic biases but most important should be an investor’s individual needs and goals. In many cases, this means making disciplined and sometimes difficult choices even when tempted with greater yield that often ignores the greater risks.
Many of our portfolios are designed with very high quality credits. The tradeoff for strong credits typically is lower yields; however, the current pandemic serves as an example of why credit discipline matters. While financially stressed obligors hang on the edge regarding their ability to stay solvent during this medical crisis, the high quality credits may undergo downgrades and price volatility but have resilient balance sheets and are financially sound enough to pay their debt obligations. In other words, high quality credits matter as they serve to protect your wealth.
As spreads have narrowed across credits, it may have opened a window to shore up the portfolio’s overall credit quality. It may be a good time to examine credits that have fallen below your own risk tolerance level and replace them in higher quality credits.
As a reminder, duration is a measure of price movement. In simplistic terms, a duration of 3 suggests that if interest rates change 1.00% (or 100bp), a bond with a duration of 3 will change in price about 3.00%. Now this needs to be framed properly. We often advocate that price movement doesn’t mean as much when a bond is held to maturity. This is true in the sense that interim price movement for a bond held to maturity has zero effect on the income, cash flow and date when the face value is returned.
In context to our discusssion, duration matters when selecting a bond. Long maturities will have higher durations and shorter maturities will carry lower durations. The Fed is telling us that they will not raise short term rates through 2023 suggesting a short term holding range greater than 2023. At the same time, the general interest rate environment is near historic lows, stipulating that duration extension should be kept in check. The current environment has created a narrow window of desirable duration from approximately 3 to 8 for buy and hold investors. This benefits long term planning by positioning for the change in the economic cycle and taking advantage of the Fed’s position while respecting the potential for reinvestment into a higher interest rate environment down the road.
Fixed income has never been accused of being a fun asset class but disciplined allocation benefits the overall portfolio through predictable performance and principal protection. Adhering to credit and duration standards will matter!
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.