Much focus has been given to appropriate asset allocation, an important discipline for investors regardless of market conditions. Falling interest rates can pressure investors to reach for yield and seek replacement strategies. The immediate potential benefits of some alternatives may mask the shorter-term risks. In addition, the alternatives may not deliver the balance or protective properties often sought with fixed income investments.
Rates in general have compressed. That is, the higher yields often associated with longer-term investments have pulled comparatively closer with shorter term yields. The above graph depicts the constant maturity monthly yields of the 1-, 5-, 10- and 30-year Treasuries over the past 10 years. At the beginning of 2010, the spread between the 1- and 30-year Treasuries was 425 basis points (bp). This spread has fallen to ~75bp. Falling interest rates and compressing yields may be a consequence of a slowing economy and/or lack of inflation, both of which heighten the expectancy that interest rates could stay low for a prolonged period.
It probably follows that this can trigger a reaction by investors seeking higher yields, especially for retired investors locked into fixed incomes and reliant upon certain cash flows to maintain standards of living. Coupon strategies can be devised to increase cash flows sometimes with the consequence of using principal. Using principal can be an essential strategy in certain investor situations. The operative undertaking is using principal, not losing principal. In many cases, fixed income is a strategic allocation fundamental in preserving investor capital. Many other assets do not provide the same protection. For example, a dividend paying stock may offer an immediate attractive current yield, but the future consistency of a dividend can change and the price of stock can fall, thus the income stream and principal are both at higher risk. The protective characteristics of a fixed coupon and stated maturity on an individual bond provide the security of a known cash flow, a predictable income and a point in time when the entire face value is returned. For a buy-and-hold investor, these benefits do not change regardless of any interim price fluctuations during the holding period.
The advantages associated with spread products also bear emphasis. Sure, yields on the curves have compressed, however, the spreads associated with municipal and corporate bonds have remained upward sloping and provide additional income without sacrificing the protective characteristics coveted in fixed income. Proactive comparisons of products are essential when composing the overall fixed income allocation. Comparing Treasury yields and the shape of the Treasury curve doesn’t do justice when your portfolio is composed of CDs, corporate bonds, municipal bonds or any individual bond spread to the Treasury curve. The above graph depicts the positive spread of both investment-grade corporate bonds and municipal bonds offered above Treasuries.
The most important take-away is to keep a focused and disciplined approach to investing, especially when it is so easy to be swayed by short-term events or moments. Fixed income allocations are long-term plans often designed to protect the principal you have worked so hard to earn. Don’t hesitate to contact your advisor to assess whether your portfolio is not only designed to grow, but also balanced to protect your lifetime nest egg.
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.