The talk of the financial markets continues to be a potential inverted yield curve. An inverted yield curve occurs when short term rates are higher than longer term rates. The challenge today often becomes bringing some sense of reality to the fear pounding message driven by media headlines. Here are some key highlights worthy of review for fixed income investors:
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.
By Drew O’Neil
September 10, 2018
A common topic of conversation lately has been the shape of the yield curve, and the question of will it or won’t it invert. The good news (for me at least) is that most of these conversations that I have are with investors in individual bonds with a buy-and-hold-until-maturity strategy, so the conversation is very simple. Here is a summary of the typical discussion:
What is going to happen to my investments if the yield curve inverts? If you own individual bonds, the answer is simple: they are going to do the exact same thing they would have had the yield curve not inverted. Owning individual bonds provides known cash flow over the life of the bond and a known date when you will get your principal returned to you, regardless of what happened between the day the bond was purchased and the day the bond matured (of course, barring a default). Trying to predict what the yield curve is going to look like a month from now or a year from now is not only a nearly impossible task but largely irrelevant as it concerns holding bonds. Most investors are purchasing high-quality individual bonds as part of a long-term financial plan, not as a short-term total return play where an investor has to correctly time the market in order to “win”. For those of us who are visual learners, the chart below details what you could expect in a yield curve inversion scenario as well as what to expect if the yield curve does not invert, if you were to purchase individual bonds today.
By Drew O’Neil
August 27, 2018
There are many differences between owning a portfolio of individual bonds versus owning an actively managed packaged product that itself owns bonds. A few of the main differences, and most important to be aware of as an investor, are the “knowns” that you get with individual bonds compared with the “unknowns” that you get with many packaged investments. With a portfolio of individual bonds, an investor knows exactly what their cash flow will be for the life of the portfolio, barring a default. Knowing, down to the dollar and the day, the exact timing of cash flows for the life of a portfolio lowers the potential of a surprise, allowing an investor to plan out many years into the future. All of these individual bond “knowns” are unknowns in the actively managed packaged product universe. The cash flows in these investments can fluctuate both up and down as the holdings change, while the principal that is returned at redemption is unknown.
The objective that an investor is trying to achieve with their fixed income allocation contributes to the decision of how they choose to own their bonds. Diversified portfolios of individual bonds are often used as a stable, predictable part of a portfolio, for investors that want a known stream of cash flow and want to know when and exactly how much principal is going to be returned to them. These investors are not using their fixed income allocation as a total return play, they are using it as the income producing ballast of their portfolio that they can plan the next 5, 10, or 20 years of their life around. Many packaged products on the other hand, are managed to outperform or match some index. They are not personalized to a specific individual’s needs and goals in life, they are generalized to perform as well as, or outperform, the market over an unspecified timeframe.
The chart below highlights the “knowns” that come with owning individual bonds. This details the cash flows, both coupon payments and return of principal at maturity, of a 5-10 year bond ladder, purchased for ~$1,000,000 (illustrative statistics of the portfolio below). With a portfolio like this, a buy-and-hold investor does not have to worry about what the market does after they purchase their portfolio. No matter what interest rates do, what happens in the domestic and global economy, what the Fed does, or what “bubbles” are created or popped, the cash flow outlined below will not change (of course, barring a default). This clarity, transparency, and predictability is not something that can be stated about an investment in an actively managed investment that owns bonds.