Weekly Bond Market Commentary
February 19, 2019
The message to diversify investor portfolios is so routine that its importance may be desensitized to an investor, or worse, disregarded. It’s like ignoring the warning label attached to a prescription drug. The underlying message is important but easy to overlook. That is, until it’s too late.
Diversification can take many forms: by obligor, by sector, geographically, by coupon, by maturity, etc. The idea of not putting too many eggs in one basket carries merit. Let’s look for example, at diversifying by obligor.
The chart on the right provides a simple comparative illustration of 2 portfolios side-by-side and the effects of obligor diversification. The first uses 20 issuers to create a 10 year laddered portfolio while the second uses 10 issuers. Should 1 issuer default ($25,000 in the diversified portfolio and $50,000 in the other), the downside to the 10 issuer portfolio can be greater than the difference in the size of the holding due to not only the loss of principal (assumes a 0% recovery rate and constant reinvestment), but the forward loss of interest earned on that principal. In this example, $25,000 in principal plus the lost compounding interest reflects an aggregate difference of -$32,119. Diversification cannot guarantee anything but increases the probability of mitigating negative consequences.
The same principle applies to other forms of diversification, such as diversifying geographically. Should some catastrophic event occur in a specific state, county or local region, you do not want all of the portfolio’s debt tied to that location. By the same rationale, bonds should not be tied to one industry such as all energy.
The concept is not complex but because it can be unintentionally snubbed, a reminder to the importance and mindful implementation of diversification can mitigate portfolio risk without necessarily impacting the overall portfolio strategy.
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.
February 11, 2018
Reports reflect that bond funds and fixed income ETFs are experiencing net inflows. The stock market has recently demonstrated much more volatility while global economies are displaying uncertainty, both contributing to a flight to quality. As such, it is important to point out that just because other products use bonds, there are many differences to how individual bonds work within an investment portfolio. Understanding the purpose of holding individual bonds goes a long way into understanding why they can be such an important investment tool for balancing your portfolio.
One of the greatest hurdles for investors seems to be the different evaluation process between products necessary to gauge value. For example, the well-known idiom for equities, “buy low, sell high” exploits how that product often times relies on price appreciation to increase its value. When you purchase a house, there is typically an expectation that when you sell the house years later, your equity will grow by an appreciated market value. We are programmed as investors to monitor, seek and use these assets as a means to grow our wealth. Therefore when monitoring individual bonds, it is not surprising that investors may desire the same.
The truth is, comparing individual bonds to equities, real estate, bond funds or bond ETFs is like comparing apples to oranges (related article: True Fixed Income - A Favored Asset Class for a Rising Interest Rate Environment). Many investors have the need to protect their wealth and/or hedge the portfolio’s growth assets. I would argue that individual bonds are tailor-made to accomplish this and price is among the least important characteristics to achieve this purpose. Among the most important features is an individual bond’s stated maturity. When an individual bond is held to maturity, the interim interest rate volatility will not alter an individual bond’s yield, cash flow or date when its face value is returned, in essence negating any price movement experienced over the holding period. As long as a bond is held to maturity, price movement is irrelevant to a bond’s performance and the ultimate price (par at maturity) is known. No product without a stated maturity can be or should be compared in the same way. The option to hold an individual bond to maturity therefore protects principal as a bond’s face value (barring default) is returned in full on its redemption date.
In addition, individual bonds allow investors to customize strategies for desired cash flow stream, maturity schedule and credit profile. There are products that use bonds or even have some of the features, but no matter how they look or quack, these products are not individual bonds.
February 4, 2019
• It took the final day to rouse any movement as the 10-year concluded the month down 6bp to 2.63% from December’s month-end 2.69%. Over all, intraday volatility was quiet which resulted in the Treasury yield curve exhibiting very small changes for the month of January. The biggest Treasury point moves were 8bp on the 1-, 5- and 7-year Treasuries. The curve remained inverted from 1- to 7 years but actually steepened between the 6-month Bill and the 10 year Treasury.
• The Federal Open Market Committee (FOMC) met on the 30th with what could be argued as a remarkable about face, at least in tone. The shift in direction appears to be from a slow-moving tightening policy to what now appears to be a potentially accommodative policy. Bloomberg’s World Interest Rate Probability1 reflects less than a 2.5% hike probability for 2019. This probability swung in extremes both directions during the month. Just 1 day prior to the FOMC meeting, the probability of a rate hike this year was ~24%. Now, the probability of a rate cut has elevated to ~23% in December and ~33% to start 2020.
Furthermore, the FOMC suggested that its balance sheet reduction might end. The Fed’s balance sheet has moved from ~$4.4 trillion to ~$4 trillion in assets over the last year. All of this is to suggest that interest rates may be locked into a very tight range with a bias towards lower rates, at least in the near term.;
• The highest performing investment grade bonds continue to be corporate bonds inside of ~10 years and municipal bonds outside of 10 years.
• There is scarce data or impending events supporting significant upward rate movement. In addition to the transparent Fed tone change, there are several impactful “market movers” or material events which could amplify the flight to quality and/or hinder economic growth. This in turn could move intermediate to long-term Treasury rates down. These events include: the Mueller investigation and/or escalation of impeachment talk, an intense more complicated Brexit, continued trade wars with China and/or an Italian bank implosion.
• Corporate bond spreads tightened in January. High yield corporates tightened more compared to investment grade. Relative to the risk, investors in the high yield space will receive less yield versus 1 month ago.
• Municipal demand remains strong on the short part of the municipal curve. During January, yields inside of 15 years in maturity were marginally down while yields greater than 15 years were slightly up. The net of this created a slightly steeper municipal yield curve (similar to the Treasury curve movement).
• The sweet spot of the municipal curve where 80%-90% of the entire curve’s yield can be captured is between 14-18 years out as of month’s end. In the corporate sector, it is between 6-11 years.
• Laddered portfolios can mitigate interest rate risk and with a specific duration strategy, can optimize yield while hedging against growth asset allocations in the portfolio.