Weekly Bond Market Commentary

Inch By Inch

Doug Drabik
November 5, 2018

Yields are climbing… inch by inch. As anticipated, long end rates are outpaced by the short end yield increases prompted primarily by Fed Funds rate hikes. Since the start of year, modest increases can be seen across the Treasury yield curve:

It is not unusual to see investors position for the future, after all, this is the tactical approach common for equity investing. Buy low, sell high. However, the process for fixed income allocation merits its own distinct method and altered thinking process. Many investors utilize fixed income as a beneficial balancing tool. In other words, bonds primary purpose is DIFFERENT than other assets. It is to protect principal while delivering a known income and cash flow, not a tool to gain growth through future price appreciation. The goals of these various asset classes are typically very different yet not always treated as such.

Tactical assessment warns investors that as interest rates rise, bond prices will fall. This is a basic mathematical fact associated with a fixed coupon bond. However, the consequence to heeding this warning, “don’t buy bonds in a rising interest rate environment because their prices will go down”, may produce dismay to long term investment plans. For investors informed on the distinct goal differences between asset classes, isolating only on price may alter a portfolio’s balance away from an ideal allocation. Keep in mind that as interest rates rise (or fall), bonds held to maturity will see absolutely no change to the income or cash flow they produce and face value will be returned upon maturity, regardless of any price fluctuations. Moreover, increasing yields will benefit the net portfolio yield as cash flows and rollovers are reinvested in the increased yield environment.” Different asset classes, different goals… different mindset!

The benefits of this slow rising interest rate environment will deliberately benefit the portfolio’s fixed income allocation. The Treasury curve continues to trade in a very tight range but in a range that has slightly elevated yields versus those experienced at the start of the year. The following graph may help sum up the story:

Don’t allow short-range moments in the market to dictate long term investment planning. In the long run, higher yields will mostly help the fixed income allocation by increasing the predictable income and continue balancing the growth asset allocation.

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.

ARCHIVE: Suitable Assets… Strong Portfolio Foundation

Doug Drabik
October 29, 2018

A recent fashionable endorsement for dealing with low interest rates has been the comparison of equity dividend yields versus Treasury yields. Since the great recession of 2008-2009, there have been 2 brief periods when the S&P 500 Index dividend yield on the S&P 500 Index was actually higher than the 10 year Treasury yields, thus the advent of the proposed potentially unwise asset substitution.

Why might such an asset class substitution be ill-advised? For beginners, stocks and bonds support very different portfolio purposes. Stocks provide the mainstay for growth. Although they often possess higher risk, they may also provide a course for abundant growth of wealth. Conversely, bonds may not provide as much potential for growth, however they often have less downside risk and deliver a fixed amount of income and predictable cash flow. Often, bonds primary goal is to maintain already acquired investor wealth. Beyond a comparison of yields of the different asset types, investors should also be mindful of the fact that dividends are only paid when, if and as declared by a corporation’s board of directors. Bond interest, on the other hand, is an obligation of the corporation.

Comparisons often contrast the S&P 500 Index to a Treasury Index as graphed above. The two indices can be tracked back to 1980 and the only time when they are remotely close is between 2008 and 2017. In other words, the above graph is a worst case scenario for bonds. Even as the two indices get close or cross over, the short term event should not deter from an investor’s long-term investment plan and asset allocation balance. A more realistic comparison may be corporate yields versus equity dividend yields. After all, many of our fixed income investors use spread products such as CDs, corporate bonds and municipal bonds for their portfolio’s fixed income asset allocations. These products may be a more appropriate representation of fixed income allocation designed to balance the growth assets such as equities and provide a means of wealth preservation, income and cash flow. The following chart compares the S&P 500 dividend yields to corporate yields as opposed to Treasury yields:

As the chart illustrates, dividend stocks are not a comparable match or replacement of fixed income for the income producing and wealth preservation allocation of portfolio assets. As we often state, appropriate asset allocation is the foundation for optimizing balance, efficiency and protection for your investment portfolio.

ARCHIVE: Monetary Policy or the Economy?

Doug Drabik
October 22, 2018

Much like the pondering over which came first, the chicken or the egg, the debate continues over whether the economy is driving monetary policy or monetary policy is driving the economy. Investors are constantly trying to get ahead of the future enamored by incessant debate over how to position the portfolio based on what may happen. The pondering and predictive insight may swing the consequences for a portfolio’s growth assets and their potential output but can paralyze fixed income allocations which are typically much less reliant on future market changes.

What sometimes gets lost inside of the discussion concerning the future is what is actually going on in the present. The U.S. economy is modestly growing and paced ahead of nearly all other developed economies worldwide. Employment is reaching 60 year highs while inflation is very close to what is considered the target level. Through historic trial and error and monetary policy, the U.S. economy is impressively balanced. Does it really matter if policy or the economy is driving the activity?

The truth is, there are probably a lot of different impetuses to the market’s shifts and among the more recently prominent, the Fed takes center stage. The most blatant show of Fed force began in 2008 with the announcement of Quantitative Easing (QE) policy, a program of open market purchases that eventually blossomed into 3 rounds of QE from November 2008 through October of 2014. As the Fed bought Treasury and Mortgage-backed securities in the open market, the results were an increase to money supply. Prices were pushed higher and interest rates lower.

The Fed used its influence and manipulated short term interest rates dropping the Fed Funds rate to Zero Interest Rate Policy (ZIRP) and keeping short term rates near zero for over 7 years. Low interest rates allowed cheaper borrowing, reduced savings/encouraged spending and created economic activity. Not until December 2015 did the Fed begin to reverse this policy. The Fed’s very slow rate hike moves seem to be working despite the debate. Inflation, a potential negative fallout of rate hikes, has remained in check while the economy continues to positively trend along.

As the Fed slowly changes policy, fear slowly seems to be creeping into the market. The recent stock market pullback and push in interest rates perhaps signal investor apprehension. When the market believes interest rates are headed up, investors tend to move from stocks (growth assets) to bonds (more conservative protective assets).

The Fed’s balance sheet peaked at roughly $4.5 trillion. It has slowly dropped to about $4.1 trillion. Think of it as reverse QE. As Treasury securities which were purchased during the QE days mature, the Treasury pays the Fed which in turns destroys the money. It created money from nothing during QE and eventually takes the money back out of the economy. Much like the slow methodical process of raising short term rates, the Fed is slowly attempting to “normalize” the balance sheet, too. As with any policy move, it triggers debate over what should be done. I suggest we keep an eye on the results and not the hype.

In an ideal world, the Fed wants to reload its arsenal. By raising interest rates and reducing the balance sheet, the Fed permits itself some wiggle room to make adjustments should, for example, the U.S. go into a recession. Higher rates allow the Fed room to lower them just as a smaller balance sheet better tolerates the action to purchase securities should the need arise. These are arguably the strongest tools in the Fed’s arsenal.

We seem to be experiencing some market fear, a typical investor reaction to rising interest rates which can lead to slower growth and higher inflation. However, for now, the Fed seems to be contributing to what could be considered a great economic balance which currently boasts near target inflation, high employment and a positively producing economy. The bump in rates allows investors an opportunity to bump the yield in the portfolio’s fixed income allocation. Putting the debate over what is driving the market aside, the opportunity to slowly increase the output of the portfolio’s bonds continues to hum along with the economic growth.