Weekly Bond Market Commentary

If a Horse Has Stripes, It’s Probably a Zebra

By Doug Drabik
August 13, 2018

You can call a zebra a horse, but that doesn’t make it a horse… it’s still a zebra!

An investment portfolio strategy should strive to optimize an investor’s return within that investor’s risk profile. The current market conditions and recent market reactions have helped to emphasize the importance of portfolio asset allocation. This is nothing new to the fixed income experts. A strategy poised for growth almost certainly will miss its target if invested in a five year Treasury ladder in the same way a capital preservation strategy invested in high yield or equities could potentially miss the mark. If growth is desired, an advisor might suggest that you employ growth assets such as: equities, MLPs, real estate, etc. If principal protection, wealth preservation and/or defined income streams are desired, the choice is often to use individual bonds.

The “fixed” in fixed income is not a play on words. It means your income is fixed. Barring default or early redemption, outside variables such as changing interest rates/changing bond prices ultimately have no effect on a bond’s income. Income is fixed for the life of the bond when held to maturity.

Media headlines and product advertising can confuse investors. It’s like an ad for a low fat diet bar avoiding exposing 40 grams of sugar destined to counter any health benefits. A packaged bond fund is NOT the same product as an individual bond. The fund may offer exposure to bonds, but it is not necessarily emphasized that funds lack a stated maturity, the income component is not fixed and price fluctuations may affect principal balances. There is no known date at which the invested bond fund’s par value will be returned to the investor. A fund’s net asset value changes and therefore principal is at risk in a much different way versus that of an individual bond. In a rising rate environment, a packaged product may experience principal loss which time may or may not remedy. Conversely, an individual bond’s stated maturity allows an investor to hold-to-maturity and therefore provides a fixed amount of income over its life as well as a known date where the bond’s face value is returned.

More confusing are packaged products that are labelled “fixed income” yet composed of instruments that perform differently or unlike traditional individual bonds. Many individual investors would not be comfortable investing in high yield bonds (bonds with higher credit risks, generally deemed to be below investment grade). Others may not understand the mechanisms of interest rate futures or swaps or interest only bonds. Yet, there are funds that package, label and advertise these as a fixed income fund. Don’t be fooled by the label. If the ingredients are risky, the investment (investor) likely carries that risk. This is not to suggest that these are bad products because all products serve a particular purpose. This is to suggest that labels and certain combined packaged products are necessarily not good individual bond alternatives.

Many investors are anticipating a modest, perhaps more steady, rise in rates. Protecting wealth and locking in income may best be served with individual bonds. A balanced strategy is just that – balanced. “Fixed Income” engineered for price appreciation may parallel objectives similar to total return growth assets. True fixed income is designed to provide a constant stabilizing effect on both income and cash flow while mitigating or removing the effects of appreciation/depreciation. Don’t be fooled by the label or marketing… if the horse has stripes, it’s probably a zebra!

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: An Alternative View

By Drew O’Neil
August 6, 2018

A popular topic in the financial press recently has been the shape of the yield curve. More specifically, the recent trend of a flattening yield curve and the debate over whether or not it will invert (short-term yields higher than long-term yields) and if it does invert, whether or not it is a signal that we are heading for a recession. Many are arguing that if the yield curve does invert, the US economy will enter a recession based on the logic that the last few times the curve inverted, we entered a recession. Those on the other side of the argument are pointing out that we are in an unprecedented yield curve environment given the enormous amount of global quantitative easing experienced over the past 10 years, thus creating and “artificially” flat yield curve that can’t be compared to previous situations.

I am not going to debate this today, but I would like to point out an alternative recession indicator that was highlighted in a paper (read the full piece here) that was recently published by the Federal Reserve, in order to give another point of view on the topic. The metric that the paper focuses on is the spread between the three month T-Bill and the market implied forward rate 6 quarters in the future of the three month T-Bill. Simplified, it is the difference between the current three month Treasury and where the market expects the three month Treasury to be 18 months from now. The idea is that this is a good indicator of what the market expects the Fed to do with monetary policy for the next year and a half. As this spread goes negative (current three month rate is higher than the market thinks it will be in the future), it essentially means that the market expects the Fed to begin “easing” (lowering rates) soon, as the Fed does when the economy starts sputtering and needs a boost (i.e. a recession). Focusing in on just the short end of the yield curve and its corresponding futures, in theory, will eliminate some of the “noise” present in the 2 to 10 year spread.

This forward spread model essentially incorporates all available information that the market has as far as predicting which direction the economy is heading. Looking at the chart below, which plots both the traditional 2 to 10 year spread (blue line) as well as the 6-quarter forward spread (red line) discussed above, shows how both of these indicators have behaved over the past 50 years. The forward spread has historically shown steeper declines just prior to previous recessions than the traditional 2 to 10 year spread measure, indicating that it is a sharper predictor. They are highly correlated for most of this time period, although since the Great Recession, when the major quantitative easing by the central banks began, the lines start to diverge.

Since late 2015, when the Fed started raising short-term rates, the blue line has taken a fairly steady path towards inversion territory (below zero). Looking at the red line, we see that it has displayed much more of a sideways movement. Assuming an inverted yield curve is the signal for a recession, the 2-10 year methodology indicates that we have been steadily heading towards a recession since 2015, while the forward spread indicator has been moving fairly parallel. Another point to note in this graph is that these two lines are currently at roughly the same spot, so they are indicating the same likelihood of a near-term recession, with the main difference being the trend of each respective line/indicator.

Correlation does not indicate causation; these metrics may or may not be a signal for a coming recession. The point is to be aware of some of the outside influences that may be affecting the traditional recession indicator often discussed by the financial media, and consider that there are alternative viewpoints.

So what is the take away from this? The future is unknown and whether we are going to enter a recession at some point in the near future is anyone’s guess and is biased by whatever indicator they trust. Take this opportunity to prepare your portfolio for whatever might be coming our way. That means making sure that your growth assets are appropriately allocated to growth products and your capital preservation assets are appropriately allocated to capital preserving products.

ARCHIVE: The Scorecard on Individual Bonds

By Doug Drabik
July 30, 2018

In the sport of basketball, the highest score wins yet in golf, the lowest score wins. In football, the offense controls the ball yet in baseball, the ball is controlled by the defense. A perfectly pitched baseball game allows 0 runs while a 300 score is a perfectly bowled game. In the investment world, a successfully owned stock position relies on a rising price while a successfully owned bond does not necessarily need to worry about its price change. Different games rely on distinct means to achieve an end and the methodology suitable to the specific game.

Many growth assets rely on total returns to meet objectives. For example, stocks capture a portion of return via dividend income but many investors rely on price appreciation to capture desirable returns. The two components of positive total return are income plus price appreciation. Real estate holdings are another asset which can gain great returns via price appreciation. Even within the bond world, certain asset types rely on price gains, such as packaged products containing bonds. Growth goal assets are “scored” mostly by their total return prospects.

Not all investments are employed as growth assets, meaning “success” of different asset classes is determined by different criteria. Individual bonds are often assigned to preserve wealth first and provide income and cash flow secondarily. Individual bonds are able to accomplish this largely because of a unique asset characteristic: their stated maturity. With an individual bond, barring a default or early redemption, its face value remains intact regardless of interest rate or price changes experienced during the holding period. Simply put, individual bonds protect an investor’s principal even in a changing rate environment.

Why is this significant? The latest whisper (or roar) is that interest rates are on the rise. Investors considering rising interest rates should take notice that without a stated maturity, principal is not protected in the same way as it is with an individual bond having a stated maturity. Should interest rates rise, package products composed of bonds could potentially reflect lower net asset values. A lower net asset value translates to a loss of principal. During inverted curves, equity appreciation has not historically fared well. Real estate appreciation may slow as rates rise. The take away is that different asset classes serve different purposes and perform better or worse in different economic environments resulting in very different ways investors should “score” them. A properly balanced asset allocation can provide protection of wealth as well as potential for growth.

Keep your scorecards out because there’s more good news about individual bonds. You actually get what you pay for. Individual bonds held to maturity do not rely upon future pricing or interest rates to increase or decrease their results. Cash flow and income are delivered as scheduled and principal is returned at maturity. Although growth is generally not the objective of the buy and hold individual bond buyer, barring default, there is also no loss of income or principal.

Maintaining discipline with asset allocation starts with the realization that not all assets serve the same purpose and therefore should not be thought of or scored in the same manner.