Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
The start of a new year inevitably brings a fresh round of predictions by financial pundits from around the investment universe. In the fixed income world, most of these predictions revolve around forecasting where interest rates will end up at the end of the year, and based on those forecasts, which products types will perform the best.
As you read through these predictions, keep the historical track record in mind. The graph below shows the 10-year Treasury forecast based on a Philadelphia Fed survey each year (red line) graphed along with what the 10-year Treasury actually did (blue line). So, the red line shows what forecasters thought was going to happen, while the blue line shows what actually happened. The graph speaks for itself, but as you can see, the track record is less than stellar. The point is not to take anything away from the economic experts that participate in this survey, but just to keep in mind that when it comes down to it, predicting the future is difficult/impossible to do. No matter how sound a forecast model might be or how grounded a theory is, even the smartest minds can’t see into the future with perfect clarity. Keep this in mind when basing an investment decision or allocation on a forecast.
Most of the predictions you read are tied to assets anticipated to outperform over the next year. When considering this, it is important to keep in mind exactly how you measure performance. We can break up “investing” into two general buckets: tactical and strategic. Tactical investing is short-term focused and intended to benefit from a specific or momentary market opportunity. Strategic investing is a long-term focus based on a long-term financial plan, not necessarily what might happen in the next hour, month, or quarter.
Tactical investing in individual bonds relies on actively trading and attempting to capture gains based on price movement. Producing a positive total return requires an accurate forecast about price/yield changes over a specified timeframe. We see how difficult this is to do in the graph above.
Strategic investing in fixed income is traditionally a buy-and-hold strategy, where price and interest-rate movement over the holding period have no effect on realized return. The wonderful thing about individual bonds is all of the aspects that are fixed (hence the “fixed” in fixed income). From the date of purchase: the cash flow is fixed, the income is fixed, the yield is fixed, the date and amount of principal returned to the investor are fixed. A 10-year bond purchased with a yield of 3% will earn 3% annually for the next 10 years, no predictions or forecasts required.
Tactical investing and strategic investing can both have their place for different investors and different situations. There is no right or wrong, but identifying which approach you are going to take is a crucial first step, especially when it comes to fixed income. Are you actively trading and trying to capitalize on short-term price movement? If so, then basing an investment decision off of a short-term forecast that you deem likely to play out is appropriate. Are you investing as part of a long term plan where you need a fixed amount of cash-flow and income? If so, focusing on a portfolio of bonds that meets your personal needs and implementing a buy-and-hold strategy is likely the best course of action.
As stated in a Bond Market Commentary from October of 2018 …
You can also think of this as trading (tactical) versus investing (strategic):
Trading takes a short-term point of view, attempting to maximize total return based on short-term market moves and opportunities. This tends to lead to a fairly active approach, where sharp market moves like we saw last week could trigger some sort of reaction.
Investing generally comes with a longer-term time horizon. Instead of looking to capture short-term gains or limit short-term losses like a trader might, an investor is likely sticking with a long-term plan to make sure they have enough money to support their current lifestyle, to retire in 10-years at a stated date in the future, or to make sure their grandchildren’s college funds will be fully funded 15 years from now.
A trader positions based on what just happened or what they predict is about to happen in the immediate future. Positions are generally entered and exited over a relatively short timeframe.
An investor will reposition or reallocate based on changing market fundamentals and/or a change in personal goals, life events, or risk tolerance. These investments and allocations are generally held for a long period of time and tend to shift slowly according to a disciplined plan.
A trader might think they can “beat the market”. If they outperform their benchmarks, they consider themselves a winner.
An investor does not care about beating the market, an investor cares about achieving their personal long-term goals. Whether they outperform or underperform an arbitrary benchmark does not affect their personal outcome.
A trader might buy an individual bond priced at 105 because they believe that due to some short-term market dynamics, the price is going to increase to 108 over the next month and they will be able to sell at a profit.
An investor will purchase a bond at 105 that is yielding 4%, knowing that it will mature at par (100) 10 years from now, because earning 4% annually over the next 10 years will help them achieve their long-term goals.
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.
Stocks are appropriate for investors who have a more aggressive investment objective, since they fluctuate in value and involve risks including the possible loss of capital. Dividends will fluctuate and are not guaranteed. Prior to making an investment decision, please consult with your financial advisor about your individual situation.