Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
The interest rate environment we are experiencing today did not just happen. Interest rates have been in a general decline for nearly four decades now. During a 25 year period from 1970 through 1994, the 10 year average rate was 8.69%. By comparison, during the following two-and-a-half decades from 1995 through 2020, the 10 year average rate is 3.87%. As of this morning, the 10 year Treasury rate is 0.71%.
If you had $500,000 and held it for 25 years, compounding at 8.69%, you would accumulate $4,019,809. In contrast, $500,000 held for 25 years compounding at 3.87% creates $1,292,555 and at 0.71% it is only $596,797.
For those investors that have been at this for 50 years or more, things are different today. We need to work longer and/or save more in order to be prepared to retire. The old cliché that time makes money takes on a very different tone today. The 1980s and 1990s created an anchoring bias that can hurt us as investors today. Our expectations (biases) are that fixed income allocations should continue to double our money every 6 or 7 years and if they can’t, the willingness to add risk to portfolios can end with disastrous results.
The one “anchor” that has never changed becomes even more important during uncertain times. That anchor identifies fixed income for its true purpose: protection of principal. That has and always will be the primary purpose for many investors.
Protecting principal becomes exponentially important at a time when uncertainty abounds. A 2020’s mature portfolio may not grow at a 1980’s pace, so its preservation value is perhaps even more imperative because it is more difficult if not impossible to recreate lost wealth in today’s interest rate environment.
The psychology of how our accumulated wealth works for us may be another bias hampering our judgment. Elevated interest rates 40 years ago, permitted greater fiscal freedom to leave principal intact. In a period of historic low interest rates, although we do not want to lose principal, we may need to use principal to provide adequate cash flow during our retirement years. Fixed income portfolios can be designed to create adequate cash flow through coupon selection via diligent use of capital.
Keep interest rate expectations real. Many of the same rate drivers keeping interest rates low over the past several years remain essentially the same today:
- Interest rate disparity among global economies (U.S. rates remain significantly lower despite arguably a stronger economy),
- Lack of inflation,
- Aging demographics (By 2034 the U.S. 65+ adults will outnumber children <18 years old. The older wealthier population have less of an appetite for many goods and services.), and
- Central Bank Intervention. (Another stimulus package is getting close to passing. In addition, the government has little incentive to raise rates as government debt continues to climb).
Never lose sight of the primary purpose of the principal protection that your fixed income allocation serves within your portfolio regardless of where interest rates stand.
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.
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