Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
When making any purchase, analyzing the relative value between available options is ultimately what should determine what you choose to buy. Focusing on the relative value that two options offer is the most fruitful way to approach most decisions and also the most grounded in reality. Let’s say for example that you need to purchase a new car. In this hypothetical world, two cars exist that meet your needs. The first option costs $25,000 and the second costs $30,000. Purchasing the first option provides you the most relative value, as it meets all of your needs and costs you $5,000 less than the second option. This is a logical line of thinking using a relative value approach. What would not be useful is showing up at the dealership and refusing to buy either car for more than $15,000. Assigning an arbitrary threshold (max price of $15,000) that is not grounded in reality only serves as a barrier to acquiring a new car.
This same logic applies when it comes to investing in fixed income. Many investors have an arbitrary yield target that they have set for themselves that is not grounded in reality. This has driven many investors to move their “fixed income dollars” either into other non-fixed income products or into cash-type products (actual cash, bank deposits, money market funds, etc.). It might be different for every investor, but on an almost daily basis we receive requests where someone wants something like a 6-month CD yielding 2.00%, 3-year A-rated corporate bonds yielding 4%, or 15-year AA-rated municipals yielding 5%. These types of yields might have been achievable at various times in the past, but the reality is that they don’t exist right now and there is no guarantee that they ever will again.
Remaining un-invested or invested in products that don’t provide the same benefits as fixed income puts your financial future at risk. A much more useful approach to fixed income investing in this (or any) environment, is to take a look at the options currently available for whatever your goals are and choose the option that provides you with the most relative value. Instead of waiting for the perfect option to present itself, analyze the available options and choose the one that is best for you.
Back to the example above, you could probably find a car that you can purchase for $15,000 but it will not likely meet all of the needs and provide you with the same benefits as the $25,000 car would. It might be a used vehicle instead of new and have a higher likelihood of mechanical problems. Essentially, in insisting on paying a lower price, you are likely getting a product with more risks and/or that lacks the benefits that you are seeking. In the same manner, purchasing a product with a yield of 5% in a market where high-quality investments that provide the characteristics that you need are yielding 2% is going to expose an investor to more risks. That 5% yield might come with significantly more credit risk than is appropriate or might require extending into a much longer duration than desired.
A few examples where taking a step back, analyzing your options, and deciding on the best relative value for your personal situation can provide short and long term benefits:
“Short-term” money that doesn’t require daily liquidity? Consider purchasing high-quality 2-4 year corporate or municipal bonds, which can provide 5 times or more in yield than money markets are currently paying.
Prefer tax-exempt municipals to avoid taxes but in a low tax bracket? Consider the after-tax yield, which for lower tax bracket investors is often higher in a taxable product such as taxable municipals or corporate bonds. Think of it this way: would you rather earn $1,000,000/year and pay 25% in taxes or earn
$600,000/year and pay no taxes?
Want a very high-quality investment? Consider your tax-bracket to determine if high-quality (AA to AAA rated) municipals will provide more yield than Treasuries at a risk level you are comfortable with. For top tax- bracket investors, 10-year AA to AAA rated municipals can provide an over 50% after-tax yield increase over comparable Treasuries.
Cash flow a priority? Consider high-coupon, high-premium bonds, as they will provide more of the desired cash flow. Yes, when purchasing premium bonds, some of the cash flow is return of principal, but if cash flow is the objective then a high-coupon bond offers you more relative value than a low-coupon, low dollar priced bond.
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.