Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
I was just asked a similar question and the short answer is: the person that doesn’t want to risk losing 20% or more of their principal in a riskier asset.
No one really knows if they will lose or gain 5%, 10%, 20%, etc. in these volatile markets. The point is that being in the right position to operate within your own risk profile is proving critical due to this unexpected volatility gamble.
Here is a list of questions you might want to consider:
- Is the yield curve telling us that all is not well and that fear and uncertainty currently govern the future?
- Is this a time to change allocations? Does a portfolio with a 70%/30% (equity/fixed income) ratio want to shift to a greater or lesser percentage of assets to the riskier or safer side for holdings?
- Will individual bonds provide a tremendous relative “cushion” to alternatives that lessen returns via fees and/or charges?
- Although the yield curve is taking away yield, prices have rallied so strongly that total returns are sizeable. Do I take this future income off the table now? Where or how would I position at that point?
- Is this the time to seek alternatives to fixed income? How about dividend paying stocks? Do I ignore the difference in risk to principal? Do I ignore that the bonds will pay income and return my face value at maturity regardless of interest rate swings? Or do I ignore that stock dividends are not guaranteed and that equity principal is at the market’s mercy?
- How do I measure or compare the risk/reward relationship between more yield and increased duration versus less yield and decreased duration?
- Do I worry about being too short in this market? Will the Fed cut another 50bp? Will they bring Fed Funds down to 0.00%-0.25%? Should I, therefore, dwell in a 2-5 year range?
Not all investors will answer all of these questions the same way, but defining the purpose of your fixed income allocation can provide clarity.
Long Term Planning:
Ignore short market volatility and be disciplined in keeping a percentage of assets in fixed income to balance portfolio volatility. The last two weeks prove how valuable this is. While the S&P 500 index has a -6.07% year-to-date return, those stock losses were tempered for investors holding corporate or municipal bonds with positive 4.77% and 2.97% total returns respectively.
Do not shift allocations. Balance maturities in the sweet spot of the curve. Do not radically increase your risk profile to find yield (do not use alternative investments as substitutes). Principal protection is primary.
Worried Investors Seeking to “Park” Assets:
There are several cash alternatives: FDIC certificates of deposit, short Treasuries and/or short corporate bonds. Treasuries provide the safest credit path but lowest yield; however, investors residing in states with high state tax brackets reap after-tax benefits since Treasuries are exempt from state taxes. CDs provide FDIC insurance and yields that typically are higher than Treasury yields. Corporate bonds have more credit risk but usually offer the best comparative yields.
Investors Seeking Returns and Mindful of Duration:
Move in on the curve. The relatively flat shape and low rates on the Treasury curve provide an argument to position new money or reinvestments toward a more rapid cash flow turnover. A 2-6 year ladder mitigates interest rate risk but in a shorter range and format that turns assets over relatively quick. It provides some income but most importantly it protects principal (via a stated maturity) in a way that packaged products cannot. Due to the recent market run, net asset values are elevated permitting an opportunity to capture gains and re-position back into fixed income with stated maturities, thus changing the risk metrics associated with your holdings.
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.
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