Nothing to Fear
Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
Last week, intermediate and long Treasury yields shot higher (relatively speaking) with the 10-year yield increasing by ~15 basis points over the course of the week, flirting with the 1.00% threshold late Friday morning. While we have been lulled to sleep by a mostly uneventful fixed income market over the past few months, last week was a wake-up call that rates will one day move higher. It might be all product types or it could be isolated to a specific product. It might be next month, next year, or 5 years from now. It could be driven by higher benchmark yields, widening spreads, or a combination of both. The when and the how are not the point of this commentary. What I want to address today is the investor mindset towards what higher yields mean.
Fixed income investors know that when bond yields rise, prices fall. At first thought, this is never something that any investor would want to see. We want the prices of every investment we make to do nothing but move higher, right? Not necessarily. Owning bonds provides an investor with a unique set of characteristics that sets it apart from most other asset classes. One of these very important characteristics is that when you purchase a bond, you know the exact dollar amount of principal that will be returned to you (face value) and you know the date on which it will happen (maturity date)*. Knowing these two pieces of information as a purchaser of individual bonds means that you don’t have to worry about the thing that most investors stress over on a daily basis: price movement. You know your maturity date and price, so any price movement that happens between the day you purchase a bond and the day that the bond matures is just noise. It has no effect on the stream of cash flows that you purchased when you chose to invest in an individual bond.
As a fixed income investor, you should hope that yields rise and the price of your bonds fall. If your bonds fall in price due to higher yields, the same price decline is likely occurring with bonds across the market, which means that you can now buy bonds cheaper. Falling bond prices are an opportunity for you to purchase bonds at a higher yield. The bonds you currently own might fall in price, but this doesn’t affect the primary reasons you purchased the bonds in the first place. You locked in your yield and stream of cash flows when you bought those bonds. So the bonds you currently own are locked in and now you get to purchase new bonds at a higher yield. It’s a win-win.
So why do most headlines you read and most commentators in the financial media make it sound like higher rates are horrible news for fixed income investors? Because most of this commentary is looking at things from a packaged product point of view, which measure themselves on a quarter-to-quarter total return basis. Although these packaged products might have “fixed income” in their name and might themselves own individual bonds, they do not maintain the most important characteristics of individual bonds: known income, known cash flow, and a known redemption date. As these products do not have a maturity date, there is no date when you know that you will have your principal returned to you. Without a known maturity date and price, price movement does matter and does affect your return. So when you own a product with no known redemption date and the price falls, it matters. It is not just “noise” as it would be if you owned individual bonds.
As an investor who values the characteristics of individual bonds and chooses to protect their principal with a portfolio of high-quality bonds, you should be cheering for higher rates. If Treasuries shoot higher in yield or spreads widen out, it’s not the end of the world, it’s an opportunity to purchase investments offering you a higher return while knowing that your current portfolio of bonds already has its income, cash flow, and redemption date locked in.
* Barring a default and assuming non-callable 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.