Bond experts speak out: words from a fixed income perspective
Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
Our Only Benchmark is Yours. This has been a Fixed Income Solutions mantra for years. But what does it mean? So often things are said and more importantly influence us but do we always interpret or understand these statements in the appropriate context? The latest hype and data can be framed in different ways rendering diverse interpretations. We want to give you the Fixed Income perspective.
OUR ONLY BENCHMARK IS YOURS
The Fixed Income Perspective: Fund managers often use an index as a standard with the goal that they will perform better than that index. Beating that index can be viewed as performing competently. Managers tend to focus on indices and total return while many individuals focus on cash flow and income. Theoretically, if the market was down 5% and a manager’s performance was down 3%, they will have “outperformed” the market. Although that may be admirable from a general viewpoint, our intent is for fixed income allocations to perform well based specifically on your goals, not some generic market target. Each individual investor has their own exclusive and unique goals, liquidity needs and future targets. While a fund manager holds the same benchmark for everyone, our benchmark is different for each and every investor.
THE BOND MARKET IS OFF TO ITS WORST START OF THE YEAR SINCE 1992
The Fixed Income Perspective: In reality the writers are often talking about Treasuries when they say the “bond” market. Perception is everything. Many investors buy-and-hold bonds and are interested in protecting principal and getting the most income within their risk parameters. Remember that as interest rates rise bond prices fall and conversely as interest rates fall bond prices rise. In this case, we can say that interest rates are off to their best start since 1992. Buy and hold investors will welcome the opportunity to lock in the higher income associated with higher rates. For bond buyers, higher rates equal a greater income opportunity.
TOTAL RETURN
The Fixed Income Perspective: Total return includes interest/dividends plus capital gains/losses. Total return is a very important measurement for growth instruments such as stocks. If you buy a stock at $100, you want capital gains (e.g. the stock price increases to $200). Your return often relies on capital gains. As a buy and hold bond investor, capital gains or losses are typically mitigated away as a bond approaches maturity. Bond prices approach par ($100) as they move toward maturity. Bonds held to maturity have a known end price therefore total return is ultimately not affected by interim price movements. A buy and hold bond investor therefore derives return based on interest earned, not market price. Total return is generally not an important measuring stick for buy and hold bond investors.
UNDERWEIGHT/OVERWEIGHT
The Fixed Income Perspective: The terms at first glance appear easy to delineate; however, it should be said that underweight does not mean eliminate and overweight does not mean entirely isolate. Asset allocation is a strategy that utilizes certain asset classes to accomplish specific investment functions. Using a simplified classification/clarification, the portfolio is composed of growth assets and principal protection assets. Growth assets (e.g. stocks, MLPs, real estate, etc) may possess greater risks coupled with greater potential for higher returns. Principal protection assets (individual bonds) may reduce certain risks and can offer known attributes such as fixed yields to maturity and known redemption dates. The appropriate ratio of each asset allocation provides a balance to investors navigating an unknown future. Overweight implies maintaining an appropriate balance between growth assets and principal protection assets but pushing discretionary balances toward an overweight bias. Regardless of market bias, it can be argued that maintaining appropriate asset allocations remains important in any economic environment.
INCOME GENERATION IS NOT LIMITED TO SPECIFIC ASSET CLASS CATEGORIES
The Fixed Income Perspective: Certainly income can be generated through a multitude of approaches. However, these approaches carry an array of risks, with some greater than others. Dividend paying stocks are often pinpointed as viable bond substitutes. First it is typically an in-the-moment opportunity where a dividend yield compares favorably to a bond yield. Stock dividends are not guaranteed and can be reduced, increased or eliminated at any time. These might be good growth assets but not necessarily good principal protection substitutes. If a stock market correction pulls the price of the stock down 20% then that 20% decrease or principal loss incurred contradicts the very goal of bonds in the income asset class category and principal protection is compromised. Individual bonds have a stated maturity so although market prices may fluctuate, barring default, the face value of a bond is locked and will be returned at maturity. The maturity date positions individual bonds with a wealth protection characteristic not possessed by many other asset classes. Various substitutes carry varying risks and accomplish different ends. Know the purpose of allocated assets and don’t compromise long term strategy at the cost of unwanted risk.
REAL YIELDS ARE NEGATIVE SO DON’T BUY BONDS
The Fixed Income Perspective: Real yield equals yield minus inflation. If a bond’s yield is 3.0% and inflation is running at 4%, there is this feeling that the bond is losing money. As the consumer price index (CPI) and personal consumption expenditure index (PCE) have elevated, the media and articles have created the image that bond portfolios are wasting away as value drips into a worthless abyss. The truth is that each individual bond holding is performing exactly as it has since the day it was purchased. Cash flow continues, income is being earned and the bond will return the face value on its maturity date. Inflation does not take this away. The purchasing power of the money being earned is lessened but that is not exclusive to bonds. Every asset that is earning income is subject to the same buying power reduction; however, individual bond structures deliver one of the most effective means to protecting the portfolio’s principal value.
FIXED INCOME FUNDS, ETFS AND INDIVIDUAL BONDS PROTECT PRINCIPAL IN THE SAME WAY
The Fixed Income Perspective: Individual bonds and packaged products that contain fixed income are different products. For years, actually decades, bonds have reaped the side benefit of great total returns because as interest rates fell, bond prices rose. It was a pretty good safety net. If rates were to rise in a more permanent trend, fund managers will no longer have the benefit of trading positions or liquidating them with profits. Unfavorable market conditions could lower the net asset value (NAV). Lowered NAV is an assault on principal which ironically is the primary purpose for fixed income allocations with many investors. Individual bonds have the favored characteristics of a known yield, maturity price and maturity date. Only a default or early redemption can prevent individual bonds from performing the same from day one through their maturity and then returning the face value. The best way to protect principal in a rising rate environment may be individual bonds.
CASH IS AN INVESTMENT ALTERNATIVE WITH NO RISK
The Fixed Income Perspective: Cash is… well cash. It is not an earning asset. It represents opportunity but of course opportunity comes with risk. The risk is that idle cash earns 0%. The idea is that waiting for a much higher yielding opportunity will more than offset the idle time when 0% was earned. The future investment typically would need to earn a significant amount over and above current investment yields in order to make up for the lost earning period. There is no right or wrong answer or amount of appropriate cash because each investor’s risk profile, goals and future outlook is different. Another way to mitigate future interest rate uncertainty is by laddering investments (as short or as long as desired), thus allowing a percentage of the portfolio to be reinvested in controlled increments all while earning income along the way.
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.