Staying Invested
Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
One of the unique benefits of owning individual bonds is that at some point they will be redeemed by the issuer*, either through a call or at the maturity date. When this happens, your principal is returned to you in the form of cash in your investment account. Then what? Generally, the principal is invested back into your fixed income portfolio in order to maintain the appropriate fixed income allocation for your investment plan. For those investors who might be tempted to leave the cash until “yields move higher”, I would caution against trying to time the market. For those investors considering taking this cash, which was part of your fixed income allocation, and re-allocating into a different product, ensure that you make that decision fully aware that you are shifting the overall allocation makeup of your portfolio.
The investors who are waiting to invest in order to try to time the market should keep in mind just how hard it is to actually time the market. As an example, at the start of every year since 2008, the Philadelphia Fed’s Survey of Professional Forecasters’ consensus estimate has called for the 10-year Treasury to rise over the following five quarters. In 12 out of the 14 years, the consensus estimate turned out to be too high. In those 12 years, their estimate was an average of 100 basis points higher than the actual 10-year Treasury yield was five quarters later. Keep this in mind if you are considering trying to time to market by waiting for higher rates. The participants in this survey are some of the best economic minds and forecasters in the nation, and 12 of the past 14 years when they aimed too high, they missed their target by an average of 1.00%. Predicting the future is very hard to do.
This highlights one of the primary benefits of maintaining a bond ladder as your fixed income allocation. As a reminder, an example of a bond ladder would be a portfolio with bonds maturing each year from 1 to 10 years, with 10% of the portfolio in each year (each “rung” of the ladder). This structure diversifies redemptions and just as important, diversifies reinvestments over time, so that there is no need to try to time the market. As each bond matures, its proceeds are reinvested on to the back end of the ladder. As you are reinvesting at regular intervals, acquisition yields are going to vary from purchase to purchase. You are taking what the market gives you, in similar logic to dollar-cost averaging, while staying fully invested at all times.
The investors who are considering shifting proceeds from a matured or called bond to another asset class in an attempt to capture more yields need to be mindful of the overall shift that is being made to the portfolio’s allocation. Instead of thinking of your portfolio as 60% equities and 40% fixed income, think of it as 60% total return and 40% principal preservation. In shifting 10% of your principal preservation assets from bonds over to dividend stocks, you are reducing your principal preservation allocation down to 30%. Essentially, you are chasing total return with assets that were intended to have preservation as priority #1. There is absolutely nothing wrong with high dividend paying stocks, MLPs, REITs, or other common products that investors seek out in a reach for yield, but they don’t have the characteristics that bonds do that make them ideal for preserving and maintaining wealth.
When bonds that you own mature or get called and you are suddenly looking at additional cash sitting in your account, remember what that cash is earmarked for and what the purpose of that money is. You likely allocated that money to individual bonds in order to preserve your wealth. Ensure that your goals, risk tolerance, and long-term financial plan dictate your asset allocation, not the market. Don’t put your wealth preservation goals at risk by trying to time the market or by chasing total returns.
*barring a default.
Philadelphia Fed’s Survey of Professional Forecasters: https://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-forecasters
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.