Functional Fixed Income Potentials
Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
There are commonly asked fixed income questions relayed between our clients and advisors. Investor uncertainty, amplified by the pandemic and economic circumstances, have fostered many new inquiries. Today we seek to outline some of the more important aspects concerning how investors can respond to or implement quality ideas in today’s market.
The Fed is giving us a 2 year map on short-term rates. There are no guarantees, but the Fed has come about as close as investors could hope in highlighting their future intentions. They do not intend to raise short-term interest rates through 2022.
Assuming that the Fed’s word is dependable, there are a couple of actions worthy of consideration. High quality short-term (inside 24 months) bonds have been highly sought, raising the price some investors are willing to pay. The increased demand leads to higher prices which translates to lower yields. Think about taking advantage by liquidating these short holdings and reemploying the proceeds in the 3 to 5 year part of the curve. Assuming a quality bid, the missed future income plus a potential additional amount of income can be captured (the difference between the low take out yield and the reinvestment yield). Given that the Fed is not intending to raise rates until at least 2023, the additional market exposure is minimalized.
A slightly different take can be considered for investors too heavy in cash or low yielding money market instruments. These investors can consider a short barbell by offsetting the large cash balances with holdings in the sweet spot (3-9 year) of the curve. Look at corporate bonds 3-9 years in maturity and/or municipal bonds in the same range or 10-15 year municipal bonds with 5-10 year call structures. Talk to your advisor about a proposal that will highlight these opportunities in more clarity.
In the big picture, look to shorten duration with new money or cash flow reinvestment. Although this seems counter-intuitive to the previous point which suggests a short extension, this point is to limit long term exposure given that interest rates across the yield curve are near historic lows. The idea is to better position for the eventual economic cycle turnaround. The sweet spot is between 3 year and 10 year maturities.
Look at sectors within sectors. What this means is that certain sectors have suffered as a result of low interest rates and/or the pandemic; however, not all companies or municipalities within those sectors are equally affected or equally financially positioned to weather the adversity. There are numerous opportunities and many of these change day-to-day. These ideas will require your advisor’s updates. By example, all hospital bonds are not alike. A small rural hospital is not as equipped to withstand today’s shutdown as a large hospital conglomerate with multi-state and large bed coverage. Certain REITs invested in long-term care facilities might be better positioned than those devoted to retail box-stores. High quality strong financially positioned oil & gas companies offer better opportunity versus the troubled sector companies that have been stricken by declining prices and beaten-up demand caused by the coronavirus.
Portfolio structure still matters. Laddered portfolios may seem commonplace or unexceptional, however, the structure mitigates interest rate risk in a very uncertain time. Ladders allow investors to better position for reinvestment without guessing future interest rates. Once implemented, the rollover investments take advantage of the longer end and typically higher yielding part of the curve. The laddered structure provides a sort of “floating rate” portfolio since a portion of the portfolio is reinvested on a timely basis.
For investors wanting to keep duration very short, floating rate corporate bonds with short 3-5 year maturities provide adequate yields well above money market yields. The options are very narrow but the selections can provide good short term duration substitutes.
Finally, do not overlook premiums. Premium bonds have ceaselessly been misunderstood as the math is not as easy to comprehend. Many fixed income allocations are meant to protect principal and are purchased with hold-to-maturity intent, therefore, the yield associated with bonds can be the most important component. The uncertainty and misunderstood math can provide opportunities in premium bonds which often provide wider spreads/income. Raymond James Fixed Income Solutions has several educational articles available, which help investors understand premium bonds and the opportunities they can provide.
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.