Read the weekly bond market commentary from Doug Drabik.
August 13, 2018
You can call a zebra a horse, but that doesn’t make it a horse… it’s still a zebra!
An investment portfolio strategy should strive to optimize an investor’s return within that investor’s risk profile. The current market conditions and recent market reactions have helped to emphasize the importance of portfolio asset allocation. This is nothing new to the fixed income experts. A strategy poised for growth almost certainly will miss its target if invested in a five year Treasury ladder in the same way a capital preservation strategy invested in high yield or equities could potentially miss the mark. If growth is desired, an advisor might suggest that you employ growth assets such as: equities, MLPs, real estate, etc. If principal protection, wealth preservation and/or defined income streams are desired, the choice is often to use individual bonds.
The “fixed” in fixed income is not a play on words. It means your income is fixed. Barring default or early redemption, outside variables such as changing interest rates/changing bond prices ultimately have no effect on a bond’s income. Income is fixed for the life of the bond when held to maturity.
Media headlines and product advertising can confuse investors. It’s like an ad for a low fat diet bar avoiding exposing 40 grams of sugar destined to counter any health benefits. A packaged bond fund is NOT the same product as an individual bond. The fund may offer exposure to bonds, but it is not necessarily emphasized that funds lack a stated maturity, the income component is not fixed and price fluctuations may affect principal balances. There is no known date at which the invested bond fund’s par value will be returned to the investor. A fund’s net asset value changes and therefore principal is at risk in a much different way versus that of an individual bond. In a rising rate environment, a packaged product may experience principal loss which time may or may not remedy. Conversely, an individual bond’s stated maturity allows an investor to hold-to-maturity and therefore provides a fixed amount of income over its life as well as a known date where the bond’s face value is returned.
More confusing are packaged products that are labelled “fixed income” yet composed of instruments that perform differently or unlike traditional individual bonds. Many individual investors would not be comfortable investing in high yield bonds (bonds with higher credit risks, generally deemed to be below investment grade). Others may not understand the mechanisms of interest rate futures or swaps or interest only bonds. Yet, there are funds that package, label and advertise these as a fixed income fund. Don’t be fooled by the label. If the ingredients are risky, the investment (investor) likely carries that risk. This is not to suggest that these are bad products because all products serve a particular purpose. This is to suggest that labels and certain combined packaged products are necessarily not good individual bond alternatives.
Many investors are anticipating a modest, perhaps more steady, rise in rates. Protecting wealth and locking in income may best be served with individual bonds. A balanced strategy is just that – balanced. “Fixed Income” engineered for price appreciation may parallel objectives similar to total return growth assets. True fixed income is designed to provide a constant stabilizing effect on both income and cash flow while mitigating or removing the effects of appreciation/depreciation. Don’t be fooled by the label or marketing… if the horse has stripes, it’s probably a zebra!
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.