A quick review of the fixed income markets

Daniel Lippincott, The Daily Record Newswire

Interest rates available on fixed income investments are low. This can be seen by looking at the current yield of the 10-year U.S. Treasury, which now stands at 2.30 percent. To put this yield into context, over the last 30 years, the 10-year U.S. Treasury has yielded 5.41 percent on average.

Given today’s low yields and the prospects of the Federal Reserve hiking short-term rates later this year, many conservative investors are examining the usefulness and future of their fixed income holdings. In contrast to current consensus thoughts that fixed income investments should generally be avoided or underweighted, I believe that long-term investors will continue to benefit from their
allocation to fixed income investments and stand to benefit down the road when interest rates do in fact rise.

In order for investors to independently assess the benefits of bonds in their portfolio, they must first think about why it is that they purchased bonds in the first place. In many circumstances, investors purchase bonds for their predictable income stream, the diversification that they offer to a balanced portfolio, and to help preserve capital during periods of economic weakness.

With respect to the first of these attributes, income, it is critical to note the income component is responsible for more than 90 percent of bond investors’ total return. Moreover, the income received by bond investors acts as a cushion when bond prices decline.

Next, in terms of bonds’ diversification benefits, fixed income investments have shown to be much less volatile than stocks throughout history. If fact, since 1980, the worst 12-month time period for stocks,
as measured by the S&P 500 Index, produced a -43 percent return, while the worst 12-month period for bonds, as measured by the Barclays Capital Aggregate Bond Index, was a mere -5 percent.
Looked at another way, over that same period, the worst two-year period for stocks was -45 percent, while there was no two-year period where bonds failed to produce a positive return.

In my opinion, long-term bond investors should welcome an increase in rates as it will lead to higher total returns down the road. For example, let’s look at the effects of an immediate 1 percent increase in rates on an intermediate duration bond fund (5 years) with a 3 percent average yield to maturity. The immediate 1 percent increase in rates would cause the price of the bond to drop by about 5 percent.

However, the sample fund would now have a 4 percent yield to maturity going forward. This works out to a negative 1 percent return the first year, the exact same 3 percent per year return after 5 years, and significantly higher returns from that point forward.

In a rising rate environment, it is also important to remember that not all fixed income investments are the same and some investments tend to outperform Treasuries in a rising rate environment. For example, investments in senior loans and floating rate bonds can offer attractive yields with little interest rate sensitivity. On top of this, these bonds are senior in the capital structure and have minimal correlation with traditional fixed income investments.

Similarly, municipal bonds tend to be less volatile than Treasuries and have historically performed well in rising rate environments. This can be attributed to the absolute value of the tax-exemption increasing as yields rise. For instance, a municipal bond yielding 3 percent has a tax equivalent yield of 5.3 percent. Should the yield on a municipal bond rise to 5 percent, the tax equivalent yield jumps to 8.83 percent.

While I expect fixed income returns to be lower than normal over the next few years, bonds should continue to provide dependable returns, while offering a high level of safety in an uncertain investing environment. As is usually the case, following the consensus view may not always lead you to the right decision. With respect to your fixed income investments, I urge you to take the time and speak with your financial professional about the role bonds have played and should continue to play in your portfolio.

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Daniel Lippincott is a senior tax sensitive manager/director of investment personnel for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
 

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