This week’s update is focused on fixed income/bond investments. It’s in question and answer format and I hope it gives you an idea of how this asset class works and who this might be appropriate for. I will also share our overall philosophy related to fixed income investing and how we are positioning portfolios in this asset class.
1. What are fixed income/bond assets?
These are contractual obligations between a lender and a borrower (an investor) representing a loan to a corporation for a certain amount of money receiving a set interest rate. The set interest rate is referred to as the coupon rate and is the annual interest payable to the investor.
2. I have seen other interest rates listed such as yield to call and yield to maturity. What are these?
Yield to call is the yield that is payable to the date when the corporation has an opportunity to call the bond and retire that debt. Companies may be eager to call a bond if that bond has been issued in a higher interest-rate environment. When the call date arrives, a company will pay out the face value of the bond (even if you paid more for that bond in the secondary market).
If you paid $1200 for a bond and the call date comes, you will only be paid $1000. This means the effective interest rate is lowered by the amount of premium or discount that you paid on the bond in the secondary market.
Yield to maturity refers to the actual yield you will receive if you hold the bond to maturity factoring in the premium or discount that you paid. It's an important consideration as a bond with a face coupon rate of 5% may not effectively be paying you 5% when you factor in the premium or discount you paid.
3. Why do people buy bonds?
When interest rates are low, as they are now, it's a reasonable question. There are three primary reasons why people buy bonds:
- Certainty of income
- Diversify portfolios
- Reduce stock risk
There are often hybrid reasons why people buy bonds beyond these three, but these are the core reasons. Every investor is different, and one needs to assess carefully whether bonds are an appropriate investment depending on long-term investment goals. Additionally, risk assessment is a critical factor when determining if bond strategies makes sense in a portfolio.
4. If long-term returns on stocks tend to be more favorable than bonds, why would anyone buy bonds rather than fixed income?
It really comes down to how much fluctuation you can live with in your portfolio. The S&P 500 in 2009 dropped over 50%. Bonds did not drop over 50%.
The more volatility that you can take in your portfolio, the more equities may make sense depending on your situation and place in life. Remember, just because stocks may provide greater long returns over a period of time, that doesn't necessarily mean it's appropriate to take that risk if you are already on track to meet your financial planning goals with a less risk focused portfolio. This is an important part of your investment decision making process.
5. What moves the price of bond investments?
Bonds are impacted by two major issues.
First, bonds are impacted by interest rate levels. In a rising interest-rate environment, bonds tend to drop in value. In falling interest-rate environments, bonds tend to rise in value. This is because investors are factoring in current cash flow relative to the cash flow that might be achieved by going out in the bond market pursuing new issues. Said another way, when interest rates are falling and you own a bond at 5%, that bond becomes more valuable because it pays a higher rate than current lower market rates.
Another factor that impacts bond prices is credit quality. AAA bonds pay the lowest interest rate and have the highest degree of perceived safety. Lower grade bonds or junk bonds pay higher rates of interest but have more credit risk issues. We believe the correct mix given the current environment is a bond credit quality somewhere in the neighborhood of “A” to “AA” on average.
6. Should you buy individual bonds, ETFs, or mutual funds when investing in fixed income assets?
In a normal interest-rate environment, or when rates are much higher, we think it makes sense to buy individual positions that can be held to maturity. However, when rates are as low as they are now, we think it makes sense to buy more diversified assets so one can broaden the credit risk. It might be scary to invest in an individual bond that has a “BBB” rating, but it might not be so alarming to invest in an ETF that has a diversified portfolio including a few BBB rated bonds. By being diversified, it allows you to take slightly higher credit risk therefore increasing your overall yield.
Mutual funds may make sense although it's important that you are targeted when investing in funds because of the added expense. Investing in a mutual fund needs to be based on some special differentiation that the particular fund manager provides.
7. How is DWM positioning bonds now?
Since we believe interest rates will remain low for a significant period of time, we have increased the level of A and AA bonds greater than normal relative to AAA fixed income. The slightly reduced credit quality allows us to capture more yield on a diversified basis.
To avoid any unpleasant interest rate surprises, our fixed income portfolios tend to have durations that are lower than the average bond market to avoid an unexpected spike in interest rates.
8. So, should I own bonds?
It depends. If an investor is looking to have a portfolio with some level of stability not buffeted quite so much by equity price swings, fixed income can be a stabilizing force. The decision is an individual one and really depends on your comfort level as well as your financial planning goals.
It's also important to recognize how you react to risk when that risk occurs. While one might be tempted to go all equities because long-term returns might be higher, remember how you react when markets drop. There's an old adage that I believe is quite true that I've been saying for many years,
"Everyone is a long-term investor when markets are rising.”
Don't make the mistake of thinking you can tolerate more risk than you really can. Excess risk might put you in a position where perhaps you make a decision that is not in your best interest at the worst possible time.
Remember that as a client of Destination Wealth Management, you are entitled to free complimentary financial planning. We can help you address your financial objectives and how your portfolio should be structured accordingly. As a result, this can help you determine how much of your investments should be in fixed income positions. Feel free to reach out to your Destination Advisor who would be happy to discuss with you your financial planning goals and how your portfolio is currently structured.