I recently received a phone call from a client who had questions about some bonds he had in his portfolio. This interaction sparked a very candid conversation about bonds, interest rates, and what role they play in the investment world today. I thought I’d share the highlights of that conversation as somewhat of a bond refresher course.
First let me begin by saying the current fixed income world is somewhat unprecedented. Interest rates are abnormally low, and have been for quite a while. Any future increases are expected to happen gradually and slowly. Couple that with the massive influx of retirees (baby boomers) who are seeking income, and it looks like a classic over-demand for a limited supply. The word “conundrum” comes to mind. So, what are investors and financial advisers to do? There are several different schools of thought on the topic, but before we address them: let’s take a simplistic view of what you need to know about fixed income investing.
What is a bond and how do they work?
When you buy a bond, you are lending your money to a private or public entity for a specified period. During that time, let’s say 10 years as an example, you will receive interest payments based on the original rate. In addition, at the end of the term you receive your original money back. Simply put, when you buy a bond you are a lender. When companies or municipalities sell bonds, they are borrowers. The bond market, like the stock market, is a place for buyers and sellers to come together.
An investor puts up his or her money, and the bond issuer agrees to pay interest and return principal at some point in the future. It doesn’t take a rocket scientist to figure out that today, and for the past few years it has been good to be a borrower but not so great to be lending.
With expected volatility in the fixed income markets, is it prudent to avoid bond investing all together right now? Let’s look at three different scenarios that warrant some analysis, and should be discussed with your financial adviser.
Option One: Avoid Bonds Entirely
The first option is to avoid the asset class entirely, and instead hold more cash or more stock. At first glance this may seem a little radical, but there are some strong arguments for choosing this option.
Let’s start with increasing cash in lieu of bonds. First, cash and bonds have one common characteristic – they do not grow. Only stocks grow. Cash and bonds pay interest. Interest on cash is virtually non-existent, but cash does not go down in price the way a bond does if interest rates rise. For some, this is very appealing.
Sitting on the sidelines and waiting for interest rates to normalize has some merits. It is also a way of playing the market timing game, and as many have experienced, that is a tough game to win.
The opposite of holding more cash would be holding more stock. This is an option that requires a longer than 5-year time horizon and absolutely no need to utilize principal for living expenses during that time. It also requires the ability to buckle your chinstrap and ride out the volatility no matter what.
If you like that funny feeling in your tummy when you take the first drop on a roller coaster, this just might be for you. For most investors, yours truly included, the shocks that can occur in this scenario are too much to absorb. But for those who can handle the volatility, and if the increase in equity exposure leans toward conservative, strong balance sheet type stocks, then I can see how this might be an acceptable modification.
Option Two: Modify Asset Class Weightings
The second option that exists for investors is to keep all three asset classes in your portfolio mix, but to modify their weightings.
For example, in a moderate portfolio that would normally be comprised of 60% stock, 35% bonds, and 5% cash, we could adjust those weightings to 65% stock, 25% bonds, and 10% cash. This is called tactical weighting, which is a way of saying we are tweaking our core strategy in an effort to increase our returns given the current investment and economic landscape. This option is more palatable for most investors, and a more common strategy for advisers to implement. It does still carry the risk of timing.
At some point, you will need to readjust the allocations to a traditional composition, and making a call about when to do that cannot be done with 100% accuracy.
Option Three: Stick with Your Plan
The third option is to simply stick with your original financial plan and asset allocation model that was established based on your needs and goals, and realize that we won’t be in this low rate environment forever. Interest rates will eventually normalize. We just don’t know when.
The late 70’s was also an unprecedented time for interest rates and that did not last forever. A traditional asset allocation model that is regularly rebalanced might not be terribly exciting. I get it. But keep this in mind, things that end up as headlines, are headlines because they are newsworthy. Newsworthy is not common. Newsworthy events don’t happen with regularity. Newsworthy is something that evokes emotion.
In closing I will leave you with this thought. Your financial plan and portfolio should have been constructed with the notion of keeping emotion at a minimum so you could achieve your goals and not be tempted to change course at an inopportune time. Headlines will come and go. Geopolitical events will always be present, and economic conditions will always be changing. At the end of the day, how you choose to respond to the current interest rate and fixed income environment should be based on your goals and needs, not on a headline.