Bond Market Commentary
Keep It Simple
By Doug Drabik
April 22, 2019
The financial markets are wrought with complexities and to further complicate things, investors are inundated with articles that can misrepresent the purpose and detail of bonds, often times to try to sell a service or supposed advantage. Ultimately, it can cost an uninformed investor needless service fees, thus diminishing net returns.
Investors do not fall into a single category and investor needs are very personalized which in itself lends credence to the advantages of a customized bond portfolio. For many of our investors, the allocation to bonds represents the offset to the potentially higher return (and higher risk) growth assets such as equities. Bonds can be a hedge to that risk and often the intention is to provide income without “playing” the market or exposing an investor to higher risks.
Some pundits pitch against strategic methods such as bond ladders and perhaps miss the simplicity yet effectiveness of such a strategy. It has been suggested by some that investors avoid ladders in lieu of active bond investing. There are contradicting arguments and data on whether investors are better served with active or passive management and therefore, each investor should gauge their own situation to optimize what is most important. Keep in mind that many investors are taking their risk with growth assets. The whole concept behind bond allocation in a passive state can be to counter actively traded equities and the associated market risks.
It has been suggested that with ladders, bonds are selected by their maturity rather than their value. This is not a “this or that” concept. Bonds can and should be selected for their maturity and their value. The importance of varied maturities is that it takes away the need to guess or prognosticate interest rate movement. By spreading maturities across the curve, investors remain in the market and invested throughout the ebbs and flow of market swings. Relying on forecasting is a tough prospect as even the most respected financial minds have struggled with predictive accuracy. Furthermore, investors do not give up value selection as the redemption date is just one of the features along with credit quality, spread, coupon, pricing, etc. These are assets not necessarily intended for spot market situations or market plays, those are the risks left to the growth allocations.
In many cases, bonds are not purchased for capital appreciation. That’s the point: when held to maturity, bonds provide a known cash flow, known income and a given point in time where the face value is returned. It is an income portion of the portfolio and is most often not intended to provide neither capital appreciation nor depreciation and thus disregarded as a total return investment. The tax efficiency of bonds is knowing their income stream from day one through a bond’s maturity.
Another spin indicates bond ladders, when held to maturity, cap investment returns. Yes, and barring default and holding to maturity, they also prevent principal loss. The assumption suggests an investor should sell their bond if it has appreciated. Sounds great, but if prices have gone up, then reinvesting those proceeds means that you can’t match the yield with the same duration and credit quality. An investor purchased the bond for its income and it is now being suggested they sell that income for a bond with lesser income? Or a bond with higher duration (more risk) to match the income? As articles often do, they comingle the purpose of different portfolio asset allocations. Bonds are there for their income, cash flow and offset to growth assets. Don’t confuse their objective or underestimate their effectiveness at providing for that purpose.
It is also suggested that bond ladder investors have a higher default risk. A very broken assumption is that when bonds are held to maturity or purchased in a passive format, they are not monitored or managed in any way. This simply may not be true (of course depending on where your bonds are held). Just because bonds are typically held to maturity, it can be a fallacy that they are thrown into the portfolio and forgotten. For example, an investor may work with an advisor on a portfolio review as often as needed at Raymond James. It can be pointed out that the number of bond experts in the bond department and the years of experience and expertise often dwarf that of a manager and their staff.
Don’t make the bond allocation difficult. Investors often take their bigger risks in real estate, MLPs, owned businesses and/or equity holdings. Individual bonds can and most often should be viewed and treated very differently. Strategies for bond allocations should also be viewed and treated very differently from those utilized for equities. Bond ladders can keep it simple but that doesn’t mean it is forgotten money or not fulfilling an important and impactful role for your portfolio.
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.