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With interest rates at such low levels for so long, many conservative investors have been struggling to find fixed income solutions that will deliver the yields they need to keep their long-term financial plans on track. With interest rates rising this year, investors are even more confused about what to do. Although conditions are far from optimal for heavily overweighted fixed income investors who are seeing their statements down as much as 10-15% year to date, things are not as bad as they seem.
At least they’re not if we’re talking about investors holding individual fixed assets, such as individual bonds, CDs, or preferred stocks.
It seems counterintuitive, so let me explain. It’s like a seesaw. When interest rates go up, the price of bonds go down, and vice versa. Hence, when the Fed raises rates, as it has been doing to fight inflation (the 75-basis-point hike on June 15 was the largest boost since 1994 with more to come), the price of bonds go down. The face value of the bond doesn’t change, but what the market is willing to pay for that bond does. That’s why many fixed income indexes are down 10-15% so far this year, and why so many investors, especially conservative income investors or those who are highly risk averse, have been panicking when they get their monthly statements.
The easiest of the two ways your clients can invest in these fixed income instruments is through a bond mutual fund or ETF. Buying a fund is a way to access the broad bond market, but there are also negatives to that approach. The biggest drawback is that in a rapidly rising interest rate environment, bond funds are likely to suffer negative performance because they bought those bonds at the lower rate (and higher price) and have to wait for them to mature or sell at a discount. It’s even worse for short-duration bond funds, which are unable to adjust to interest rate changes fast enough.
Buying individual bonds takes more work but is usually worth it in the long run. When putting together a client’s bond portfolio, the objective should be to purchase each security at par or slightly below (typically $100 for bonds and $25 for preferred stocks). The investor then collects the coupon rate for the life of the bond to maturity. At maturity, they get back the face value of the bond.
Here’s how it works: Bond ABC is purchased today at par ($100) with a 5% coupon. The bond holder receives interest of $5/year for the next two years, and when the bond matures in June 2024, they get back their principal at par ($100). During that two-year maturation period, rates can go up or down and daily prices will affect the value of the bond. But those movements directly affect the investor only if they choose to sell the bond on that day rather than hold it to maturity. Hence, on a statement, it looks like there’s been a loss when in reality the bond is performing exactly as was expected when the client bought it.
Before building out a customized portfolio of fixed income instruments for a client, I use the example above to explain why we subscribe to a strategy of buying individual assets and holding them to maturity. I also try to explain the “add back” factor, which is the relationship between what the daily price of a bond is to its maturity par value.
Let’s say the same hypothetical ABC June 2024 bond is today priced at $90 with that same 5% coupon. On paper it looks like the bond has gone down 10% in value. But that’s only true if it was sold today. As long as it is held to maturity two years from now, the bond holder will get $100 back. I also explain that if they sell it prior to maturity, they will only get whatever the market is willing to pay for that bond at that time, which could be a greater discount to par or even a premium to par. But unless there are some exigent demands requiring early liquidation, the goal when building out an individual bond portfolio for clients is that all bonds will be held to maturity. In a market filled with uncertainty, bond maturity dates and coupon interest are things investors can count on.
And although we’ve been talking specifically about bonds in this article, the principles discussed can be applied to any fixed income instrument, even CDs. The tax implications of fixed income choices should also be considered for non-IRA accounts since some bonds earn tax free income.
There is some risk from holding bonds with long durations if rates continue to rise, as well as inflation risk. Still, for more conservative investors, there’s a lot of appeal in knowing how much they’re going to earn and when they’re going to get their principal back rather than worrying about every market hiccup.
What types of bonds go into the portfolio will vary according to each client’s goals and risk tolerance. The bond universe is large; there are thousands of different instruments available with varying durations, coupon rates, and tax implications. With careful diligence, most advisors will find a fixed income solution that meets clients’ needs even in this environment.
Eric Sweeney is vice president and wealth manager with Boston-based Sweeney Wealth Management Group at Steward Partners.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
