Locking in Target Returns

Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.

A portfolio of individual bonds provides something that is somewhat unique in the investment world: a known outcome*. If held until the bond is redeemed (either by call or maturity), the annual yield earned for the life of a bond is known upfront at the time of purchase. Knowing the return on an investment upfront makes long-term financial planning a much easier task.

Many investors have a “target” return for their investment portfolio that, based on a range of assumptions, serves as a guidepost for a long-term financial plan. This is often further broken down into different target returns for different asset classes. While the fixed income target return might be different for every investor, a common target for many is 5%. This means that if an investor can earn 5% annually on the fixed income portion of their portfolio, their fixed income investments have essentially accomplished their goal.

For years, this 5% target proved elusive as the Fed kept the Fed Funds rate at historically low levels and Treasury yields mostly followed suit. An opportunity is presently available in the fixed income market that has been rare in recent memory: the ability to lock in yields greater than 5% for an extended period of time. To state the obvious: locking in a 5% (or greater) yield with a portfolio of individual bonds today means that the annualized yield is locked in and will not be affected by changes in interest rates. The longer the maturity, the longer the annualized yield is locked in. A 1-year bond yielding 5% locks in a 5% return for 1 year while a 10-year bond yielding 5% locks in a return of 5% every year for the next 10 years. Extending out and purchasing longer maturity bonds can make a lot of sense for a long-term financial plan right now, as the ability to lock in attractive yields for a longer period of time serves as a ballast for the overall portfolio for years to come.

 Bloomberg US Corporate Bond Index