Fixed income 101

Typography

Recently, I was at a mutual fund conference in Washington, D.C., with some of the best money managers in the world.  While the conference was mostly focused on equity investing, there was a good deal of attention given to target-date funds as they are also products of the Investment Company Act of 1940, or the 40 Act, as it is known today. As an aside, it is interesting to note that the 40 Act, which was enacted by the 76th Congress in the wake of the Great Depression, was 70 pages long and was passed with wide bipartisan support, allowed the Securities and Exchange Commission latitude in rule making and has withstood the past 75 years. So how do you like that, Dodd-Frank?

Now, back to fixed-income investing. The first thing to remember when taking a leap into the bond or fixed-rate bank debt market is that the price of the bond is negatively correlated to the yield of the bond. In other words, as the price goes up, the yield will go down. The reverse of that is also true; as yield goes down, the price goes up. To put this in context, let me refer you to the following graph of the 10-year Treasury bond yield from 1900 to 2014.

There was a prolonged period of time, beginning in the 1940s, when interest rates were headed up. Rates rose from roughly 2 percent in 1940 to over 15 percent in the early 1980s. Since the peak, the 10-year Treasury bond has been on a steady path down and settled under 2 percent earlier this year. That is about 35 years of declining and a historic 112-year low for this benchmark bond.

Of course, U.S. government bonds or notes are not the only fixed-income investments available to folks looking to generate income, but these are the safest options and often are referred to as “risk-free” and most other instruments are priced off of them. Other common bond or fixed-income investment vehicles include municipal bonds, bank debt and corporate bonds. The capital markets price these various instruments by estimating the credit risk and liquidity risk associated with individual issues.

Historically, fixed-income investing was a way to achieve predictable monthly income that had minimal volatility and protected the principal. If held to maturity, those characteristics continue to hold, but in a rising interest rate environment it may be difficult to resist the temptation to reach higher yields.

Be thoughtful and seek professional investment advice when you get your brokerage statements later this month. Since bond funds are marked to their net asset value at the end of each trading day and yield on the long end of the interest rate curve has been moving up, you are likely to see the overall value of your investment in fixed-income assets has done down.

Just like in hockey, where the skater needs to skate to where the puck is going, investment markets trade on where market professionals think rates are going, not where they are today.  Based on the previous graph, pronouncements from Janet Yellen, chairwoman of the Federal Reserve, and an improving global economy, we are likely in for a prolonged period of rising interest rates. Build a plan with your professional financial adviser, ignore short-term volatility and construct a well-diversified investment portfolio that meets your personal risk tolerance objectives.

Elihu Spencer is a local amateur economist with a long business history in global finance.  His life work has been centered on understanding credit cycles and their impact on local economies.  The information contained in this article has been obtained from sources considered reliable but the accuracy cannot be guaranteed.

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