New opportunities in fixed income

by Brian Erickson, Vice President of Fixed Income Research and Strategy, Ameriprise Financial

October 2018

Key Points

  • A changing interest rate environment highlights the importance of reassessing your fixed income portfolio
  • Attractive opportunities exist in today’s market, particularly in shorter-term securities
  • Partner with your advisor to develop fixed income strategies based on your goals

Beginning with the Great Recession and financial crisis of 2008, fixed income investors have become accustomed to an environment of historically low interest rates. The status quo in the bond market has lingered for a surprisingly extended period. But the environment has changed notably over the past year, prompting investors to consider new strategies for their fixed income portfolios. 

High quality, short-term bond yields keep up with inflation

Investors seeking yield may no longer need to add undue or uncompensated risk through lower-quality or longer-dated investments. Instead, it’s time to consider returning to investing in high quality, short-term securities, where inflation-matching yields have returned.

At the end of September, high quality, short-term bonds offered a 3% yield1, surpassing the year-over-year rise in the Consumer Price Index (CPI), which is considered the inflation benchmark.

Prepare for more volatility in the bond market

Now may be the time to re-evaluate the types of investments you select for liquid or short-term allocations. Options include money market funds, certificates, CDs and ultra-short term bonds (which have maturities of about one year). Differences among these investments may have seemed insignificant in the past. In today’s changing environment, however, you should carefully weigh your options based on factors like yield, credit quality and liquidity when matching investments to your financial objectives.

We believe bond markets are likely to experience more volatility ahead. Be aware of that risk as you consider investing available assets. 

The impact of a flattening yield curve

In the current environment, you have an interesting opportunity to reduce the interest rate sensitivity of your portfolio. The Treasury yield curve flattened this year, as the gap between yields on short-term and long-term bonds narrowed.

Since longer-term bonds are typically more sensitive to interest rate changes, there is little advantage to investing in a 10-year Treasury note when the two-year Treasury note is likely to generate only a slightly lower yield, with less interest rate risk. At the end of September, the yield on the two-year Treasury was 2.81%, compared to 3.06% for a 10-year Treasury.2 Last year, investors may have been more tempted to transition their investments to bonds with longer maturities in order to benefit from the greater yields, which is a common investor misstep when yields are rising.

 

 

Strategies vary based on goals

The best approach for your portfolio will depend on a variety of factors, most notably the key investment objectives you are trying to accomplish.  

Investing goal: Preserve wealth
The best strategy to preserve wealth in a rising interest rate environment is to focus primarily on short-term investments. In today’s market, these investments offer returns that keep pace with inflation and avoid much of the impact from rising yields. Buying and holding bonds to maturity can remove the uncertainty caused by changes in price since investors receive their principle investment back at maturity – although this return is subject to the risk level of the investment.

Investing goal: Generate total return
Investors seeking total return should be cautious in the current highly valued bond market, considering Fed policy and greater inflation risk may push bond prices lower and yields higher. You may want to avoid taking on excessive risk in an effort to capture yield, such as using borrowed money to invest in fixed income securities or investing in strategies that rely on embedded borrowing. Stock and bond markets in general have benefited from the Federal Reserve’s monetary easing strategies, but they may see greater challenges ahead as the Fed begins to tighten the money supply.

You may find better total return potential in short-term fixed income instruments, compared to intermediate and long-term bonds. More conservative investors with sizable allocations to fixed income should focus on short-term, one- to five-year debt securities. For moderate to aggressive investors, we believe a similar approach could be considered, along with blending in intermediate fixed income investments. This can help retain the diversification benefit of fixed income investments when balanced with equities.

Investors seeking ways to further diversify their fixed income portfolios might consider non-traditional bond funds as a complement to traditional fixed income investing. Non-traditional strategies cover a variety of goals and styles, some designed for measured risk taking and others that are aggressively tactical and opportunistic. Consider incorporating lower risk, high-quality non-traditional bond funds into your allocation to expand portfolio diversification beyond mainstream fixed income allocations.  

Investing goal: Income Generation
Investors seeking to generate income should consider implementing a buy and hold approach focused on high quality assets that they would be comfortable maintaining, even through a future recession. The recent rise in yields means higher yields from reinvested funds or new investments, which is a positive for income investors. We believe that seeking broad diversification across fixed income, equities and alternatives where appropriate in order to avoid overly investing in one market segment or asset class should be considered.

Are you capitalizing on today’s opportunities?

We believe fixed income investments continue to play an important role in a broadly-diversified portfolio. Talk to your financial advisor about how changes in the fixed income market should be applied to your portfolio.

Changing times favor those who prepare. Now is the time to revisit your strategies for fixed income investing.

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