Finding Income in a Weak Bond Market

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When were Bonds at their best? Was it the original Bond, Sean Connery in 1962? Or is today’s James Bond, portrayed by Daniel Craig, the bee’s knees of intelligence agents?

Whatever your preference is, there is likely a valid counter-argument for one of the other five actors who depicted the British gentleman spy. However, when it comes to the financial industry, there isn’t much argument as to when bonds were at their best. A quick glimpse at the early 80’s when rates neared 16% will settle that argument (shown below).

Chart Source: www.macrotrends.net

Since then, bonds have dropped substantially, which has created a problem in many investors’ retirement portfolios. In this podcast, I discuss our March Portfolio Review Meeting (PRM), which largely revolved around fixed-income. I will give an overview of what a bond is, their relationship with interest rates and inflation, their near-term investment horizon, and alternative options for intelligent income-seeking investors.  

WHAT IS A BOND?

[0:48] First, let’s determine what a bond is. The dictionary definition, as provided by Investopedia, is: “…a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments.”¹

For example, XYZ Clothing Corporation wants to expand its business by building a new store in Denver. Rather than dipping into cash, the XYZ Clothing Corporation will issue bonds to investors. Investors lend XYZ Corp. money in return for the promise of periodic interest payments at a fixed rate of return and a return of principal at a stated future date. There are many other factors and considerations when investing in bonds, but that’s the gist.

The United States government can also issue debt, referred to as Treasuries, with various time horizons (maturities). If you want to lend money to the government for one year or less, you purchase a Treasury Bill; for 2-10 years, you buy a Treasury Note; for 10-30 years, you buy a Treasury Bond.

Right now, if you purchase a 52-week U.S. Treasury Bill, the government will pay you 0.08% interest upon maturity. A 10-year Treasury Note—the proxy when referring to the broader bond market—will pay 1.45% annual interest. A long-term 30-year Treasury Bond will pay 2.23% annual interest.²

INTEREST RATES, BOND PRICES, AND INFLATION

[1:43] Bonds have held the investment spotlight recently as they’ve proven an issue for many investors. Looking back at March 2020, when the market fell dramatically, the Fed quickly reacted by dropping interest rates to near-zero. The rationale behind the Fed dropping rates is an entire discussion in itself, but what investors need to identify is the inverse relationship between interest rates and bonds: when interest rates rise, bond prices drop (and vice versa).

Let’s say you own a bond that pays 2% annual interest, and interest rates rise to 5%. If new bonds are being issued at a 5% annual interest rate, then your 2% outstanding bond is pretty unattractive, hence the price decrease. Who wants to buy a bond that pays 2% income when you can purchase new issues that generate 5% interest?

Essentially, that’s what’s happening right now. At the beginning of 2021, the rate on the 10-year Treasury was 0.93%. In the two months following, that rate spiked more than 0.5% (50 basis points)², putting downward pressure on bond prices.

Another critical factor to consider is inflation. Historically, the Fed has had a target inflation rate of 2%. Thus, if the average cost of goods and services is increasing by 2% annually and your bonds are growing at a rate of only 1.45%, then you’re losing purchasing power.

Between the low interest rates, decreasing value, and potential loss of purchasing power, there’s an uncompelling argument right now for investing in bonds.

WHAT ABOUT STOCKS?

[5:27] Retirees are at a crossroads. Bonds are unattractive right now, but, historically, all-equity portfolios have been too risky for fixed-income portfolios. In March of 2020, the S&P 500—a broad-based stock index—dropped 34% from peak-to-trough (shown below). A $1,000,000 all-equity portfolio falling to the mid-600s would be challenging for most retirees to stomach.

Chart Source: www.macrotrends.net

On top of that, stocks face a headwind in rising-rate environments as well. If rates rise too quickly, like bonds, stocks also become less attractive.

WHAT IS AN INTELLIGENT INVESTOR TO DO?

[7:11] Many of our investors are in a growth-with-income model, which is as it sounds: your co-objectives are to generate steady income and grow your investable assets. As Richard Goblirsch, MBA—a managing partner at Denver Wealth Management, Inc. (DWM)—likes to remind us: “It’s called growth with income, not growth with bonds.” In other words, investors shouldn’t solely rely upon bonds to generate income in their portfolio; other investment options may produce a similar income stream.

In our March PRM, the most highly discussed fixed-income substitute was utility stocks. Utilities are interesting in that they’re a somewhat private-public partnership. Take Xcel Energy for example—our Denver-metro energy supply company. Years ago, Xcel Energy signed a deal with the city of Denver that promises a rate of return to Xcel and the ability to increase rates relative to their expenses. In return, Xcel will provide energy to households in the greater Denver area.

Thus, if Xcel is guaranteed a stated rate of return on the energy provided, they can pay more steady income to investors through dividends. On the other hand, they’re capped at that rate, which limits potential gains.

Our team also touched on Real Estate Investment Trusts (REITs; pronounced: “reets”). The 2008 financial crisis left many REITs battered; however, some specific real estate sectors may be on the verge of recovery. Take commercial office space for example: Droves of corporations are moving into developed, mid-sized cities like Nashville, Kansas City, and Omaha.

If you’re determined to stick with bonds, you have other options as well, including floating-rate, preferred, and convertible bonds. Please note, when it comes to these potential fixed-income substitutes, a higher reward equals higher risk. Government Treasury bonds expose you to minimal risk. As you climb the investment ladder, utilities, REITs, and various other debt vehicles generally present more risk.  

FINAL THOUGHTS

[11:45] As part of our proprietary investment process (The Summit Investment Process), I regularly talk to multiple fund managers. The consensus is true throughout: they do not think interest rates will rise before 2023.

For many investors, low interest rates are good news, a green light even. Equities are more attractive to growth-seeking investors. Corporations can issue cheap debt to enhance their business. Small business owners can also take on more leverage.

If you’re a fixed-income investor, there is good news as well: bonds aren’t your only option. Pop the hood on your portfolio, and chat with your financial advisor to see if there are areas in which you can potentially increase your income stream.

If you have any questions about your portfolio, please do not hesitate to call our office at (303) 261-8015—our team of advisors would be happy to discuss your options. You may also schedule a free consultation here.

   

Sources

¹Fernando, Jason. “Bond,” Investopedia, 2 Feb 2021. https://www.investopedia.com/terms/b/bond.asp (Accessed 22 Mar 2021).

²“Daily Treasury Yield Curve Rates.” U.S. Department of the Treasury, (nd). https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield (Accessed 22 Mar 2021)

Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing includes risk including the possible loss of principal. No strategy assures success or protects against loss.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Bonds are subject to marker and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

Any quoted rate of return is a hypothetical example and is not representative of any specific investment. Your results may vary.

The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.

Companies mentioned are for informational purposes only. It should not be considered a solicitation for the purchase or sale of the securities. Any investment should be consistent with your objectives, time frame and risk tolerance.

All information is believed to be from reliable sources; however, Denver Wealth Management, Inc. and LPL Financial make no representation to its completeness or accuracy.