In today’s market, more and more people are looking into fixed income: an investment approach focused on preserving capital and income in the form of a reliable income stream, typically with lower risk than stocks. In this episode of The Agent of Wealth Podcast, host Marc Bautis is joined by Bautis Financial Planner Kayla Waller to talk about the considerations an investor should make before adding fixed income investments to their portfolio.
In this episode, you will learn:
- The various kinds of fixed income investments.
- How interest rate changes trickle down to bonds, mortgages, savings accounts, etc.
- The risks associated with investing in fixed income.
- Fixed income strategies, such as bond ladders.
- And more!
Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. On today’s show I brought on special guest Kayla Waller, our Financial Planner at Bautis Financial. Kayla, welcome to the show.
Hey Marc, thanks for having me.
Today we are going to talk about if now is a good time to add fixed income investments to your portfolio. While Kayla was in the Financial Planning Program at Virginia Tech, she did a lot of research on fixed income, so I thought she’d be a great person to join me for this conversation.
Before we get started, I’m going to give a spoiler to the question of “Should I add fixed income to my portfolio?” Like most things in finance, the answer is it depends. Everyone’s situation is different, in terms of what they are looking for or need from their portfolio. In some cases, fixed income is a great fit. In other’s, it’s not. We’ll get into what to consider when making that decision.
As interest rates were declining over the past 15 years, a lot of people shunned fixed income investments. But as interest rates have risen over the past year, more and more people are considering it – and asking us about it.
Kayla, can you start off by giving us an overview of what a fixed income instrument is, and the different types of fixed income that are available to investors?
Different Types of Fixed Income Investments
Fixed income is a class of assets that pay out a set level of cash flows to investors. When securities reach maturity, investors are repaid the principal amount they invested as well as any interest they have received. Common fixed income products include Treasury bonds, municipal bonds, corporate bonds, high yield bonds and CD’s. There are also fixed income mutual funds and ETFs.
Government and corporate bonds are the most common types of fixed-income products. Companies, governments and other entities issue debt securities to raise money to fund new projects or ongoing operations. For corporate bonds, in the event of a company’s bankruptcy, fixed-income investors are often paid before common stockholders.
How Interest Rates Change
The Federal Reserve controls the money supply. The Fed’s two goals are:
- Price Stability, and
- Maximum Sustainable Employment.
To achieve these goals, the Fed will follow easy monetary policy during periods when they want to increase the money supply to expand levels of income and employment. During times of inflation, the Fed wants to constrict the money supply. This in turn means there is less money available for banks to lend, which leads to an increase in interest rates.
The Fed has several ways they control the money supply. One way is by adjusting reserve requirements. Banks are required to keep a certain percentage of deposit liabilities held in reserve. Another way is by adjusting the discount rate, which is the rate at which banks can borrow from the Fed to meet their reserve requirements. Increasing the discount rate increases borrowing costs, which discourages banks from borrowing, leading to a decrease in the supply of money. The opposite is true when the Fed lowers the discount rate. The third, most common method the Fed uses to control the money supply is through open market operations, which is the purchase and sale of government securities in the open market. The Fed buys securities causing more money to be in circulation. The Fed sells securities to restrict the supply of money, when investors purchase the securities, the money is leaving circulation which decreases rates.
Since the Fed raised rates, banks can borrow funds from the Fed at a more expensive rate. Banks pass the costs on to banking customers through higher interest rates charged on personal, auto, or mortgage loans. This creates an economic environment that discourages consumer borrowing and ultimately leads to a decrease in consumer spending as rates rise.
How does an increase in interest rates affect the price of bonds?
How Interest Rates Affect Bond Prices
Bond prices and interest rates move in opposite directions. When interest rates fall, the value of fixed income investments rises, and when interest rates rise, bond prices fall in value.
Analyzing the duration of a bond is a good way to see how sensitive the holding is to a potential change in interest rates. Duration takes into account the bond’s characteristics like the maturity date and coupon payments. For example, if interest rates were to increase by 1% a bond with a 10-year average duration would lose approximately 10% of its value.
Adding bonds is not just about the interest you receive, as they can be a diversifier against a stock market drop as well. Can you talk a little bit more about this?
Sure. During most one-year periods over the past 20 years, stocks went up when bond prices fell and stocks went down when bond prices went up.
Bonds are competing with stocks for money. Bonds are generally considered safer than stocks, and they usually offer lower returns. Stocks do well when the economy is doing well and bonds do well when the economy slows as investors adjust their appetites for risk.
Sometimes, both stocks and bonds can go up in value at the same time. This usually happens at the top of the market. There also are times when stocks and bonds both fall, like we have been seeing this year where there has been a selloff in both stocks and bonds.
Over time, research shows that diversification brings the greatest return at the lowest risk. You can change the mix, or asset allocation, of stocks vs. bonds to respond to the business cycle and your financial goals.
As with any investment, there’s risk involved. Even holding on to too much cash long-term can be risky, because it’s hard to combat inflation. What are some of the risks that come with investing in bonds?
The Risk You’re Taking When Investing in Bonds
There is a common perception among many investors that bonds represent the safer part of a balanced portfolio and are less risky than stocks. While bonds have historically been less volatile than stocks over the long term, they are not without risk.
The most common and most easily understood risk associated with bonds is credit risk. Credit risk refers to the possibility that the company or government entity that issued a bond will default and be unable to pay back investors’ principal or make interest payments.
Bonds issued by the US government generally have low credit risk. However, Treasury bonds (as well as other types of fixed income investments) are sensitive to interest rate risk, which refers to the possibility that a rise in interest rates will cause the value of the bonds to decline.
What Is a Bond Ladder?
A bond ladder is a portfolio of bonds, bond ETFs or CDs that mature at different times. Bond ladders are set up to manage two things:
- Cash Flows, and
- Interest Rate Risk
Imagine an actual ladder with rungs and everything. To determine how many securities you need in your portfolio, you take the amount you want to invest and then divide it by the number of years that you would like to have the ladder. For example, if you wanted to invest $100,000 over 10 years, you would need 10 securities and your ladder would have 10 rungs.
Most bonds pay interest twice per year. Investors who utilize bond ladders can generate predictable income based on coupon payments with different maturity months and years. This is important for retired individuals, because they can depend on the cash flows from investments as a source of income. Staggering the maturity dates helps smooth out the effects of a change in interest rates since investors are not getting locked into one single interest rate. When a bond matures, the principal gets reinvested in a new long-term bond on the end of the ladder. By staying disciplined and reinvesting the proceeds from the maturing securities, investors are able to deal with interest rate fluctuations.
Now there are bonds that adjust with interest rates and inflation. Can you talk a bit about those?
I Bonds and TIPS
The two inflation-indexed bond types issued by the U.S. government are Treasury Inflation Protected Securities, known as TIPS, and Series I Savings Bonds. Inflation indexed bonds interest payments increase, or decrease, based on the official inflation rate (CPI).
I bonds pay a fixed rate of interest as well as another layer of interest that varies with the current inflation rate.. The inflation adjustment is made twice a year. I Bonds issued May 1, 2022, yield 9.62%. I bonds are available only to individuals. Individual’s can purchase up to $10,000 of I Bonds per calendar year. I bonds reach their final maturity 30 years after issuance, but investors can redeem them 12 months after purchase. If you redeem an I bond within five years of buying it, however, you will lose three months of interest.
Treasury Inflation Protected Securities are bonds whose principal value is adjusted based on changes in inflation. TIPS differ from I bonds in that the interest rate doesn’t vary. Instead, the principal value increases or decreases based on changes in inflation. Individuals and other institutions, like mutual funds, can buy TIPS. They are sold in $100 increments, and carry terms of five, 10, and 30 years.
Normal Yield Curve vs Inverted Yield Curve
The yield curve plots the interest rates of similar bonds with differing maturities. Usually, when people are referring to the yield curve, they are talking about the yield curve for U.S. Treasury debt. The curve typically slopes upward. A yield curve inverts when long-term interest rates drop below short-term rates because investors expect short-term rates to decline in the future, typically as a result of poor economic performance. Essentially, it’s viewed as a signal that markets are expecting the economy to worsen.
One way to analyze the yield curve is by looking at the spread between two maturities. Unfortunately, there is no consensus on which spread is the most reliable recession indicator. Many investors look at the spread between the 10-year bond and 2-year bond or the spread between the 10-year bond and the 3-month Treasury bill. The 10-year to 2-year spread briefly inverted in the beginning of April, it is positive now, and the 10-year to 3-month spread has not inverted yet.
A yield curve that inverts for an extended period of time seems to be a more reliable recession signal than one that inverts briefly, whichever yield spread you are looking at.
Why Do Some Growth Stocks Drop in Price When Interest Rates Rise?
Rising rates hurt growth stocks, like technology companies. High growth companies are typically putting their cash flows towards growing their businesses, so they are churning a lot of cash. Rising rates are increasing these companies’ cost to borrow, compressing profit margins and ultimately slowing down overall growth. On the other hand, certain sectors, like financial stocks, do well during periods of rising interest rates. When rates rise, financials do well because higher rates means that banks are able to earn more from lending.
Alright, we’re just about out of time. Thank you to everyone who tuned into today’s episode, and thank you Kayla for joining me. If you’d like to see if fixed income makes sense for your portfolio, you’re welcome to schedule a complimentary consultation with our team.