Conservative does not equal short-term

Conservative does not equal short-term

by Doug Drabik, Fixed Income, Raymond James

The probability of a rate hike in March is 8% while the probability of a rate cut is 0%. The probability of a rate hike does not even reach 50% for the entire year now. The extremely stubborn core rate of inflation actually ticked up last week yet did little to change the general bond market tone. CPI less food and energy rose 0.3% last week.

12/31/15 02/22/16
1yr 0.600% 0.533% -6.7
2yr 1.050% 0.772% -27.7
3yr 1.308% 0.933% -37.6
5yr 1.761% 1.258% -50.3
7yr 2.092% 1.546% -54.6
10yr 2.270% 1.770% -50.0
30yr 3.016% 2.624% -39.2

As shown above, yields on U.S, Treasuries across the yield curve are down for the year. Global affairs, commodity prices, inflation and the dollar are likely to continue to dampen the potential for a robust economic gain. As I remind so often, interest rates have been on a general interest rate decline for over 34 years, 4 months. Is it implausible to think they continue that direction for another 6 months? 12 months?

Often times it is stated that fixed income securities represent the “conservative” part of the portfolio. What exactly does this mean? Equities, MLPs, real estate, insurance products… all typically represent more aggressive means and theoretically better tools for asset growth. Higher quality fixed income securities generally should be the safe haven assets providing predictable cash flows and income, barring a default event. Conservative does not however, translate to short-term. A decision to invest short-term implies a certain call that interest rates are going up. Certainly if we could predict interest rates, what investor wouldn’t have been stocking the portfolio with the longest, highest yielding investments that fit within their credit parameters over the last 34 years? In hind-sight, low yielding short-term investments have robbed the portfolios of income for years.

This is not to suggest that investors should load up on the longest fixed income investments they can. The point is that investment grade fixed income securities do indeed formulate the foundation of conservative portfolio assets, but not necessarily because of their maturity/duration. They are conservative because of their predictability of cash flow and income and because they have a maturity date. Particularly for buy-and-hold investors, the maturity date establishes the opportunity to generate income and be assured of returned face value of investment, regardless of interest rate movement over the holding period.

Outside of bond characteristics, a conservative yield curve position to invest fixed income securities may differ by investor. An offset to aggressive growth asset investments may dictate locking into longer defined income streams. A general conservative yield curve position may be to ladder maturities in the belly of the curve, thus maximizing yield while mitigating interest rate risk. The beauty of the fixed income portion of investor’s portfolios is the ability to tailor it to specific needs. Just don’t confuse the conservative characteristics of cash flow, income and safety of principal with the length of maturity or duration.


Copyright © Raymond James

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