On September 2, I wrote on The Fragasso Blog an article titled “Follow the Money”, whereby I explained the current state of the bond market and the staggering inflows of money into that sector. At the time, the yield on the ten year treasury (which is used as a barometer of interest rates) stood at 2.6%. A few weeks later it reached a low of 2.38% not seen since the Eisenhower Era, before making a steady and at times rapid increase, eventually settling at the current 3.42%. That is a 1% rise in just a few months. The difficulty for investment managers in a rising interest rate market comes in the form of declining bond values and increasing yields. This is offset by interest payments but ultimately rising rates put pressure on the total return. The once steady and sleepy market for bond investors became a whole lot more complicated.
To illustrate the warnings and context of that rise in the ten year treasury, Bill Gross of Pacific Investment Management (PIMCO) has voiced his opinion that the 30-year bull market in bonds may be over. This is certainly a worrisome remark from the largest and arguably the most successful bond manager. While his remarks should be taken into context to recent Federal Reserve actions and as a piece of a larger conversation, it continues to highlight the challenges we are all presented with in the bond market.
Bonds essentially spoiled us since the early 1980’s when inflation was double-digit until it was curtailed and finally at current levels. If anyone had purchased a home during that time, you may have bargained for a 15% mortgage rate! They are less than a third of that now. Declining rates tend to produce strong returns from increasing bond values, exactly what we were spoiled with since the early 1980’s. Moving forward, bonds may not have that tailwind behind them, but certainly can offer returns commensurate with the goals they are intended for, lower risk, income, and stability. Understand a rising interest rate market also signals improvement in the overall economy especially given the tax cut extension and recent economic data. This bodes well for certain sectors of the bond market.
While Bill Gross attempts to set expectations for bond returns moving forward, we have not abandoned that sector, nor will he. Our confidence in his management remains steadfast, but we have some advantages that would be his envy, that of flexibility.
The previous blog mentioned we continue to seek appropriate bond and bond alternatives to meet the objectives for that portion of investor’s capital. We have over-weighted emerging market debt and the corporate bond market. We intend to avoid certain areas, such as U.S. Treasuries and some agency debt that we feel has reached fair value. And finally, we employed such strategies that are impervious against rising interest rates and offer little correlation to the bond market. Bonds will offer continued attractiveness for meeting the investor’s objectives, but our confidence resonates with the flexibility we are afforded.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise. Bonds are subject to availability and change in price. Stock investing involves risk including loss of principal. CD’s are FDIC insured and offer a fixed rate of return if held to maturity. 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. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
Daniel Dingus is Managing Director and Chief Portfolio Strategist at Fragasso Financial Advisors, a Pittsburgh-based investment and financial planning firm. Due to industry regulations, comments are not permitted on this blog. If you would like to contact the author, please email us at blog@fragassoadvisors.com. Dan can also be reached for comment at 412-227-3200.