Interest rates are doing the financial markets version of the limbo. Lower, lower, lower in a back wrenching display of fear-driven buying of riskless short-term U.S. Treasuries and Certificates of Deposit. These short U.S. Treasuries with no risk of principal or interest rate movement have rallied tremendously over the past months. As we write this a 3-month Treasury bill is yielding 0.31%, a 6-month returns 0.50% and a 2-year U.S. Treasury note only has a yield of 0.99%. This search for safety has worked its way into the money market yields that investors cherish as short-term havens for their “safe and liquid” monies. A year or ago, many of these money markets were offering yields of 4.6% to 4.8% and they are now somewhere in the range of 0.5% to 0.75%.
The rally in the Treasury market, debt instruments backed by the full faith and credit of the U.S. Government, has coincided with volatility in the stock market and general uneasiness in the Federal Agency, Corporate and Municipal credit markets.
First, let’s take a look at some of the basics of bond investing. Generally speaking, three factors affect the value of your bonds, the maturity date, the interest rate and the credit quality. Quite often, these three factors influence each other and do not act independently. Issues to remember when investing in bonds include. When an investor extends the maturity date of a bond or of a bond portfolio, changes in interest rates or changes in the perception of the ability of the issuer to pay off the bondholder upon maturity, will have a greater impact upon the current value of the bond. Two, when interest rates decline, the current value of a bond generally appreciates. There is therefore an inverse relationship between interest rates and bond prices. Declining credit quality or downgrades of credit rating is always a concern to the owner of a bond. Three, the further away the maturity date of a bond is from now, the more volatile the price of the bond will be.
Currently, we strongly advise that bond investors have a close eye on both the average maturity of their bond portfolio as well as the credit quality. As noted above, longer duration bonds are generally more volatile than shorter ones and if interest rates should rise, investors who make longer commitments at these levels will not be happy with the interest rates that they receive. These are the pitfalls of longer-dated maturities.
On the flip side, the danger with short maturities is that when the bond matures and it comes time to renew, investors are now facing issues with lower rates. What is a bond investor to do? Clearly the appropriate strategy in this environment is to ladder your maturities, which requires that an investor buys bonds over a series of maturities. For example, an investor with $100,000 to invest can create a “ladder” by purchasing ten bonds, each for $10,000 that mature over an equal period of one to ten years. This may sound obvious and many investors may balk at making longer commitments at lower interest rates BUT there are no rules that demand interest rates move higher from these historically low levels. Playing it safe makes sense with interest rates as volatile as they have been lately.
Another possibility is to consider dividend playing stocks for a portion of your fixed income assets. Granted, this asset class offers no FDIC insurance or government guarantee but does provide investors which competitive income. Another advantage with equities/stocks is many of them have histories of boosting their annual dividend payouts. This strategy is not for the investor who desires no risk of principal or fluctuation but does make a ton of sense for investors seeking total return over longer periods of time, perhaps three years or more.