Municipal Market Commentary – October 20, 2014
Reaching For Yield May be Reaching For Trouble
Recently the Federal Reserve’s Federal Open Market Committee (FOMC) released its most recent guidance on future Fed action. The message was clear-The Fed plans on holding short term interest rates near 0% for a “considerable time”. This has been the Fed’s consistent language for some time.
While individual fixed income oriented investors are clamoring for higher rates, the Fed’s policies are driven by a broad set of goals that do not include increasing the income of bond investors.
One of the Fed’s prime directives is the stabilization of the labor market. While unemployment rates have fallen to 5.9% in September from the 10% peak of the recent “Great Recession”, the needs of the labor market still rank high on the Fed’s to-do list. “On balance, labor market conditions improved somewhat further . . .” the Federal Open Market Committee (FOMC) said in its statement. “However, the unemployment rate is little changed and a range of labor market indicators suggest that there remains significant underutilization of labor resources.”
While Fed actions are still keeping rates low, most Fed watchers and FOMC members seem to project a rise in interest rates within the next two years. These higher short term rates, when they take effect, may be welcome from investors currently waiting on the sidelines. But be careful what you wish for.
When interest rates drop, those seeking higher returns may buy the following to obtain higher yields:
1) Lower credit quality.
2) Longer maturities.
The potential impact of lower credit quality to an investor’s risk profile is somewhat obvious. If a given portfolio has a lower credit quality, the potential risk is greater.
Longer maturities are more price sensitive to changes in interest rates than shorter maturities. As rates go up the value of bonds go down. However, single issue bonds typically pay a fixed rate of interest and if held to maturity or an earlier call date, the investor, in addition to regular interest payments will receive the full face value of the bond at redemption.
With current general market uncertainty over future Fed action, what is an investor to do? The first step is to ask the basic question required of all successful investors: “What am I trying to accomplish?” The answer for many fixed income investors is, “I want income.” The solution then is really pretty simple; Buy the highest quality bond providing the best return currently available.
But what happens if the Fed does increase its rates as many market experts are predicting? Won’t an investor be better off waiting for the Feds action and the “inevitable” increase in bond yields? A look back at historical activity can be instructive, even though past performance does not guarantee the same results.
The last time the Fed aggressively raised the Fed Funds Target Rate was from June 2004 through April 2006. During that time the FOMC continued to raise the rate, with single period increases of no greater than 25 basis points (i.e. 0.25%), moving it from 1.00% to 5.25%. And what happened to the market rate for the benchmark 30 year U.S. Treasury Bond? That went down from 5.289% to 5.187%. If an investor had waited for the Fed’s rate increasing to reach its peak before investing, not only would they wind up buying bonds that were paying a lower rate than was available at the start of the Fed’s actions, but they would have lost almost two full years of income.
So once again the simple answer: buying the highest quality bond providing the best return currently available, may turn out to be the best answer. Over time, that approach will provide diversification of maturity, coupon and issuer, protecting an investor’s portfolio form the roller coaster ride of rising and falling rates.
Investing in bonds involves risk including the possible loss of principal. Income may be subject to state, local or federal alternative minimum tax. When interest rates rise, prices will fall, when interest rates fall prices will rise.
Our Trader’s Analysis charts the movement of Fed Fund Target Rate and 30 Year U.S. Treasury Bond market rate from June 2004 through April 2006.
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