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Fixed Income – Know Your Risk

There is a general consensus among market strategists that higher interest rates are on the horizon. Some expect substantially higher interest rates in the years ahead. That said, anyone investing in fixed income investments, whether that would be corporate bonds, municipal bonds, preferred securities, bond mutual funds, or the like need to be keenly aware of the risks to the principal value of these investments when rates rise. As interest rates have fallen, investors have been tempted to move into longer term maturity fixed income products to pick up higher interest rates. That’s all well and good when rates are stable or falling. The problem arises when rates begin to rise. A rising interest rate scenario can have a significant negative impact in the value of fixed income investments. The impact is typically more pronounced on the pricing of long term maturity products. As a general rule, fixed income products with the longest maturities and the lowest coupons will be impacted the most. The reason for this is because of the inverse relationship between bond prices and interest rates. In other words, interest rates and bond prices move in opposite directions. So, if interest rates rise, the underlying value of the bond goes down just as the reverse has held true as interest rates have fallen. This valuation is even more pronounced when the fixed income product is leveraged.

I have been an investment advisor for nearly 30 years. I remember early on in my career when fixed income investors would come into my office with bonds paying 3 and 4% that they had purchased years prior. I thought to myself then; why are these investors holding this paper when interest rates were double digit? If those bonds were sold into the market at that time, they were only bringing 50 cents or so on the dollar. Imagine the dilemma. You could buy bonds paying 10% with new money and you’re holding bonds only paying 3-4% that you would lose 50% of your money on if you sold. How did this happen? I suggest complacency. Those investors felt comfortable with their bonds and maybe didn’t realize the tremendous negative impact to the current value of the bonds.  I implore all fixed income investors- DON’T BE COMPLACENT-TALK TO YOUR ADVISOR-UNDERSTAND THE RISK TO YOUR PRINCIPAL!! What I am most concerned about is income investors being faced with rising rates will again be complacent, just as they were 30 years ago, because they have had above average returns in these products for a very long time and have developed a false sense of comfort, a false sense of security.

We have recently witnessed a “warning shot across the bow” so to speak when Ben Bernanke announced a possible decrease in bond purchases (QE) by the Fed. Just the possibility was enough to spook the bond market and push the yield on the 10 year Treasury bond from 2 to 3%.  Think about that for a minute. The rate on the 10 year USTY increased 50% in a matter of 60 days! Imagine the impact to the principal value, particularly if rates had continued to rise. In that same period of time we witnessed leveraged bond funds, long term, low coupon preferreds and bonds get hurt the most, some over 20% to the downside. If 20% or more downside market loss is not to your liking or does not meet your investment objectives, I urge you to speak to your advisor.

I can’t say when rates will trend upward for an extended period of time, all I can say is it will happen. So what can fixed income investors do to protect themselves from a rising rate environment? Have a plan in place. First and foremost, know your risk. Now more than ever you should consider working with a financial advisor.  If you rely on fixed income investments to supplement your livelihood you need to carefully review your holdings. You should be having serious conversations with your financial advisor. At Delta Trust Investments, we have the ability to “stress test” your fixed income holdings. That is, we can run a report showing what would likely happen to the value of a bond or other fixed income product if interest rates increased by 1, 2, or 3%. Don’t be complacent. For a complementary analysis of your holdings, call us at 501-907-2297 or 1-877-349-9333.

James Alger
President | Delta Trust Ivestments, Inc.
jalger@delta-trust.com

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