Someone asked me what I heard in my office when the Dow plunged more than 700 points, and at one point, 946 points, on July 18. My answer was: “Crickets.”
With these kinds of moves in the stock market, and these two-point moves on the long end of the bond, we have grown accustomed to these bigger moves. Basically, a few hundred points on the Dow is nothing nowadays.
On top of that, with what we’ve experienced in the past year with volatility, we’ve seen some extreme swings and negative prices in the oil market. Investors and traders have become kind of numb over these moves that are not even considered “big” anymore.
In my position, I can see what’s coming on. Typically, there is a lot of overreaction. But when the dust settles, we usually return to where things started. It’s just the nature of the beast.
A Large and Attractive Market
I am not just a corporate bond guy; I trade tax-free municipal bonds and taxable munis too. Most of my recent buys have been munis with a corporate bonds mixed in.
Municipals are a rich market and we do see a lot of buying. Spreads are tighter over the past six months, but it is no wonder that people keep buying munis. Being the world’s biggest market, there will always be a demand despite its low rates.
We have been in a low rate environment for a very long time and people have gotten comfortable with that. I guess you could say it is becoming the new normal for fixed income investors. Expecting a 4-or-5 percent 10-year Treasury is almost a dream at this point. But, people would happy with a 3 percent Treasury by adjusting their expectations.
When you read that the bond market’s 5-year inflation forecast is now lower than it was in mid-March, remember everyone has his or her own expectations. You have economists with counter arguments and the Fed with theirs. I say take it with a grain of salt. To me, everyone is kind of guessing. When you think you know something, it’s really just a wild guess.
If you take anything away from this article, know that a lot of people have inflation fears right now. We all see the price increases on food and goods and services. That’s a genuine fear, and one that’s difficult to just put aside. But remember, too, there is nothing that we can do about it and that everyone has a different view about its duration and intensity.
Diversification and Strategy in a Low-Rate Environment
Inflation or not, it is important to diversify and to build a bond ladder. You want to ladder it out and not put all your eggs in one basket. What is a bond ladder? It is extending your maturities.
We want to go down the bond yield curve by buying a block of maturities, let’s say, ‘23, ‘24, ‘25, ‘26, etc. (These are the years the bonds will reach maturity). By doing it this way you expose yourself to a decreased or minimal risk of interest rate risk. Your portfolio performs with less volatility as you go down the ladder. Your rates are going to move, as you would expect, so position each bond accordingly.
You want to buy a few bonds at least at 2-or-3 percent – and not lower coupon bonds, because they don’t perform very well. This may sound familiar to you if you have ever purchased a CD ladder. It is similar to that. The rates are going to change and you want flexibility.
In three years, you might want to invest at a higher rate. So you want to minimize your interest rate risk because interest rates are going to fluctuate. Building that bond or CD ladder minimizes that interest rate risk. You might have money coming to you in three years and use it for a special project or something equally important to you.
Some people feel that callability is a risk. The callable bond features means the issuer can redeem (or call) the bond prior to maturity. I wouldn’t say it is a risk; I would say it is a characteristic. Sometimes you can look at it as a positive-buying characteristic too.
For instance, we’re buying longer muni bonds that mature in 15 years. I am looking for a bond that has a call of ‘25, ‘26, ‘27, basically, at the call as a possible buy. When you’re looking at a callable bond, you’re getting at that yield-to-call at 1.03 percent in this market. That is the yield-to-call in ’26.
If you’re trying to get 5-year returns, but the bond is a ’35 – which might be called in ’26 or it might not – you’re getting that extra “kick” when it doesn’t get called. That might be an extra 1-or-2 percent. Now, if you want to buy a 5-year muni, you’re going to get 0.75 percent.
If you’re going to buy a callable bond, with a call date of ’26, you’ll probably get a 1.20, 1.30 percent yield. You’re getting 50 basis points extra, give or take, which is why callable bonds are very attractive in this low-rate environment. Why not get an extra 50 or 60 basis points versus buying a bond and simply letting it mature in four or five years?
Volatility Based on Maturity
The longer you go out (the longer maturities) the more pervasive volatility becomes. That’s because you are exposing yourself to a longer holding period. One way to minimize volatility in the bond market is to buy a higher coupon bond. They perform better. If you are going to buy a longer maturity, stay with a 2.5 percent coupon and up. Actually, 3 percent and up is really preferred, which is the best way to minimize volatility if you are going to buy a long bond.
We can walk you through it all if you’d like. Just ask your Hefren-Tillotson advisor for details.