There has been an incredible number of incorrect predictions regarding interest rates over the last several years. Economists, Market Gurus, and TV Commentators have all been wrong when trying to predict the timing of the interest rate cycle. These predictions lacked two key ingredients that were needed to start us on a path to higher rates; an improving economy and a committed Federal Reserve. As we now see both of these occurring, the media can’t stop their endless chase for ratings trying to make a huge story of the 10-year treasury crossing the 3% mark.
As our Chief Bond Analyst, Lew Coffey, said this morning, “As long as rates are rising in response to an increase in demand for credit as the economy grows, without an acceleration of inflation, the cycle remains intact. As soon as the Fed begins to get ahead of the cycle, tightening in an effort to decelerate inflation, the cycle is over! So, the fact that the 10-year treasury crossed the 3% line at this point is totally meaningless and simply eye candy for the media and the uninformed”. As you see from the image, going back to 1870, the 10-year treasury has averaged 4.57%.
One very important point in regards to fixed-income strategies is that certain holdings are appropriate for certain economic situations. Not all fixed-income is created equal. For example, Windsor’s short target duration strategy and diversified approach will benefit from higher rates, whereas owning long maturity bonds will not.
Let’s review just two of the main reasons people own bonds, or have an allocation to them in an investment portfolio.
The first reason is simply because bonds, over time, should outperform money markets and CD’s. For many investors, there is simply no need or desire to accept the risk and volatility of the equity markets. The lower returns of a conservative portfolio is a tradeoff that many are willing to accept for a higher “sleep tolerance”. The only obstacle is keeping envy in check as equity returns outperform bonds over longer periods of time, as they always have.
The second reason to own bonds (or a diversified mix of fixed-income) is to act as a ballast to smooth out the waves of volatility in a diversified investment portfolio. An allocation to bonds will normally reduce the volatility of a portfolio that includes equities. History shows us that over 5-year rolling periods, equities outperform bonds, and bonds outperform cash. However, the equity markets are unpredictable in the short-term (under 5 years) and structuring a portfolio to reduce volatility may be the appropriate thing to do in many specific circumstances. Pullbacks, corrections, and bear markets have an ability to distract and derail a client from their long-term goals and objectives. Emotional decision making, media hype, and market timing are just some things that rock the boat and can lead to “jumping ship”. Having an allocation to fixed-income often smooths out the ride, provides income to assist with total return during equity turmoil, and creates less stress and anxiety.
Not everybody should own just bonds, and not everybody should own just equities. However, understanding the reason for owning just bonds, or just equities, or in most cases a proper mix of both, plays the important role of helping you stick to your long-term plan. One of our founding goals is to make sure clients enjoy retirement with good cash flow and without the worry of running out of money. Planning to achieve this goal starts early and only survives with discipline. Don’t hesitate for a minute to discuss any of the above with your Windsor manager.