Turbulent Bonds

Current market dynamics reveal the difficulties in predicting market outcomes. As of this writing, the Dow Jones Industrial Average stands at a record high and, simultaneously, interest rates have risen dramatically from pre-election levels. Just as the pollsters showed that their crystal looking glasses suffered from severe cataracts, traders erred with similar aplomb. The post-election reaction has been swift and material for bond yields and borrowing rates. The cost of borrowing for the US Treasury snapped higher, and the ten-year rate currently stands at 2.39% – a 31% increase over the level immediately prior to the election.

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The new administration is perceived as adding significant capital outlays to fund national infrastructure projects and defense, while simultaneously reducing the inflows to the Treasury via material reductions in tax rates. Economists additionally surmise from the Fed’s guidance that short-term interest rates will increase by a quarter percent in December, with further rate hikes expected for next year. These forces combine with a strengthening dollar, newly increased inflation expectations and a general fear of the unknown, to increase yields across the curve.

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What has this meant for investors? Stating the obvious is in order: increases in interest rates punish the prices of fixed-income holdings as the value of future payments are diminished by both increases in real rates and rising inflation expectations.

At Farr, Miller & Washington we employ bonds as a ballast for our clients’ portfolios. Our bond buying has been defensive in nature with an aim at providing meaningful income while protecting against a future increase in rates. We do not employ bonds as a means of adding risk for our investors. Rather, the intention is to reduce over portfolio risk. Each portfolio is custom built, and we generally buy smaller lots of individual blocks of bonds that have defensive characteristics. For example, in recent years we have bought highly rated, high-coupon bonds that are subject to a call prior to maturity. These bonds are known as “kickers,” as they pay the holder an attractive yield to the call date. But if they are not called, the client’s yield rises considerably. Our average life or effective duration has been held within five years. This means that approximately 20% of the principal comes due each year and can be reinvested at more attractive rates (in a rising rate environment).

Many individual investors have established their fixed-income allocation via bond funds and ETFs. Years of declining interests rates have generated strong returns in bond funds; however, the risks associated with a fund’s investment model can be difficult to assess. Current conditions reinforce the benefits of carefully constructed portfolios for which you have clear transparency as to what you own.

For all of the changes that the market has experienced this year, the chart of Treasury yields from this date in 2015 as compared to today adds context. Rates remain low on a historical basis, just not as low as they were when the month of November commenced.

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We remain committed to the conservative stewardship of our clients’ assets, with bonds representing a pillar of stability in what can be an uncertain marketplace. Years of defensive grounding mean that the current rising rate environment represents an opportunity for our maturing assets. Please let us know if we can help you take advantage of these prospects as well.

We would like to take this opportunity to express our gratitude for our many wonderful clients and their families. We wish you all a Happy Thanksgiving and a prosperous end to 2016.