Episode # 253 – Do Bonds Still Have a Place in Your Portfolio with Interest Rates This Low?

August 14, 2020

Interest rates are at historic lows.  Today, we discuss managing the bond portion of a diversified portfolio in the current low interest rate environment, that may not have reached bottom yet.  Joining us is Joe Cortese, Senior Consultant at DiMeo Schneider & Associates and member of the Cordasco Financial Network Investment Team. We also analyze indicators to help us better understand the direction interest rates could be moving in the future.

Program Length: 24 minutes

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Transcription:
The content shared on your life, your wealth network reflects the views of the host and guests of the program only and are not necessarily the views of Cordasco Financial Network or its advisers. This media production is educational in nature and should not be construed as financial, legal or tax advice or a solicitation or presentation of sale of any financial products or services. Please consult a professional prior to making any financial tax or legal decision.

Welcome to your life, your well network, helping you find clarity and comfort for your life and well, now here’s your host.

Financial adviser and CEO of Cordasco Financial Network, Steve Cordasco. Welcome to the Your Life Your Wealth podcast.

As promised, we would talk in this episode about interest rates and bonds specifically with so much going on with the economy and the pandemic that’s taken place. Interest rates are at historic lows. And for many investors who have diversified portfolios like you, the question is where does the bond portion of a diversified portfolio go from here? In an interest rate cycle that is so low. So to help answer the question on bonds and interest rates, is Joe courtesy? He is principal and senior consultant at Tamayo’s Schneider, part of our investment team and who we rely on a Cordasco Financial Network. Hey, Joe, thanks for being part of today’s program.

Thanks for having me, Steve. It’s always great to be with you.

You know, this interest rate cycle that we’re in, lowest rates that we’ve seen in a lifetime. The interest rate cycle and specifically the bond market cycle is a very long dated cycle. It almost over a 30 year period. We’re now venturing that 30 year mark where interest rates hit their peak and now seems as if we’re at a low. Where does this cycle take investors?

Well, it’s a good question. And we may not be at the cycle lows, right? I mean, interest rates are low. Yes. But, you know, they’re they’re not zero. If you look at 10 year bonds in and out, and this could persist for for a long period of time. And that’s kind of the conundrum here is is, you know, particularly for investors that are in retirement and rely on their portfolios to fund their living expenses. It’s tough because of the low interest rate environment. But but that’s the market telling us that, you know, there’s some concerns about growth going forward here. And and, you know, there’s some concern about, you know, that the path forward and what that means for the economy generally.

So are you saying that looks as if we could be at zero? Are you predicting zero on rates?

It’s tough to make predictions. You know, I don’t I don’t have a crystal ball on saying that there is a potential that rates could continue to decrease from here. It’s not a foregone conclusion that, you know, we only go up from here now. Who knows? We could stay relatively stable for, you know, five or 10 years or something like that as well. And just kind of go, you know, trade and arrange it. You know, it’s it’s tough to predict what’s going to happen. But, you know, if you look at where we are today with, you know, still sort of clawing our way out from a global pandemic, a lot of political and social unrest. You know, it’s it’s. And if you look at what the markets are telling us, you know, we don’t see any major risk of runaway interest rates or inflation on the horizon. Certainly with the massive amounts of liquidity and deficit spending and those things that are taking place, at some point, you would expect higher interest rates and and maybe elevated inflation. But, you know, you look at the policymakers like the Fed and they’ve said that they’re comfortable allowing us to, particularly on the inflation side, have some above trend readings there for a period of time when it comes to the investment side of our listeners.

Total financial plan. Right. A total financial plan, a comprehensive financial plan will have a lot of pieces and components to it. One of the components that that we put together in those plans is an investment plan. And within an investment plan, it’s built around somebodies risk tolerance and how much volatility they can handle on their money.

The more risky they can handle their money to be, the higher the risk tolerance, the more aggressive they can be. But the more volatility that will be there. Someone who wants to muddle some of that volatility, meaning they get a little bit more nervous when the market starts swinging big on the downside and upside and moves around so much, they tend to try to muddle that by putting other types of investments in specifically bonds. But if you look at a total diversified portfolio that we might have foreign investor, there are certain asset classes that are sending us a message. Right. So the message right now coming from gold. Is it hey, inflation is likely on the horizon. Is that which moving gold or is gold moving for some other reason? And the reason why I’m using gold is because I’m looking to see if gold is sending me a message about the future of interest rates and therefore, should I be doing something in the bond side of investors portfolio.

So let me I’ll answer the gold question. Second, let me just speak first to the role bonds play in a portfolio because it’s very important. And Bonds act as that ballast, that core of the portfolio that is designed to meet volatility at the overall portfolio level. Because, you know, historically, you look at bonds, you look at other risk assets like equities. Bonds have exhibited less meaningfully, less volatility. And they also tend to hold up very well in very difficult environments, like what we saw in March during the height of the cold 19 panic, where investors sell riskier assets because of that uncertainty. And they typically, you know, go to safer assets like like bonds and sort of that safe haven dynamic that we see in difficult markets. And that’s the role that bonds play. We don’t necessarily add bonds and portfolios because we think there’s got to be a tremendous amount of capital appreciation there. We do know we like the yield in the consistent and predictable yield that we get from bonds, but it’s low today. That’s the environment that we’re in. But the other role of bonds is to act as that store of value when other riskier assets are selling off. And then when we you know, we use the models that we have to tell us, OK, riskier assets have declined in value, enough that the portfolio is out of whack from where we want it to be. And we can take some of those assets from the bond side of the equation that have held up better and reinvest those on the risk side or within equities in those riskier assets at lower valuations and lower prices. And we can do that over and over again. And a rebalancing methodology and in that way were were selling high and were buying low over and over again, which is what we want to do. So that’s a very important aspect of all of this, is that the role bonds play in a portfolio is very important. And it’s not necessarily about the return that we get from bonds. That’s part of it. But it’s also in protecting value in difficult markets and reducing the volatility of the portfolio at the overall level.

Well, kind of playing devil’s advocate then. Sure. Then could there be an argument given that why even take the risk that if rates spike up because the Fed gets nervous with some inflation number that comes out, they start really getting aggressive on the rate side. We’re going to lose money in bonds is just the way it works, right? The interest rate right now is not high enough to absorb heavy volatility on the principal side. So given that for somebody who says, hey, look, why would I play it this way with bonds and take on that risk that we’re not at the bottom of the interest rate cycle? Many would say they think we are in that there could be losses coming from the bond side.

Given that, could you make the argument that in today’s low current returns on bonds, a cash might be a better play, even though cash is at zero, meaning you still can’t lose principal? But with rates so low on bonds, you can lose principal.

That’s true. We would argue that cap, that bond still represent a better risk reward trade off relative to cash because any any assets in Gazzard are by definition going to be losing purchasing power as inflation is not zero, inflation is more than zero, and therefore cash, which which earns zero today, will not beat inflation. And therefore we recommend and we and we utilize bonds over cash for that reason. And there are things you can do to mitigate the risk on the bonds. I mean, things that we do in portfolios, we have different types of bonds and portfolios. We have some allocations to Treasury inflation protected securities or tips. And as inflation expectations increase over time, our allocations to tips will increase. Concurrently, we have different types of within. We’re even within core bonds. There are different types of bonds that we can use. We can use treasuries, we can use agencies, we can use corporate securities from different different credit qualities and different durations. And that helps mitigate volatility and then things like bonds from other countries around the world. High yield bonds, emerging market debt there. There we can we can diversify out the types of bonds that we hold. And also within each of those, as I said, broad sort of bond sub asset classes. You can have different credit quality. You can have different durations or maturities. And so there’s quite a bit you can do to mitigate the risk of potential increases in interest rates. And one thing I’d point out is this fear of of, you know, substantially rising interest rates. That’s a risk, no doubt. But we would say that’s a low probability risk if you look back to World War Two. There’s been six or seven periods of sort of quote unquote, rapidly increasing interest rate cycles and even those periods you haven’t seen sort of runaway spikes. And the other point about it is rising interest rates can actually be a good thing in that while there may be some short term loss of decline in principal as bonds come due. So, I mean, you hold them to maturity, you can then reinvest the principal at the higher interest rates. And so if you look back in time and you measure the periods where interest rates have kind of spiked up again, it’s been six or seven periods since World War Two. Total return throughout those periods is actually positive because of that reinvestment dynamic. If you if you stick to the plan and you reinvest as interest rates are rising.

OK. So over those inflated interest rates cycles where all of a sudden it’s sort of a rogue spike in rates. You’re saying during that slow process of that happening that people were still able to make money in bonds? Hate tips. So for many of the investors at Cordasco Financial Network, tips are part of the bond portion of their portfolio. Talk about tips and how they work and what’s the percentage of allocation today for a moderate type investor with regards to exposure to tips and tips or just one of the type of asset classes in a total bond portfolio mix? So I’d like to go from tips to maybe high yields and some short duration stories, but let’s start with tips. So Tip is sort of an acronym. It stands for the T is Treasury Inflation Protected Securities. I know we don’t say bonds because technically, Joe, they’re not bonds, but they fall into the fixed income bonds side of a portfolio.

They’re different than most traditional bonds in that their prices adjust based on inflation expectations as opposed to regular bonds. Prices adjust based on interest rate movements. As interest rates go down, traditional bond prices go up. And as interest rates go up, traditional bond prices go down. Just a mathematical function. Tips are different. As I said, in that their prices adjust based on inflation expectations. And so the way it works is if inflation expectations are rising. So we there are market derived measures of inflation expectation.

If those measures are increasing, meaning we the markets are telling us there’s likely to be more inflation in the future. The price of a tip triggered inflation, protected security goes up. And conversely, if inflation expectations are declining, the price of the tips bond goes down. So that’s how they protect against inflation, because if inflation is rising, inflation expectations are rising. The price of the tips bond is rising. And then, in most cases, traditional bonds. The opposite happens when inflation is rising. Typically, interest rates are rising, which is causing the price of traditional bonds to decline. So that’s how tips are different than traditional bonds.

And I know for those of you listening, some of you are saying, well, what part of the market tells us what inflation is doing? Is it the activity and the amount of demand for tips or is it gold or something that’s not related to a Treasury inflation protected security?

Yes, so there’s, you know, common common indicators like the CPI Consumer Price Index, which measures, you know, a basket of goods and the price changes over time that the Federal Reserve monitors. There’s a core price index within there that strips out more volatile categories like food and energy and just focuses on what they call core prices. And that’s one that the Fed focuses on, more so than the standard the standard consumer price index to mute some of that volatility, in essence. And then there are other things we can look at and it gets technical. But you can you can look at break even interest rate expectations in terms of where inflation expectations are today versus where bonds are trading today. And I can give you some sense of potential forward looking inflation. So there are a number of metrics that we can look at to get a sense of what markets think inflation will be like over there. So they’re coming in with in the future.

Are tips gaining a larger percentage of someone’s fixed income portfolio?

I do think they will over time. Today, our allocations to tips are relatively low anywhere from, you know, as small as one percent in aggressive portfolios to three, four percent in conservative portfolio. But the overall portfolio level, not just within fixed income.

And is that because your expectation of future inflation is not high at the moment?

That’s correct. All the indicators today are telling us that inflation expectations or inflation, at least in the near term, will remain relatively subdued and far below the Fed’s preferred measure of two percent over time. But to your point, you know, looking at gold and other things, you know, there is some, you know, potentially early signs that inflation expectations are likely to increase in the future. In fact, the CPI for July was released. CPI rose zero point six percent in the month of July. We are increasing in from from June to July. And that’s a that’s a big increase in one month and it’s a one percent increase from this time last year. In fact, that’s the largest monthly increase since 1991. So about 30 years or so now, the Fed said that that is likely as a result of more so supply disruption because of kov it and those sorts of things, as opposed to like sustained price increases.

But you look at you look at that. You look at the dollar, which has weakened substantially about 10 percent over the last three months.

And you look at things like gold and silver and then you see increasing prices there. Now, I think a lot some of that has to do with just some momentum factors and some sort of US trading issues that are distorting those markets a little bit. For example, silver was down 13 percent. And one day earlier this week, I think it was Tuesday, which is the largest one day drop since the Lehman bankruptcy. And that gives you some sense that there’s some other factors at play there. More than likely, just short term trading and speculating. But no doubt gold has increased recently. And, you know, and then and then the inflation expectations or the CPI readings, which have risen, too, you know. And you think back just logically, the amount of debt that we’re incurring, the deficit spending, the aid that’s being promised by the federal government, that is likely to stoke some inflation down the road. But it doesn’t mean that it’s going to be hyper inflation and it doesn’t mean that it’s going to be a disaster for financial markets. In fact, you know, some some inflation is a good thing here. Meaning that, you know, economic activity is coming back to life and and therefore, we expect slightly higher prices in the future. That’s not necessarily in and of itself about debt.

Joe Cortese sticking to the interest rate cycle and assuming maybe there’s risk in bonds other than we talked cash as a place to drift to to help protect volatility on a bond portfolio? What about shorter matured bonds? Shorter duration bonds is a strategy that can often fit into a portfolio, a diversified portfolio. What percentage right now can we tell our listeners of a bond portfolio of a moderate investor what portion would be short duration?

Duration is really a measure of interest rate sensitivity and it’s a function of the remaining life span of the bond. And the simplest example is this if a bond has a one year duration and interest rates increase by one percent, the corresponding price of that bond will fall by one percent. For example, if a bond has a five year duration and interest rates increase by one percent, the price of that bond will fall by five percent. For example. So, again, it’s it’s it’s a it’s a it’s a measure of of interest rate sensitivity for bonds and it’s based on the lifespan of the bond. That’s really what duration is. So when we say short duration, it means we have bonds in portfolios that have a very short lifespan and also have lower interest rate sensitivity due to that short lifespan. And in this environment, with the yield curve very, very flat, meaning interest rates on short term bonds are, you know, close to what interest rates on long term bonds are know, for example, the 10 year Treasury is paying 70 basis points today, not even one percent. And just a quick little aside here, at the beginning of this year, the 10 year Treasury was at one point eight percent. So you can see how how drastically interest rates have declined this year. But the point being, you’re not getting paid to take duration or interest rate risk. You’re not getting paid much more to buy a 10 year bond versus a 30 year bond or a one year bond, frankly. And so, therefore, we we’ve shortened up duration, meaning that we’ve got exposure to bonds that have a shorter lifespan and less interest rate sensitivity in order to protect against the potential for rising interest rates. Because if you’ve got bonds with shorter duration and portfolios, that means they have a shorter lifespan. And it goes back to my earlier comments about that reinvestment dynamic. We’ll have more bonds coming due earlier on that we can reinvest. And if interest rates are rising, that can then, you know, that can mitigate a lot of that volatility because we can reinvest and bonds that have higher interest rates along the way and potentially maybe even produce positive rates of return throughout the rising interest rate cycle.

Hey, Joe Cortese with the Mark Schneider, part of the Cordasco Financial Network Investment Brain Trust, high yield bonds. Where’s their fit and how are you allocating now towards the high yield space, knowing that interest rate swings create a lot of volatility in that space?

Yes. So high yield bonds play an important role not only within the fixed income side, but but but the overall portfolio level as well.

And we use them to increase overall yield of the portfolio. And what high yield bonds are are bonds issued by corporations that have lower credit quality. And therefore, you know, they pay a higher interest rate because investors need to be compensated for taking the additional risk of investing with a company that has a little bit of a lower credit quality. For example, you know, you’ve got very, very strong credits like, you know, large blue chip companies that are out there. And then you’ve got companies that, you know, have have weaker balance sheets and are in are quite, quite as strong from a credit quality standpoint. And therefore, the market requires a higher interest rate for their debt. And so we get paid more for that.

Now, you’ve got to be very careful about weighing the risks, the additional risks versus the additional reward. And we don’t we don’t recommend investing in sort of the junkiest of the junk that’s out there. You know, bonds that are sort of, you know, what we’re called junk bonds are, but that are below investment grade ratings, those sorts of things. We invest at the higher end of the high yield spectrum in terms of credit quality. So we’re kind of moving down the credit quality spectrum a little bit to take advantage of those higher yields.

But we’re not going to the far end of the extreme and investing in very, very risky bonds of companies that, you know, have have, you know, an elevated risk of insolvency, for example. And also then because of that additional risk, that allocation is right sizing the portfolio and can on average range anywhere from five to 10 percent of an overall portfolio in the high yield bond space. And we we did increase those allocations a little bit, you know, during the height of the COGAT pandemic, because high yield bonds sold off very materially. We were able to add a little bit of assets there. And frankly, that spread the spread of high yield bonds excuse me, interest rate and pricing over safer types of bonds. That spread has collapsed or come down fairly significantly since the height of the COGAT panic. As you know, investors have come back into that market.

Hey, Joe Cortese, good stuff. I can kind of get the sense you’re bullish on bonds to size it all up.

It’s not I wouldn’t say I’m bullish on bonds. I would say that we are not eliminating bonds from portfolios just because interest rates are low.

There are many more reasons why we hold bonds in portfolios and they continue to play a very, very important role in portfolio construction.

I’m Steve Cordasco. Joe Cortese is my guest. He’s principal and senior consultant to Mark Schneider and part of the investment team at Kouddous. Financial network.

Thank you, Steve. Always happy to help.

Thank you for listening to the Your Life Your Wealth podcast with me, Steve Cordasco. You can reach me. Just email me. Ask Steve at CFF Plan dot com. Any questions? You have guest topics that you want me to discuss. All open and ready for you.

Just send me an e-mail. Ask Steve at CNN Plan dot com or if you have a question, you can reach out to me as well. I’m Steve Cordasco. Have a great week. If you’re interested in learning more about applying the principles we discussed to your personal financial circumstances, please visit Cordasco Financial Network at CNN Plan dot com or call our office at two one five five five eight.

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