For many years, we have experienced historically low interest rates, and expectations are that the Federal Reserve will maintain is near-zero rate policy through the end of 2022 or until it sees inflation rise.
This means that your investments in fixed income securities, such as cash, certificates of deposit and high-quality bonds, are paying relatively little. If you reach for higher yields by turning to lower-quality bonds or move into more equities looking for greater returns, you take on more risk of suffering declines in your portfolio if the economy goes south.
For a little background, the coupon rate you receive on a bond is not the same as the yield on this type of investment. The coupon rate is the stated rate on the bond and is based on its par value. For example, if you purchase a $10,000 par value bond with a coupon of 5%, you will receive annual interest of $500. When the bond matures, you expect to receive the $10,000 repaid to you. However, you most likely paid more or less (a premium or discount) than that $10,000 when you purchased this bond, and therefore your yield will be more or less than 5%.
If you are a borrower, low interest rates likely have served you well. Low rates have encouraged people to travel (before the pandemic, anyway) and buy homes, automobiles, furniture and other goods, helping the economy to grow. Borrowers have also been able to refinance higher-interest-rate debt to much lower rates and realize substantial savings.
Given the possible continuation of the low-yield environment, what is the benefit of an allocation to fixed income? It’s a reasonable question, but expected return is never the only factor to consider when deciding which investments to include in your portfolio. Managing risk is also a key consideration, and high-quality fixed income is one of the best diversifiers of equity risk. Fixed income’s function is to provide stability by reducing your portfolio’s overall volatility.
When considering an investment, it’s important to examine its volatility and understand how it interacts with the other assets or investments you’re holding. You may have certain investments that tend to perform well at a time when other investments may tend to decline in value. Owning investments that act differently can reduce risk. When looking at equities and fixed income, for example, if equities (stocks) are declining, the value of fixed income may be increasing.
Despite today’s low yields, we believe fixed income investments have a place in a well-diversified portfolio. By acting as ballast, high-quality fixed income can help you better weather the ups and downs of the markets. It also provides a source of funds if you suddenly need cash for a large purchase or if you lose your job. An allocation to fixed income does play an important role in your larger financial plan, and you shouldn’t abandon that plan over low interest rates.