Navigating the Rapids
Our goal with investing for our clients is to help them arrive safely at their destinations in life. It’s a bit like taking a raft trip down a river. You have to read the river and make judgements along the way to minimize dangers. There are tricky rapids to negotiate, boulders to avoid, and placid stretches to be enjoyed.
In reading the river today we can see that:
- We’ve had a relatively smooth ride for almost a decade due largely to historically low interest rates. Now risks are rising for U.S. stock investments.
- The overvalued stock market is encountering some turbulence leading to major declines in prices. The NASDAQ already hit correction territory as of October 25, 2018 and the S&P 500 has erased all of its 2018 gains so far. Where it will go next is difficult to ascertain.
- International equities have had their share of woes: Italy and Greece debt issues in the EU, unsustainable debt levels and trade war impacts in China, political issues in Latin American emerging countries.
- Most concerning is the increasing correlation of global markets and the US. The rolling correlation between the S&P 500 and MSCI All Country World ex U.S. index has risen to 0.95 (perfect correlation would equal 1). As a result, international diversification does not provide the same level of protection it used to historically.
- We have the new obstacle of rising interest rates which can cause damage to the bonds in your portfolio whose values tends to decline as rates rise.
In other words, the ride is getting more challenging than it has been in a long time. From our perspective, the current market environment is among the most difficult we have encountered in the 25-year history of Journey Tree. It is essential to have your investments positioned appropriately in order to make it through these dangers with minimal harm.
Journey Tree Strategy
Here are some key elements of our approach to navigating the current investment environment.
- Invest for a relatively high level of income to help create a more consistent return and to provide for client withdrawals for expenses. Rising rates are helping with this.
- Hold individual bonds to maturity whenever possible to reduce interest rate risk.
- Utilize tax-free municipal bonds to enhance after-tax returns.
Short term bonds
- Seek to minimize interest rate risk by focusing on floating rate and shorter-term bonds that are less vulnerable to interest rate risk. Short term Treasury bills (3-6 months) are becoming a good option for this.
- Have enough liquidity to be in a position to invest money in good opportunities as they arise. (Stocks at lower prices and bonds at higher rates.)
- Emphasis mutual funds with flexible mandates and strong risk management policies. If they cannot find investments at good prices, they can allow cash to build which they can use later to buy at better prices wherever they may find them.
- Seek to reduce risk and enhance returns by selecting investments that are potentially underpriced and have an attractive risk/reward ratio while emphasizing protection of capital.
The Impact of Rising Rates on Bond Holdings
For most of the last 40 years interest rates have been declining – from a high of nearly 20% in the early 1980s to 0% from roughly 2009 to 2015 for the Federal Funds Rate. Bond investors usually received substantial interest income and watched the value of the bonds increase as rates dropped. Now we face the opposite circumstances – low and rising rates. As rates rise the value of bonds tends to go down and this is reflected in the value of accounts as shown on statements.
An important factor to note that this decline in value reflects current value – the value of the bond if sold today – not your actual return if you hold on to the bond until maturity.
Here is an example:
A 5-year Treasury bond currently pays roughly 2.9%. If rates rise 1% the value of that bond drops 4.4%. The return on your statement for the year in which the 1% rise occurs would be shown as -1.5% (2.9% interest – 4.4% price loss). Yet in reality if you hold onto the bond for the entire 5 years your actual return would be 2.9% per year for five years. In other words, if the bond is held to maturity that 4.4% loss disappears.
Journey Tree normally holds individual bonds to maturity thus increasing the likelihood of avoiding loss of principle due to interest rate increases. The bond mutual funds we use can and do sell bonds before maturity but only 2 of 16 the bond funds we use sold more than 50% of their bonds in the last year. And it is likely that a given bond is sold only because they have found another bond they feel is a better value.
Because account statements are required to reflect current values for bonds they will often understate your actual return.