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Back to Basics in Bonds

Brouwer & JanachowskiApril 8, 2016

Recent statements and action (or inaction)—by the Federal Reserve leave clues for fixed income (bond) investors.  Although the economy continues to grow slowly, the Fed cited concern about economic weakness and paused in its move to raise rates. Portfolio strategies need to factor in the potential for a continued slower and weaker economy.  While the Fed may resume Fed Funds rate increases, it's not certain that longer-term interest rates are going to move up anytime soon.

On the surface, economic data points to growing employment, modest economic growth, and mildly rising wages and inflation.  This data would indicate that the Fed’s easing policy did the trick, the economy is on the mend, and that it’s time to “normalize” rates [raise the Fed Funds rate from near zero to 3.0% - 3.5%.].  The Fed ended quantitative easing and noted that economic conditions justified a reversal in easy money—it was time to begin raising interest rates.  Yet the Fed vacillated on this decision in its last meeting.  Why?  It appears that Janet Yellen & company is worried about weakness that doesn’t show up in the headline numbers.

The Fed’s indecision on raising rates, and other global central banks’ continued easy money policies have led to a world awash in liquidity.  Cash is being hoarded while credit demand remains weak.  These are signs that rates could stay low for the time being.  We recently made changes in portfolios to reflect these conditions.  We increased credit quality, modestly extended portfolio maturities to capture higher current yields, and added a position in longer-term U.S. Treasuries—global demand far exceeds a shrinking supply.  We also added a position in U.S. Treasury Inflation Protected Securities (TIPS), which currently offer historically inexpensive insurance against inflation when compared against non-inflation protected bonds.

In the current environment, as rates have declined and remained at very low yields, many investors have become creative, desperate, or simply greedy in seeking higher returns by investing in riskier securities or strategies that have turned fixed income investments into capital appreciation vehicles.  This is a misguided and hazardous strategy.  Equity investments should be where investors seek capital appreciation.  The primary purpose of bonds is to generate modest income, protect capital, and buffer the portfolio’s equity volatility.

--Steve Janachowski

 

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.  References to an individual security should not be construed as a recommendation to buy or sell that security.  The discussion represents the author’s views and opinions as of the date of this commentary, and the author’s opinions may change, without notice, in reaction to shifting economic, business, and other conditions.  There can be no assurance that the type of investments mentioned in this commentary will outperform any other investment strategy in the future, nor can there be any guarantee that such investments will present the best or an attractive risk-adjusted investment in the future.  Past performance is no indication of future results.  The sources providing the data referred to in this commentary are considered reliable, but the accuracy, completeness or reliability cannot be guaranteed.