How To Approach Fixed Income Investing in a Low Interest Rate Environment

Sunday, January 1, 2012

Bonds have historically been an investment of choice for those looking to diversify their portfolios. Today’s market is no different, but the challenge comes in determining what types of bonds to invest in and the length of time to invest, says Jim Bernard, CFA, senior vice president and director of fixed income portfolio management at Ancora Advisors LLC. “A prudent moveright now in our opinion is to focus on bonds maturing within a three- to seven-year time period,” says Bernard. “Interest rates are very low right now, so it may be tempting to go out to longer dated bonds to get yield. But most investors should be very careful about locking their money up for too long a time. If interest rates increase, the value of existing long dated bonds will likely decrease materially in value. It would then be a long time until maturity before investors get their money back at par value.” 

Smart Business spoke with Bernard about the value in U.S. fixed incomes markets and the primary risks faced by investors.

Can you put today’s interest rate environment into historical perspective?

Interest rates have been historically low for three years, and that low interest rate environment is probably going to last another three years, possibly longer. If you keep money in short-term CDs, you will get what you are getting today, which is close to nothing. Interest rates will begin to increase when the economy and/or market improve. Or, if those things don’t occur, but commodity prices or inflation spiral up, then interest rates will also go up. However, we don’t see a materially better economy for the next few years, and although there may be slight job growth, we think the job market will remain very difficult.

 

What are the primary risks fixed income investors face today?

First, how can you get any legitimate return on your money without buying long-term bonds or bonds of questionable quality? If you buy a low-rated bond, the probability of getting your all money back at maturity declines. 
 
To get a decent yield, you have to go to long maturity bonds that are going to be due in 15 to 30 years. The risk is that if interest rates were to go up materially in the future, then the value of your bond declines materially. 
 
For instance, if today, you buy a good, AA 15-year corporate bond that yields 4.5 percent, that is great for today. But if in four years interest rates go up and an 11 year bond is trading at a yield of 8.5 percent, the face value of your bond would go down to about 65 cents on the dollar to be yield competitive in the higher interest rate environment. 
 
At that point, you have a decision to make. You are earning 4.5 percent, but you could buy a new bond to earn 8.5 percent. However, the only way to do that is to sell your bond at 65 cents on the dollar. Do you want to take a loss to get more income, or are you going to continue earning 4.5 percent while others earn 8 percent? That’s the dilemma. That’s why three- to seven-year bonds may be the best move today. If you construct a portfolio of these bonds, for an average maturity of five years, interest rates may go up in three or four years. In that instance, you may not be happy in the short term, but you’re going to have access to your money at face value in the next one to three years, which is better than 10. The price of those bonds will go down but they will mature at face value, and you will know what the future value is and know when that is coming back to you.
 

How do you view the current municipal bond market?

We like municipal bonds and think they area good value, but people have to be very careful of what they buy. We recommend bigger rather than smaller issuers in this uncertain market. There may be municipal defaults on the smaller end of the spectrum over the next few years, as opposed to states and larger issuers. If a $15 million sewer district bond were to fail, the state of Ohio would survive, even if bondholders didn’t get back all of their money. However, if a multibillion dollar issuer were to fail and not pay back bondholders 100 cents on the dollar, that would have huge ramifications. Issuers with significant size may be too big to fail, but every municipality may not be bailed out.

 

Are non-U.S. dollar denominated sovereign bonds a good investment?

U.S. currency has been weak against other currencies over the last decade or so. Our view is that until we adequately address our fiscal problems here in the U.S., the dollar will continue to do worse than currencies of countries that are more fiscally disciplined. We don’t know what the ultimate outcome is going to be with the euro, but we are very concerned. The yen is also uncertain. But we have identified five to seven currencies that we believe are better fiscally positioned and have been more responsible from a budget perspective. We would rather own their government debt than ours because we believe their currency will do better than ours. We recommend buying three- to sevenyear non euro zone bonds in countries with
solid economic positioning and finances.

 

What are the keys to being an effective long term fixed income investor?

You have to understand the structure of the bonds you are looking to buy. Is this a bond in which you have a high degree of confidence that you will ultimately get all of your money back? With stocks, you want growth and higher earnings, but with bonds, you care a lot about the issuer’s balance sheet and less about their income statement, because the balance sheet will ultimately determine whether you are going to get your money back. 
 

Jim Bernard, CFA, is senior vice president and director of fixed income portfolio management as well as an Investment Advisor Representative of Ancora Advisors LLC, (an SEC Registered Investment Advisor). In addition, he is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC). Feel free to contact him at jb@ancora.net or (216) 593-5063.