Financial markets, or more specifically the assets representing the components of those markets, are typically somewhat fairly priced. When markets operate openly and freely, Economics 101 typically works its magic. The natural forces of supply and demand keep the price of any asset class in a somewhat reasonable range. Absent manipulation, a natural balancing act occurs.
In today’s fixed income markets, the manipulation has reached levels beyond anyone’s imagination. Intervention by various different entities, including most foreign governments, the U.S. government and several of its agencies, have artificially lowered the yields to levels that natural forces would have unlikely ever created. Without discussing the merits of this intervention, I will simply explain why the manipulation makes traditional asset allocation into this asset class a huge mistake.
As a general rule, the fixed income exposure in a portfolio is a component designed to accomplish several objectives, namely: diversification, stability and a level of certainty. Although the fixed income allocation has historically underperformed the equity allocation on its own accord, it actually improves the overall performance of a portfolio when allocated strategically.
Think of the rudder on a sailboat. Though it produces a small amount of drag, the positives of its attributes outweigh the negatives of that small drag. The rudder keeps the boat on a much more direct path, thus improving the speed of getting to a specific point, while reducing the maximum attainable speed at the same time. It also dramatically lowers the likelihood of the boat flipping over. Sounds counterintuitive, but proven true. Let me explain why, “This time it’s different,” regarding allocating to fixed income. To understand my conviction, you first need to understand the most basic concept of fixed income investing. With fixed income investments, prices and yields are inversely related. When prices go up, yields go down. On the other hand, when yields go up, prices go down.
Our national debt has exploded, growing from 9 trillion in December of 2007, to in excess of 26 trillion today. With the proposed congressional legislation currently being considered, the national debt is likely to exceed 30 trillion by the end of 2021.
At the same time the national debt has exploded, the federal reserve has lowered both the discount rate and the fed funds rate to levels that have driven CD rates below 1 percent and most demand deposit rates to practically zero. On March 3, the 10-year U.S. Treasury Note yield moved below 1 percent for the first time in history. As of June 15, it stands at 0.67 percent. Invest $100,000.00 at 0.67 percent for 10 years to earn $670 a year in interest: not a good option! The government has intentionally manipulated fixed income rates down to almost zero; they simply cannot go much lower.
Therefore, since you know that the price of bonds have an inverse relationship to the yield, and rates are practically as low as they can go, lower than they have ever been in history, “This time, it really is different!”
Do yourself a favor. Have the discussion about reconsidering your fixed income exposure with your trusted financial advisor. There are some wonderful alternatives that make much more sense than simply buying traditional bonds. With Nov. 3 fast approaching, you probably want to have the discussion in the very near future. Want a second opinion? Feel free to contact my office at 910-423-2020 to schedule a complimentary, confidential consultation.
Joseph D. Jackson, MBA
Certified Financial Planner
Certified Retirement Plan Specialist