It’s a foregone conclusion in the markets that the Federal Reserve will raise short term interest rates on Wednesday. But more importantly, investors will be looking for hints for future rate increases.
Why is this so important? The consensus view is for 2-3 Fed increases this year, but anchoring into this expectation comes with risks. For example, in 1994 the Fed surprised investors by increasing rates 6 times, resulting in a 3% loss for bonds that year. Of course, bonds recovered in following years, thanks largely to the long-term trend of falling interest rates since 1981.
Too much of a good thing can be wonderful, at least, if actress Mae West was right. But when it comes to your investments, we’d argue too much of a good thing can be downright
dangerous.
Consider what’s going on among blue chip stocks in today’s low yield environment. Anyone seeking income from bonds knows that yields are at historic lows. As such, many investors have sought blue chips stocks and their healthy dividends as an equivalent to traditional bonds. We don’t believe this to be a terrible idea, but it definitely comes with its tradeoffs and we question whether those risks and rewards are getting the attention they deserve today.
When building an efficient portfolio, most market practitioners would agree to an allocation to bonds. This allocation reduces the overall volatility of the portfolio and adds a layer of safety. The two main components affecting fixed income returns are: 1). interest rates and 2). the credit quality of issuers. With the recent increase of interest rates and the Fed’s plan to incrementally increase rates over the next few years, we feel investments in credit, especially high yield, offers better return potential to investors.
High yield bonds tend to deliver the potential to improve a portfolio’s overall risk/return given the historically low correlation with other core asset classes. Due to their location on the credit spectrum, high yield bonds offer enhanced yields compared to high quality bonds and can potentially increase the overall yield of a portfolio significantly. Although this has not been the case as of late, historically speaking, high yield bonds have provided better downside protection than equities while delivering equity like returns with significantly less volatility and drawdowns.
