The most common questions that we are being asked about in client meetings are about municipal bonds, interest rates and inflation (fixed income investments in general).
Interest rates: They are currently at all time lows, based on the past 5-10 years or over a much longer time period, such as 30-50 years. However, predicting the short term direction of interest rates (such as will they be higher 3 months from now), is nearly impossible to predict.
Implication: When we structure our client’s fixed income portfolio’s, we do not make investment decisions based on our “predictions” about future interest rates. We make purchasing decisions on the current rates that are available, with the intention to hold the investments to maturity (not buying them to trade them in 6 months or 2 years, based on our “bet” of the direction of interest rates).
We view fixed income investments as an area to minimize risk. This should be the foundation of your portfolio, with the objective of preserving your investment, while getting a safe interest rate return.
Due to the greater rate of defaults, we do not purchase corporate bonds. The risk of default and not getting your principal back is not worth the additional small amount of annual interest that you would receive. Others may disagree with this philosophy, but it has enabled our clients to sleep well.
We believe in holding individual municipal bonds or certificates of deposits, as long as they are FDIC insured. When selecting municipal bonds, we are extremely particular about what sectors the bond is in. As much of our investment philosophy is based on academic data and research, so to is our fixed income strategy. For municipal bonds, sectors such as housing, healthcare and industrial development have far greater default rates than other areas, such as school districts, highways, and public transportation. You may have never even heard of these statistics or had it brought to your attention by another financial advisor. In our purchasing criteria, we only buy top rated municipal bonds in certain sectors, that have the lowest historical default ratio.
We also advise our clients to diversify nationally, and not hold bonds in just one state. While this may cost some small amount of additional state taxes, the benefit of diversifying your fixed income investments is well-worth the cost. Again, this helps you to sleep well at night.
Inflation, interest rates and bond funds:
As discussed in this and other posts, we cannot predict future inflation rates or interest rates. We do know, however, that interest rates are at a historical low, and it is very likely that inflation will rise at some point in the future. If either of these events occur, the value of bond funds will decrease, and for some bond funds dramatically. If you are holding intermediate or long-term bond funds, of corporate, government or municipal bonds, and interest rates rise, you’ll be faced with a permanent loss in the value of your bond fund.
For this reason, we feel it is critical that investors be very selective and hold only individual fixed income investments, not bond funds. We feel there is the potential for huge bond fund losses, at some point in the future, when interest rates rise. These losses could be similar to losses incurred in the tech bubble. This would be almost more tragic, as bond fund holders feel that their investments are intended to be safe. However, interest rate risk will negate the perceived safety of these fixed income investments.
If you have significant bond fund holdings, we would be pleased to review them and provide you with our thoughts and recommendations.