Why Fixed Income should be in your portfolio & why we prefer a "Barbell Strategy"
The Yield Curve is inverted! The Yield Curve is inverted! Aren’t we supposed to be panicking?!
In August the 2-Year US Treasury note yield traded above the 10-Year US Treasury note yield for the first time in over a decade, which caused an influx of pessimism and squawking about an imminent recession. An article posted to MarketWatch 8/14 entitled The U.S. Treasury 2-10 year yield curve inverted and that means stocks are on ‘borrowed time,’ says BAML is a perfect example of said recession squawking. The article cites that “a yield curve inversion along the 2-year/10-year spread has come before the last seven recessions,” but concedes that “widely varying lag times between a (yield curve) inversion and an economic downturn makes it difficult to say if an inverted curve points to an imminent slowdown in growth.” In fact, the article continues to cite that historically “the S&P 500 tended to mount a last-gasp rally, peaking on average 7.3 months after an inversion along the 2-year/10-year spread.”
Yes, the inversion of the yield curve is a possible signal of an impending recession, but so is the looming Trade War with China, and discussions on rising interest rates, and the potential impeachment of President Trump, and slowing global economic growth, and the historic shrinkage of the Polar Ice Cap caused by global warming, and the escalating conflicts with North Korea, and impending BREXIT, and declining consumer spending, and…, and…, and… Throughout this latest bull market that has lasted over a decade, there has always been someone touting “red flags” of a potential recession or correction. One of these days the naysayers will be right and the market will turn downwards because IT HAS TO – as the old adage goes, “a broken watch is right twice a day” – but no one can predict when that will be.
There has always been someone touting "red flags" of a potential recession or correction. One of these days the naysayers will be right and the market will turn downwards because it has to, but no one can predict when that will be.
Instead of attempting to time the market, which is effectively impossible, it is better to develop a disciplined overriding Investment Strategy with a statistical likelihood of achieving your desired results with the least potential risk. In our opinion, such a strategy should likely include a combination of Equity and Fixed Income investments. Although everyone has different goals and risk appetites, we believe a good baseline for the “Pension Strategy” component of one’s long-term investments is approximately 60% Equities and 40% Fixed Income.
Now you may be thinking, “Why would I allocate such a large percentage to bonds with yields at near historical lows and speculation of rate hikes?” The problem is this assumes that the reason you own bonds is to make money via a return on investment, and this assumption is wrong! There are two primary reasons why we continue to utilize bonds: 1) income generation, and 2) adding portfolio stability.
Bonds, by definition, pay interest in the form of a coupon payment on a regular schedule, which can help generate a consistent stream of income. Additionally, if held until maturity, the bond will return the initial principal payment, further mitigating loss of principal. Although you may not “see” these characteristics when owning a bond fund as opposed to an individual bond, they still exist. Meanwhile, stocks have been doing what they do…acting as the engine for growth, likely on a roller-coaster of volatility.
The assumption that you own bonds to earn a return on investment is wrong! There are two primary reasons why we continue to utilize bonds: 1) income generation, and 2) adding portfolio stability.
Even if you believe the borderline fear-mongering gushing from media outlets claiming everyone “knows” rates are headed higher (which we would disagree with) we must remind ourselves that it really doesn’t matter anyway. Yes, it is true that rising interest rates cause bond prices to fall in the short-term which “feels bad”. However, we must combat our natural tendency to reel at the price slump and remember that it has no effect on our long-term strategy of using bonds to act as a counterbalance for the market volatility of our equity investments. Chant the mantra with me…rising interest rates do not eliminate the benefits of owning fixed income…rising interest rates do not eliminate the benefits of owning fixed income…
Here’s the brutal truth. Unless you have an investment time horizon of 10+ years and can comfortably stomach the peaks and troughs of the equity markets, Fixed Income HAS TO HAVE A PLACE IN YOUR PORTFOLIO in order to limit your exposure to market swings characteristic of equities. While the general strategy, as we’ve discussed, is to find ways to help diminish overall risk and volatility, there are various tactics investors can use to construct the Fixed Income allocation of a portfolio. We at Dashboard believe a “Barbell Strategy” utilizing a combination of mutual funds and ETFs can generally produce consistent yield and help to mitigate volatility.
A Barbell Strategy is weighted to short and long term bonds and aims to capitalize on higher yields while mitigating interest rate volatility.
A Barbell Strategy is weighted to short-term bonds with a maturity or duration of less than 5 years and long-term bonds with a maturity or duration of 10+ years, and generally does not utilize intermediate-term bonds. The general idea is to profit from longer term bonds that generally have higher yields with greater risks while mitigating interest rate volatility by purchasing, and reinvesting into, shorter term bonds with lower yields.
The chart below helps to demonstrate why we believe a Barbell Strategy can be effective.
This is not a Nike ad…this is the U.S. Treasury Yield Curve as of 9/30/19. The Y-Axis is the Yield to Maturity (YTM) and the X-Axis is the Duration of the bond. As you can see, the lowest yields have a duration of 2-10 years. Therefore, we believe a Barbell Strategy that is weighted to shorter and longer term bonds can generally produce a consistent yield while helping to mitigate short-term volatility by continually reinvesting back into the market at then-current interest rates.
At the end of the day, we must remember that bonds continue to do what they’re supposed to – provide income and portfolio stability. It is critical to our future financial freedom that we remain steadfast with our plans and have the courage and wherewithal to continually “Fight the Narrative”!