Adapting your fixed income portfolio to changing interest rates
The financial landscape has shifted dramatically in recent times. Over the past year, significant Federal Reserve rate hikes have pushed interest rates to their highest in two decades. As the saying goes in golf, “every shot makes somebody happy.” While the rise in interest rates may have been an unhappy challenge for borrowers, it has also kindled a renewed enthusiasm in fixed income investments. Bonds are now offering compelling yields, and are once again drawing the attention of bond investors.
Bonds contribute to the diversification and stability of an investment portfolio, with their suitability varying according to individual client objectives and risk tolerance levels. Often, they serve as a counterbalance to the volatility of equities, providing a steady stream of income through interest payments, and the promise of principal repayment at maturity. This combination of income generation and capital preservation is particularly appealing to investors seeking to mitigate risk while achieving smoother returns.
We typically favor the direct purchase of individual bond securities over bond mutual funds or exchange-traded funds (ETFs) for most of our fixed-income exposure. This approach enables us to construct customized “bond ladders” with staggered maturity dates tailored to each client’s unique situation. Such a strategy not only allows us to better adapt to changing market conditions, but also keeps costs low for our clients by avoiding the ongoing fees associated with mutual funds and ETFs.
Enhancing Bond Portfolio: Extending Maturity Profiles
For years, our bond investment strategy can be characterized by a cautious and calculated approach. In a period where interest rates were historically low, we deliberately maintained a shorter overall maturity profile for our bond holdings. The rationale was simple but important: the low interest rate environment did not offer sufficient compensation to justify the risk associated with locking in investments for longer durations.
This strategic positioning proved to be advantageous as interest rates began to rise. The shorter overall maturity profile of our bond portfolio allows us to quickly reinvest the proceeds into new bonds offering higher interest rates.
Now, as we find ourselves in a new environment of higher interest rates, our strategy is evolving. Recognizing the opportunity that current rates present, we are strategically and responsibly extending the overall maturity profile of our individual bond holdings for suitable accounts. The shift is aimed at locking in those higher rates for a longer period, thereby securing more attractive yields for our portfolio over the medium to long term. By slightly extending our maturities, we are seizing the opportunity to upgrade the overall yield profile of our bond portfolios while still maintaining a balanced approach to risk.
Corporates vs. Municipal Bonds: A New Perspective
When designing customized bond portfolios, we consider client-specific details, including taxation dynamics, in evaluating the suitability of corporate versus municipal bonds across different account types.
Corporate bonds, issued by companies, typically offer higher yields, but are accompanied by tax obligations and a higher perceived risk (although we adopt a slightly nuanced perspective that certain corporates maintain exceptionally strong balance sheets and financial robustness).
Conversely, municipal bonds are issued by state and local governments to fund public projects like roads, schools and infrastructure. The main attraction of municipal bonds lies in their tax benefits: interest income from most municipal bonds is exempt from federal income tax and, frequently, state and local taxes as well, particularly for investors residing in the state where the bond was issued. This tax-exempt status renders municipal bonds especially appealing to investors in higher tax brackets.
For a tax-advantaged account, such as an IRA or Roth, corporate bonds stand out as the favorable choice. The tax-exempt feature of municipal bonds offers no additional benefit in these tax-advantaged environments. Additionally, municipal bonds tend to offer lower yields than corporate bonds with comparable maturity and credit quality. Owning municipal bonds in such accounts might result in missing out on the superior yields that corporate bonds can offer.
When investing in taxable accounts, the decision between corporate and municipal bonds requires the careful consideration of several factors, with a client’s marginal tax rate being the most significant. Traditionally, for those in higher tax brackets, municipal bonds tend to offer more appealing after-tax yields compared to corporate bonds of similar maturities, despite the latter’s higher yield, on which taxes must be paid.
Recent market conditions have altered the investment landscape, calling into question the conventional preference toward municipal bonds in taxable accounts due to their tax-exempt status. The widening of yield differentials between municipal and corporate bonds has made the after-tax yield of corporate bonds more appealing compared to their municipal counterparts, even within taxable accounts. Furthermore, corporate bonds tend to have better availability, offering investors with a broader selection across various credit qualities, sectors, and maturity lengths. In response to these market shifts, we are strategically integrating corporate bonds into the fixed income investment portfolios of our clients with taxable accounts.
As we navigate these evolving market conditions, our commitment to your financial success remains steadfast. The strategic shifts in our bond investment approach, from optimizing maturity profiles to the selection between corporate and municipal bonds, are designed to prioritize your financial well-being. We are grateful for the trust you place in us to manage your investments, and remain committed to serving you with unwavering diligence.