For several years, we have experienced historically low interest rates, and for some time, the markets have expected these rates to begin rising. While such expectations get priced into current yields, markets provide no certainty that interest rates will increase at any particular time. Britain’s recent decision to leave the European Union only adds to the uncertainty.
For a little background, the coupon rate you receive on a bond is not the same as the yield on this type of investment. The coupon rate is the stated rate on the bond and is based on the par value of the bond. For example, if you purchase a $10,000 par value bond with a coupon of 5 percent, you will receive annual interest of $500. When the bond matures, you expect to receive the $10,000 repaid to you. However, you most likely paid more or less (a premium or discount) than that $10,000 when you purchased this bond, and therefore your yield will be more or less than 5 percent.
When the Federal Reserve increases short-term target rates, as it did in December for the first time since 2006, investors shouldn’t expect an increase in all interest rates. In fact, interest rates across the yield curve have declined in 2016, with global bond yields at near historic lows. Several countries have negative five-year yields on their government debt, and more than $10 trillion of sovereign debt outstanding carries a negative yield.
If you are a borrower, low interest rates have likely served you well. Low rates have encouraged people to buy homes, automobiles, furniture and other goods, helping the economy to grow. Borrowers have also been able to refinance higher interest rate debt to much lower rates and realize substantial savings.
Given the possible continuation of the low-yield environment, what is the benefit of an allocation to fixed income in your portfolio? It’s a reasonable question, but expected return is never the only factor to consider when deciding which investments to include in your portfolio. Managing risk is also a key consideration, and high-quality fixed income is one of the best diversifiers of equity risk. Fixed income’s function is to provide stability by reducing overall portfolio volatility.
When considering an investment for your portfolio, it’s important to examine its volatility and how it interacts with the other assets or investments you’re holding. You may have certain investments that are performing well at a time when other investments may be declining in value. You want to hold different types of investments that will act differently to reduce risk. When looking at equities and fixed income, for example, if equities (stocks) are declining, the value of fixed income may be increasing.
Thanks to its diversification benefits, high-quality fixed income can help you better weather the ups and downs of the markets. So while fixed income may not currently be reaping large yields, it does play an important role in your financial plan.