The Fixed Income Conundrum

The Fixed Income Conundrum

Here’s where we are today: As I write this, the 10-year Treasury yield stands at about 0.94% and the 30-year Treasury stands at 1.65%.

This creates a bit of a conundrum for fixed income investors. Let me explain.

The Federal Reserve Board has a long-standing policy they have stated through the years of a target inflation rate of 2%. Whether or not they accomplish this goal, here is what they reaffirmed in 2016:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.

If 2% continues to be their target inflation rate and if they achieve their goal, then the real return of the current long-term government bonds is destined to be negative. And this is before considering the taxability of the interest paid by the bonds.

Making matters worse, by the time these bonds would mature and your hard-earned money is returned to you, the inflation adjusted principal has been cut in half. That’s not an ideal scenario if you ask me, but nobody seems to be talking about it.

What we’re seeing happen as a result is that investors are chasing yield in other areas of the fixed income space. The problem with that strategy is that it further increases the correlation to equities. I find that to be a little ironic since most people invest in bonds to reduce that correlation.

This is one of many reasons that I don’t believe fixed income is designed to be a return driver for retirement portfolios. Fixed-income is there to provide access to capital during times of market upheaval. That’s about it.

I will hazard a guess (though NOT a prediction) that what is likely going to happen to the long-term government bonds noted above is not going to be pretty. If interest rates rise, the price of these bonds will fall – not good. If interest rates don’t move, but the Fed’s mandate holds true, then these bonds lose real money – also not good.

Given the scenarios, it seems to me that the only way these bonds mature with a positive real return is if interest rates continue to fall. Do you want to take that bet?

Not to rub salt in the wounds of these investors, but even as the stock market rebound has continued, the dividend yield of the S&P 500 is currently sitting at 1.96%. And just in case anyone needs reminding, that dividend income stream has nearly doubled the rate of inflation over the last 60+ years.

This is all just food for thought. It’s a wild world out there.

Thanks for reading!
-Ashby


This post is not advice. Please see additional disclaimers.

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