Today, I'd like to share a little perspective on interest rates and ask: Are we playing the record backwards again?
THE EASY DAYS
Early in my career (far too long ago), interest rates were relatively high. 8% yielding Treasury Notes were the norm. And many of my firm's clients had become accustomed to "rolling bank CDs" -- just getting a new CD when the prior one matured. It was easy money, with no measurable investment risk (because CDs are FDIC insured.)
At the risk of already overusing the "record" analogy, the music was really nice. But there still was risk, and the challenge was getting investors to see it.
The real risk was that rates could decline, and our clients' ability to live off these risk-free returns would evaporate. Getting a client to invest in a government bond with a ten-year maturity was perceived as riskier when, in fact, the REAL risk was that the investor's "liability" (their spending over the next twenty years) was not matched with their asset length.
Put another way: They hadn't locked in their income source, but their expenses were relatively fixed. If rates went down, they would need to change their retirement expectations and living standards.
In this specific case, I slowly convinced that investor to invest in longer-dated instruments and preserved her comfortable retirement.
For the next several decades, interest rates were on a steady decline, culminating in the pandemic years when bonds' puny yields provided only modest returns. Investors, therefore, could not look to bonds for a significant part of their investment strategy. They were forced to invest in more esoteric assets like infrastructure and real estate while adopting a "total return spending policy" -- i.e., spending capital gains as well as income.
HERE WE ARE AGAIN
Times have changed (again) thanks to the spike in inflation and the Fed's efforts to bring it down through higher short-term rates. Today's bonds are actually providing investors with a decent return relative to the risk they are being asked to take. The question then becomes: "Should I act now and invest in longer term bonds?"
Like those bank CD's, the temptation of short-term fixed income instruments with 5% yields is strong. But when investors choose a money market investment, the yield can change daily. When they choose a bank CD, the term is also usually quite short -- often measured in months.
Alternatively, investors can choose municipal, corporate, or government debt of longer maturities -- up to 100 years, in fact. But unlike a CD, bonds "mark-to-market" (change in price) daily in response to changes in overall interest rates. So, today's bonds offer investors the potential to profit from declining rates while also promising to "lock in" higher coupon payments until the maturity date.
Of course, bond investors felt the negative side of this equation when rates rose. But now, they have the potential to play that record backwards. At a minimum, investors should consider their long-term funding needs (i.e., withdrawals during retirement) and match some of that need with bonds of longer maturities. The returns can potentially be handsome.
This week, the fixed income team at Hartford Funds shared the graphic below showing the historical returns on different types of investments after CD rates peaked. In every one of the five time periods they sampled, both longer-maturity bonds and common stocks outperformed CDs over the following year. And every single time, the returns were positive.
So, give some thought to more closely matching your long-term liabilities with your assets. This means owning securities that could lose money in the short term -- both stocks and longer-term bonds. But when properly diversified, these longer dated assets are more likely to have volatility than to experience a permanent loss of principal.
And that beats a permanent loss of lifestyle.