By: Laurie Belew
There’s no doubt that volatility in the stock market has captured the attention of investors across the globe. We’ve also been witnessing the impact of the COVID-19 crisis on the bond market as well. A real double-whammy.
Read on to get answers to your questions about the implications for your investment portfolios. We’ve been in regular contact with our fixed income managers, and here are some common themes and questions from those conversations.
Why Did the Fed Drop Interest Rates to Zero and Institute a Policy of Quantitative Easing?
Lower interest rates are intended to keep money flowing into the economy, and the Fed’s commitment to buy $700 billion in government and mortgage-backed bonds will infuse additional funds into the system. By lowering borrowing costs for individuals and businesses, they hope to stabilize the financial markets.
The Federal Reserve sets the Fed funds rate by buying and selling securities from member banks, which impacts the rate banks charge each other to lend reserves overnight. While a Fed does not directly set your credit card rate, their moves are used as a benchmark for many personal and business loans. Rates on products ranging from lines of credit to auto loans are likely to follow. The Fed Funds rates heavily influence the PRIME rate, and adjustments often ripple down to the London Interbank Offered Rate, as well. When rates are low, consumers shop more, business expands, and home loans become cheaper. In general, it stimulates the economy.
Generally speaking, investors often do better when rates are low due to the stimulated economy, and in the short run, bond values increase. But reinvesting at lower rates or continued fear of recession can lead to selling that is not positive for investors.
Doesn’t Additional Government Spending, Funded by Deficits, Ultimately Demand a Risk Premium in the Treasury Market?
Theoretically, it is true that running a deficit potentially increases the risk of default and that investors will demand compensation for that risk. However, there are two things to remember. First, as a sovereignty that controls our currency, the U.S. government can “print” money to meet debt obligations if necessary, to prevent default. Further, as much as rates are driven by risk, they are also driven by demand. And in the worldwide economy, the United States Treasury bond is, as famed bond manager Bill Gross once put it, “the cleanest dirty shirt.” Investors looking for a safe place to invest, have few better options that the United States Treasury. That demand is likely to keeps rates manageable for the foreseeable future.
Why are the Returns on my Muni Bond Funds Fluctuating?
The recent downturn in the market for municipal bonds is mostly a result of limited liquidity. A combination of nervous investors fleeing to safety and passive investors being forced to sell to meet redemption requests has created large inventories of municipal bonds out for sell. Yields have climbed on both municipal and corporate bonds, even as Treasury yields have fallen. In the muni market, our managers believe that the credit risk is low because they always manage toward high-quality issues. Financially stable municipalities will be resilient and absorb economic shocks better than lower-quality bonds. For example, general obligations bonds are usually backed by property taxes, and it would take years for assessed values to adjust downward as a result of a pandemic.
Further, essential service bonds and especially essential service utility bonds are well-positioned to withstand a lengthy pandemic. Our managers are diligently monitoring all affected sectors and their ability to withstand the current crisis. And let’s not forget that the Federal Reserve expanded its asset purchase program to include short term municipals to restore liquidity to the market.
To the extent that managers are being forced to put good bonds are on the market at a discount, investors who are in the buyer seat have a tremendous opportunity to take advantage of.
Are Corporate Bonds Going to Default?
Certainly, there are sectors that have already been dramatically impacted by this crisis. The energy sector has been hit with not only with the decline in demand related to Coronavirus but by prices that dropped overnight as a result of price war and increased oil production. The service sector is facing a legitimate shutdown, and revenues will continue to be slashed. While no one predicted the occurrence of widespread implications of the Coronavirus, we have confidence that the teams managing our bond portfolios are continuing the monitor portfolios and test holdings for the ability to withstand potentially recessionary conditions.
At FJY, we are confident that our fixed income positions will continue to provide long term stability in diversified portfolios. While these are challenging times in all markets, we have always maintained a conservative approach to fixed income by investing in high quality and avoiding long term holdings. Our managers are well equipped to manage through the current environment and demonstrate will their expertise in doing so.