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As GSB Capital evaluates the current market scenario, we ask: Should long-term investors seeking reasonable yields and capital gains consider acquiring bonds now? It’s a question worth asking, especially as we anticipate potential drops in interest rates within the next year or so.
Many investors overlook the bond market despite its intriguing movements over recent years. It’s essential to understand the fundamentals of fixed income, particularly as bonds can sometimes prove complex.
Rising rate environment
Since the financial crisis, the Federal Reserve has pushed income investors towards riskier assets, penalising those who took on duration risk in a rising rate environment. These instruments may appeal to some appropriate investors, with short-term T-bills yielding above 5%. However, the short duration of T-bills does present reinvestment risk.
If the Fed continues to hike rates, leading to an economic downturn, they may be compelled to reduce interest rates. Unfortunately, the attractive 5% yields on T-bills cannot be locked in for extended periods. As the long end of the curve shows some catching up, the premium on T-bills remains but has shrunk.
Higher yields and declining inflation
Intermediate-term bonds are increasingly attractive due to their higher yields and declining inflation. A total bond index fund (AGG) now offers roughly the exact yield as 1-3 year Treasuries (SHY), albeit lower than T-bill yields. This is a significant improvement compared to a few years back.
Remember that duration measures a bond’s sensitivity to interest rate changes. For instance, if rates fall by 1%, a fund with a 4.3-year effective duration (like IEI) is expected to rise around 4.3%. Conversely, if rates increase by 1%, the fund would drop by about the same percentage.
Larger safety margin
With yields slightly exceeding 4.3% currently, we expect to break even from a rise in rates within a year due to yield. In previous years, starting yields on bonds were much lower, offering less of a safety cushion.
While bonds could face additional price risks if rates continue to rise, a larger safety margin exists due to the substantial rise in yields. If rates were to increase another 1%, although there might be some loss in price due to higher duration, the higher starting yield of 5.3% would help recover those losses quicker.
Rates hit historic lows
For high-quality bonds, starting yield accounts for approximately 90-95% of returns over a 5-10-year period. Thus, investors don’t necessarily need falling yields to earn respectable bond returns.
At GSB Capital, we don’t claim to predict future interest rates or inflation trends. Instead, we assess the bond market based on risk and return. In 2020, when rates hit historic lows, we perceived the risks in the bond market to outweigh the rewards significantly.
More options today
Now, however, as a fixed-income investor, you have many options. Whether you’re concerned about rising rates, inflation, deflation, or a recession, various bond instruments are available to suit your needs – each with its own risks. After enduring years of meagre bond yields, fixed-income investors finally have more options today – a welcome change.
At GSB Capital, we firmly believe in the power of a well-managed, diversified portfolio. We understand that investment is not just about immediate gains but nurturing your wealth for long-term growth and stability. Our team of experts is committed to providing you with strategic advice and guidance to ensure your portfolio is balanced, resilient and primed for growth.
Are you nurturing your wealth for long-term growth and stability?
Let GSB Capital help your wealth flourish through careful and considered investment management. For more information, contact GSB Capital to learn how we can help you achieve your investment goals.
THIS ARTICLE DOES NOT CONSTITUTE TAX OR LEGAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH.
THE VALUE OF YOUR INVESTMENTS CAN GO DOWN AS WELL AS UP AND YOU MAY GET BACK LESS THAN YOU INVESTED.
THE TAX TREATMENT IS DEPENDENT ON INDIVIDUAL CIRCUMSTANCES AND MAY BE SUBJECT TO CHANGE IN FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE.