The mantra of “know what you own & why you own it” is an existing fixed income pillar embraced by our Fixed Income Services Group. It seems a recurrent query involves the second part of this expression. Although separating the two is like splitting up Batman and Robin, understanding the motivation behind each part helps illuminate the significance of the combination and how the two realizations together provide a singular advantage to optimizing one’s investment strategy. Knowing why you own anything is crucial to the selection and knowledge of what you own.
It is too frequent but entirely understandable that investors get caught up in valuing market pricing on bonds coupled with how that pricing is going to react after asserting biases on the future of interest rates. It seems very natural to spotlight pricing; after all, rising prices on most individuals’ greatest asset, their house, is a beneficial occurrence. Then of course, rising prices on equity holdings means increased wealth. If you think about it, rising prices on just about anything we hold, cherish, collect or leverage is typically a very good thing. It is a no wonder that the way our minds are molded, as investors we tend to put great value on asset appreciation. The problem: most investors don’t own bonds for their appreciation potential, thus focusing on a bond’s price may be wayward to the actual reason a bond is owned. They purchase bonds for the income, maturity and protective characteristics associated with a buy-and-hold principle.
Is it good if a bond price goes up? The answer is not as straight forward as you think without considering why you own that bond. Remember that there is an inverse relationship between bond prices and yields. If the price of the bond goes up that implies that yields in general have gone down (isolating market factors and not credit factors). So if an investor sells the bond, they may realize some appreciation; however, if the bond was purchased for income and/or protecting wealth, reinvesting the proceeds implies that the money will now be earning less income since interest rates went down.
The unique benefit of purchasing a bond and holding it to maturity is that the cash flow and income (barring default of course) are defined as well as the point-in-time that the bond’s face value is returned and none of these change regardless of any changes in interest rates over the holding period. It simply does not matter if interest rates go up or down or stay the same when bonds are purchased to hold-to-maturity for the purpose of protecting one’s wealth and providing a fixed cash flow stream and income. As bonds approach maturity, they tend to drift back to par. This finite time feature thus provides a protective shield to an investor’s capital outlay.
Why do you own bonds? For most of our readership it is for income (not appreciation). The lack of importance on appreciation and/or depreciation consequently diminishes the significance of a bond’s price. Contrarily, the importance of income should direct an investor’s emphasis on yield. Understanding “why” we own a bond provides cause for “what” we own.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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