Activity in the Bond Market: Some Context

Extraordinary Activity in the Bond Market: Some Context

By Brian O’Neill, CFP®

Happy New Year! The beginning of 2022 has seen some extraordinary activity in the bond market, with the benchmark 10-Year Treasury yield moving from the December 31, 2021 close of 1.51%, to north of 1.8% briefly in mid-day trade on January 10, 2022.

The overall numbers don’t tend to raise eyebrows, as the nominal rate of 1.8% is still very low in historical context. However, a move of almost 20% in that yield in only seven trading days is quite unusual. Moves like this generally create headlines for the 24/7 media cycle, and thus, can also create anxiety for clients. We thought we’d add some context.

Client Portfolios and Bonds

We will continue to allocate part of client portfolios to bonds, dependent on each individual client’s tolerance for risk. With rates this low, we have continued to hear the screaming that, with higher rates, bond portfolios will somehow “destroy” value. To show why we disagree with this sentiment, let’s first look back at the past 18 months.

On June 1, 2020, after the realities of the pandemic were fairly clear, the 10-Year yield had dropped to .66%. Since that time, the move in yield to 1.8% amounts to a rate of change of 169%, and yet, during that same time, the core bond holding in our non-taxable accounts (iShares US Core Aggregate Bond – symbol AGG) is down only 1.25%.

The core bond holding in our non-taxable accounts (iShares US Core Aggregate Bond - symbol AGG) is down only 1.25%.

While not perfect, a significant move in interest rates has not “destroyed” value in client portfolios. What it has done is allowed our clients to maintain dry powder for rebalancing, cash withdrawals, and holding a simple lower-risk investment.

In a complimentary fashion, this also allows our clients to maintain their equity positions, and take advantage of the significant gains the market has provided during that 18 month period, while withstanding the volatility with which those gains naturally come. We always say that bonds are an emotional stabilizer, and allow you to take risk in the equity part of your portfolio.

Bond Portfolio Duration

The primary driver behind minimizing losses, even in a rising rate environment, will be keeping the duration of the bond portfolio under control. The longer the duration (a combination of maturity and potential calls and pre-refunding), the more sensitive a bond portfolio is to interest rate changes. A longer bond portfolio duration will lead to larger drops when rates rise (and conversely increases when rates fall), so we are very careful to manage duration risk in our client portfolios.

For anyone with an individual bond ladder, rate moves won’t impact returns, but for those in funds/ETFs, they will. Below is a good chart that shows the impact of this recent rate move on longer bond ETFs, and our core ETF (AGG).

The impact of this recent rate move on longer bond ETFs, and our core ETF (AGG).

The iShares 20- Year Treasury Bond ETF (symbol TLT), with a duration of 19.26 (per www.morningstar.com), has fallen 3.12% so far this year, compared with AGG (duration of 6.64) which has fallen 1.30%. These holdings pay their interest (in the form of a dividend) monthly, so these returns will be improved by that yield (1.88% yield on TLT, 1.61% on AGG – data again per Morningstar) when that dividend pays.

Portfolio Construction: Overall View

Our overall view on portfolio construction is to understand that the market will continuously throw us curveballs, and thus, we need to remain flexible. Bonds will allow for that flexibility, no matter the rate environment. We will use our clients’ tolerance for risk, the time horizon understood through our detailed view of cash flow, and create an allocation built to achieve your goals.

We are thankful for the opportunity to serve you as a client and look forward to continuing to be a resource for you and your family.  Please let us know if you have questions or would like to discuss in greater detail.

Brian O’Neill, CFP®, is president and a financial advisor in the Atlanta office of Cahaba Wealth Management, www.cahabawealth.com.

Cahaba Wealth Management is registered as an investment adviser with the SEC and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Registration as an investment adviser does not constitute an endorsement of the firm by the SEC nor does it indicate that the adviser has attained a particular level of skill or ability. Cahaba Wealth Management is not engaged in the practice of law or accounting. Always consult an attorney or tax professional regarding your specific legal or tax situation. Content should not be construed as personalized investment advice. The opinions in this materials are for general information, and not intended to provide specific investment advice or recommendations for an individual. Content should not be regarded as a complete analysis of the subjects discussed. To determine which investment(s) may be appropriate for you, consult your financial advisor.

Forecasts, Expectations, and Planning for Inflation

11/2021

By Josh Hegland and Will Jackson, CFP®

Inflation seems to be on the tip of everyone’s tongue, and something we are dealing with every day. Whether you’re in the market for a new or used car, considering a change in primary residence or buying groceries, pent-up demand coupled with supply chain issues have resulted in increased prices. 

Forecasts, Expectations, and Planning for Inflation
From Federal Reserve Bank of San Francisco Economic Letter, September 21, 2015

The question: Is this permanent or temporary?

“Our asset allocation strategy includes the possibility for inflation,” explains Will Jackson, CFP®, partner, Cahaba Wealth Management.

In March of last year as governments considered the best way to respond to the damaging impact of Covid-19, there was a broad consensus: the economy was in need of major stimulus to stave off another Great Depression. The U.S. Administration acted quickly providing economic stimulus payments, direct aid to businesses, and gave a broad mandate to the Fed to help stem the tide and ensure the economy continued to function.

Because of the uncertain picture on the overall impact of the pandemic, the stimulus efforts have continued with many segments of the economy seeing a swift recovery. Consumers have shown an eagerness to get back to normal, but the availability of willing workers has shown resistance.  As the saying goes, “no good deed goes unpunished.” 

We can debate to what degree, but overall, it would appear that the stimulus has worked, and resulted in improvements in the consumer’s balance sheets.  Unfortunately, this has driven demand higher and resulted in higher inflation.

We are now seeing economic growth levels that are healthier than they were pre-pandemic. Looking forward, investors are asking the question: is inflation temporary or permanent?

The simple answer: No one truly knows what long term impact the trillions of dollars of stimulus will have on the economy. Will interest rates rise, will price increases stick, can spending maintain current levels, and will long-term supply and demand levels return to historical levels?  

The impact could be different for each of these subgroups, and to date, all prognosticators have been wrong. What has continued to be true is that having a plan has never been more important. So, what should a person do in this type of environment?

Here are a two important things to keep in mind concerning the impact of your financial plan and portfolio.

1. Stocks have historically been a great hedge against inflation. Since 1928, the U.S. stock market has outpaced inflation by nearly 7%. Earnings and dividends have a real growth rate of 2.1% over the rate of inflation over the same time period. While that might not seem like much, the historical inflation rate over this time frame was 2.9%.

Our approach to asset allocation takes into consideration your risk profile, cash flow needs, and investment time-horizon. Over the long term, having the proper allocation of stocks and fixed income assets will help your portfolio not only withstand the fluctuations of inflation, but grow over time.

2. Our cash flow assumptions for clients assume 3% long-term inflation. While we may not know exactly what the near or long-term inflation rates look like, and have not seen inflation rates over 3% since the 1990’s, our conservative approach and assumptions allow us to plan for periods of high inflation. This conservative approach allows us to tailor a client’s income generation to their spending levels to ensure that we have the proper risk/return characteristic applied to their asset allocation.

For now, the Fed is keeping their long-term inflation target at 2%, and recently indicated they would consider beginning the process of reducing stimulus. Additionally, the Fed indicated that they might potentially raise interest rates prior to their previous stated target of 18 months.

Forecasts and Actual CPI Inflation 2005 to 2015 from the FRBSF Economic Letter, September 21, 2015
Forecasts and Actual CPI Inflation

But, Fed indications and the resulting predictions can be inaccurate. The San Francisco Federal Reserve recently published a research report that looked at their various inflation models and the ability to predict future inflation. The average forecast errors were all at least 1.5% across the board, and all missed the mark.

Making investment decisions on near term predictions can be ruinous to a person’s financial success. Many strategists have been recommending to short bonds and to buy gold. These are academically accurate hedging recommendations, but also proving that markets don’t read the textbooks! Recently, bond yields have increased, and gold is down 7.5% YTD. 

All of this only reinforces our cornerstone tenet – it is integral to have a long term plan, and the discipline to stick with your plan. We recognize this is difficult, and theorize that this single trait is responsible for more long term wealth creation than any other.

At Cahaba Wealth Management, we are here if you want to discuss your financial plan. Please do not hesitate to reach out with any questions. We appreciate the opportunity to be of service.

Josh Hegland is a financial planning analyst in the Atlanta office and Will Jackson, CFP®, is a partner and financial advisor in the Nashville office of Cahaba Wealth Management, www.cahabawealth.com.

Cahaba Wealth Management is registered as an investment adviser with the SEC and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Registration as an investment adviser does not constitute an endorsement of the firm by the SEC nor does it indicate that the adviser has attained a particular level of skill or ability. Cahaba Wealth Management is not engaged in the practice of law or accounting. Always consult an attorney or tax professional regarding your specific legal or tax situation. Content should not be construed as personalized investment advice. The opinions in this materials are for general information, and not intended to provide specific investment advice or recommendations for an individual. Content should not be regarded as a complete analysis of the subjects discussed. To determine which investment(s) may be appropriate for you, consult your financial advisor.

Cahaba welcomes C.J. Laws

C.J. Laws 
Financial Planning Analyst

C.J. Laws began the summer as an intern, after graduation from Rhodes College with a Bachelor’s Degree in Business Administration with a focus on finance and a minor in statistics.

This month, we are delighted to announced that C.J. has become a Financial Planning Analyst in our Nashville Office. C.J. works closely with advisors to develop and implement customized financial plans. During his time at Rhodes, C.J. was also a member of the football team. As a student-athlete, his studies consisted of data analysis and model development in relation to practical business applications.