In this episode of Buckingham Weekly Perspectives, Head of Investment Research Jared Kizer explores fixed income investing in the current rate environment and shares three reasons why it’s crucial to take additional maturity risk.
Jared Kizer: Today I wanted to jump on and talk about how to think about fixed-income investing in the current rate environment focused on a very specific question that we’ve started to see filter in here in late August, heading into September. And that’s the question of giventhat ultra short-term rates, let’s think about like money market rates or other very, very short-term versions of fixed income, those rates are quite a bit higher than some of the slightly longer maturity rates that you’ll see out there.
Why Not Allocate Everything to Ultra Short-Term Maturities?
Jared Kizer: So natural question that we’ve been getting is why not just allocate the entire portion of whatever it is that I’m allocating to fixed income in money markets and ultra short-term fixed income? Basically, why take any interest rate risk at all is the way to think about the question. And we recently posted a video in terms of how to think about the term or maturity premium, which overlaps a little bit with what I’m going to talk about today. But today we’re very, very focused on this question here that we’re getting in late August around fixed-income allocation. So a little bit more specific.
The Impact of The Fed’s Rate Increase
Jared Kizer: So again, that question is being driven by, as the Federal Reserve has pushed interest rates up, that has pushed up short-term, ultra, ultra short-term interest rates the most. If you look at relatively high-quality or high-quality ultra short-term fixed income, those rates are now in the 5.5% range or higher. But as you go out a little bit longer, you start to see rates fall off a good bit. So that’s the impetus for the question we’ve been getting.
Three Reasons for Maturity Risk
So I want to cover three reasons why we would say you still want to think about having some portion of your fixed-income allocation out beyond those ultra short-term maturities.
#1: Diversification is Always a Smart Strategy
Jared Kizer: The first is something that we harp on a lot, which is basic diversification. Even in fixed-income investing, we think it would generally never make sense to allocate the entire fixed-income allocation to a single specific maturity, even if that maturity is where the rates are the highest. You want to have some diversification or laddering, as we would like to say in your fixed-income allocation to protect against that risk that rates across maturities don’t all move in the same direction at the same point in time. So you want some diversification there. And keep in mind here, we’re not talking about moving out to 10-or-20-plus-year maturities. This is moving out just a little bit further on the interest rate curve with some portion of your fixed-income allocation.
#2: Interest Rates Are Volatile
Jared Kizer: Number two, very closely related to number one is that we don’t know how interest rates will evolve from here. In fact, the very fact that interest rates are a little bit lower for longer-maturity fixed income says the market thinks there’s a good, good chance that short-term rates are not going to stay at this high for a very, very long period of time. So that’s just saying we don’t know how interest rates are going to evolve from here. If we knew for certain that ultra short-term rates were going to be much higher for much longer than the market expected, then yes, we would say we would all know then exactly what to do. It would be to only invest in ultra short, short-term fixed income. But we don’t know that. So one way to protect against that risk of not knowing how these short-term rates are going to change over time is to be a little bit more diversified across the maturity spectrum in your fixed-income portfolio.
#3: Expect the Unexpected
Jared Kizer: Last one is one that I did hit on in the term or maturity premium video , which is there is a good bit of evidence that if we do see a negative shock to the broader economy, that impacts the stock market, so something unexpected that develops that’s negative for the economy, you generally see, although it’s not always the case, as we saw just last year in 2022, generally you’ll see interest rates tend to fall on high-quality fixed income in that environment. So, you tend to be happy that you have some caution portion, not just in ultra short-term fixed income where prices won’t appreciate much. So basic diversification argument also from a holistic portfolio point of view would be to have a little bit of interest rate risk in that fixed-income portfolio.
So hopefully this is good perspective in terms of how we think about allocating the fixed income in the current structure where rates are across maturities. If you have questions that you’d like for us to tackle, feel free to reach out to your advisor and suggest those questions or click the link below and submit questions in that way. Thanks.
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Source: Ken French Data Library
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