Fixed Income, An Important Tool Before and During Inflationary Times

Alan Remedios, Fixed Income Portfolio Manager

Within financial circles, the prevailing view about fixed income is that the bond market’s glory days are numbered. According to conventional wisdom, a rapidly expanding economy brings with it the dreaded kryptonite of inflation to the bond market, which reduces purchasing power and thus causes fixed-income values to spiral downward, resulting in negative returns to bond investors. While this is a reasonable theory, the outcome is far from certain. In our view, there remains a justifiable role for fixed income in a portfolio, even in a higher rate environment.

Role of Bonds

Fixed-income securities provide the dual benefits of income as well as price stability. It’s obvious that the regular coupon income from bonds creates a steady positive income flow. What’s less obvious is that bond values act as a hedge in the event of economic uncertainty and geopolitical risks and fears—problems that persist today.

Even in a higher-rate environment, a fixed-income portfolio doesn’t have to face the wrath of sharply lower values. First and foremost, bonds have a terminal maturity date (unlike many other asset classes). So even if the value of bonds falls as a result of higher rates, they always pay back principal and interest over the life of the issue and at maturity, except in the case of default.

It’s also important to note that not all bonds are created equal. For example, short-term bonds are less volatile than long-term bonds, and higher-quality issuers are more stable than lower-quality issuers. Additionally, some complementary, non-core fixed-income strategies (see table) should perform better in a rising U.S. rate environment and benefit an otherwise broad, well-diversified bond portfolio. This being said, it follows that a strategy of high-quality, short- to intermediate-term bonds are well protected in the event of higher rates. In fact, if positioned optimally along the maturity spectrum, a portfolio may benefit from reinvesting maturing principal and income payments at higher, more attractive rates. Lastly, if additional non-core assets are utilized tactically, these higher rates also may benefit the overall portfolio.

Non-core Fixed-Income
Complementary Strategies

Outlook for Rates From Bond Market Perspective

While some observers consider a spike in interest rates inevitable, we believe it’s still too early in the economic recovery to expect that outcome. The overall economy certainly has improved since the onset of the financial crisis, but it can hardly be described as robust. Three commonly followed economic barometers (see table) suggest that we remain far removed from what would be considered a rapidly expanding economy that would trigger changes to the country’s broader monetary policies.

*Bloomberg Composite Forecast 2014 Source: Bloomberg

It’s important to note that the modest growth experienced since 2008 occurred only after massive and unprece­dented stimulative policies implemented by the Federal Reserve over several years. Indeed, the Fed overnight rate has been reduced to zero, a number of asset protection measures have been instituted to increase confidence, and it continues to actively purchase long-term bonds to keep rates low. The Fed also has indicated it could take further steps to keep a low-rate environment until signs of a robust economy are clear. Our view is that despite positive signs, the economy still is reliant on these policies and not yet self-sustaining.

Continued economic headwinds have the potential to threaten progress as well. Fallout from the never-ending European debt crisis, a possible China asset bubble, and rising international tensions (from North Korea, the Middle East and elsewhere) all pose potential hurdles for the U.S. economy that would keep rates in check.

With the economic recovery still a work in progress, we believe fixed income should remain a vital part of a client portfolio. There continue to be diversification benefits from having bonds within a riskier overall portfolio. Given the likelihood the Federal Reserve would provide guidance regarding future policy changes, we also feel that any price risk to portfolios would be minimized. Importantly, the fundamentals of the U.S. economy don’t justify the notion that inflation will occur in the near future and pose a threat to a well-diversified, short- to intermediate-term portfolio. When rates are likely to rise, a properly positioned portfolio can benefit through broad diversification and an active maturity allocation.

The views of the authors of these articles do not necessarily represent the views of First Republic Bank. First Republic Private Wealth Management encompasses First Republic Investment Management ("FRIM"), the Luminous Capital division of First Republic Investment Management, First Republic Trust Company ("FRTC"), First Republic Trust Company of Delaware LLC and First Republic Securities Company, LLC ("FRSC"), Member FINRA/SIPC. FRIM, FRSC and FRTC of Delaware LLC are subsidiaries of First Republic Bank. FRTC is a separate division of First Republic Bank.

This document is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein. 

Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such.  This document may not be reproduced or circulated without our written authority.

Past performance is not indicative of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

The investment services and products mentioned in this document may often have tax consequences; therefore, it is important to bear in mind that First Republic Bank and its affiliates do not provide tax advice. The levels and bases of taxation can change. Investors' tax affairs are their own responsibility and investors should consult their own attorneys or other tax advisors in order to understand the tax consequences of any products and services mentioned in this document. Accordingly, you and your attorneys and accountants are ultimately responsible for determining the legal, tax and accounting consequences of any suggestions offered herein.  Furthermore, all decisions regarding financial, tax and estate planning will ultimately rest with you and your legal, tax and accounting advisors.  Any description pertaining to federal taxation contained herein is not intended or written to be used and cannot be used by you or any other person, for purposes of avoiding any penalties that may be imposed by the Internal Revenue Code.  This disclosure is made in accordance with the rules of the Treasury Department Circular 230 governing standards of practice before the Internal Revenue Service.

Investment and Advisory products and services are not deposits or obligations of, or insured, guaranteed or endorsed by any bank, Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency, entity or person.  The purchase of securities involves investment risks including the possible loss of principal.