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Does anyone care to get struck by lightning? I’ll guess not, but did you know that your odds of getting struck by lightning in the U.S. are about 417 times greater than winning the lottery jackpot and I’ll assume some of you have played the lottery this year? If you desire to take a chance on winning a $100 million lottery jackpot, the odds are something like 1:292,000,000. However, many of us take that ridiculous chance because the consequence of not winning costs us a measured degree of speculation of only two dollars. There is a measured degree of speculation or chance to nearly everything we do, including how we construct our investment portfolios. Are you willing to bet 55% or even 36% of your hard earned investment portfolio on where we are in this economic cycle? What are the consequences of our decisions?
The fixed income allocation of a portfolio is often designed to protect principal, not necessarily generate growth. It sort of boring necessity that isn’t exciting or even fun to construct, but nonetheless the foothold for portfolio stability. It is far more stimulating to invest in assets geared to expanding our wealth versus preserving our wealth. We find ourselves in a market environment filled with uncertainty. My hope is to emphasize the basic benefit of preservation of capital: let’s not lose what we’ve worked so hard to make and grow. During the last recession, equities lost 36.3% of their value and lost 54.9% over the last entire bear market. Of course we don’t know exactly when the next recession (or bear market) will be or if equities will lose as much value. No one knows whether we are at the economic cycle’s end or not, but there are quality arguments that suggest we could be. Maybe in 18 months? 12 months? Perhaps within 6 months?
Interest rates continue to plummet and the 3 month T-Bill remains inverted to the 10 year Treasury. Finding yield is difficult and the thought of settling for 2.00% yields starts discussions of asset class alternatives. For example, why settle for 2.00% when a 4.00% dividend paying stock exists? This appeal hinges on a stock’s price remaining constant or increasing. Is this an appropriate time to put principal at risk? That is a very individualized question with no right answer. There are individuals that think the economy is in better shape than is being scripted while others claim we are in increased economic uncertainty and even a declining productive state. Perhaps this divergence in opinion is enough to create pause?
Say you choose to invest in a 4.00% dividend paying stock rather than the 2.00% bond. On $100,000 that’s an extra $2,000 income per year. But what if things go wrong? What if we go into a recession? According to Bloomberg articles, Stanley Druckenmiller moved to a risk off trade and bought a bunch of Treasuries and Jeffrey Gundlach puts a recession as a 50-50 probability in the next 12 months. These are some well-respected and household financial names thinking the cycle is ending and committing to caution. Let’s say a recession does occur and you lose between 36.3% and 54.9% of your equity value. The potential higher $2,000 in income may be accorded with a loss in principal of $36,300 to $54,900 should the market fair like it did in the previous bear market. Will the dividend continue during a recession? Who knows? Is the measured degree of speculation providing sufficient reward to offset the potential downside? The bond (baring an outright default) will continue to pay its coupon. During the 2 previous recessions, interest rates declined so if that repeated, the bond price would rise in value providing a positive total return. More importantly, the principal invested stays intact regardless of interest rate movement. When the bond matures, the entire face value is returned, ready to be reinvested.
Maintain appropriate allocations to fixed income. Don’t “chance” the wealth you want to keep. Misreading the market’s economic cycle position can create catastrophic consequences. Although a 2.00% 10 year U.S. Treasury bond epitomizes a low interest rate environment, it boasts a significant advantage to many global economic powers (i.e. 234bp higher versus Germany’s 10yr). How aggressive or conservative you decide to be with your equity portfolio allocation during this uncertain economic period may have a significant effect on the portfolio’s net worth. Be cautious and measure any “chance” against the possible consequences, good or bad.
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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