The hot topic in financial news for at least the first three quarters of this year has been rampant inflation, and the Federal Reserve’s efforts to curb it by raising its benchmark interest rate, the federal funds rate, through a series of systematic rate hikes that began in March. Subsequently, we have seen the fastest pace of rate increases in history. In recent months, the team here at Copia has been making a tactical shift in our fixed income (bond) and cash holding strategy to help mitigate bond market volatility and take advantage of higher short-term rates.
Many of you likely already know (and if you don’t, here’s my best shot at a quick lesson) that interest rates have an inverse correlation to the price, or value, of bonds – meaning that when interest rates rise, the values of issued physical bonds fall … and vice versa. While slightly confusing and not exactly intuitive, the reason for this is fairly simple: older bonds with lower interest rates become less valuable because their coupon payments are now lower than those of new bonds being offered in the fixed income market. Investors would obviously prefer to have a higher coupon, or interest rate, so the older bonds trade at a discount to new bonds with higher coupons.
Now, a traditional “Moderate” to “Conservative” investment portfolio might contain anywhere from 20 – 60% of fixed income in the form of bond funds, either by way of Mutual Funds or Exchange Traded Funds (ETFs). By owning bond funds, investors not only get a diversified portfolio of bonds with varying degrees of quality, durations and expected yields, but they also receive the benefit of an appreciation in the price of a fund when amid an interest rate decreasing environment (remember: rates down = values up). Interest rates have been in a secular cycle of decline since the peak of interest rates in mid-1981, which has helped “traditional” bond portfolios provide a relatively safe “shock absorber” to an investment portfolio that also has exposure to equities (or stocks). Longtime clients of Copia might be familiar with ETF symbols AGG, LQD, TLT, MBB, BSV, and SHY, which have been staples in portfolios for many years. Until recently.
Our shift in strategy within fixed income removes these bond funds and replaces that portion of the portfolio with physical individual bonds. Specifically, our strategy is called a T-Bill Ladder Strategy, and it works best in interest-rate rising environments. It is called a “ladder” because we purchase a U.S. Treasury Bill with a maturity that starts 30 days out, and then additional bonds in 30-day increments up to about 150 or 180 days out. So, if we have 5 or 6 bonds each about 30 days apart, we have a bond that matures every 30 days. At maturity, we then can reinvest at the back end of the curve, at what will likely be an even higher interest rate. Hopefully, you can visualize “climbing the ladder” … every 30 days we “take a step” and reach for a new rung (buy a new bond at the end of the ladder). We can continue this practice for as long as it makes sense and there is increasing value in interest-rate yield in the curve. The other thing we like about this strategy is it gives us new liquidity every 30 days to potentially add some capital back into equities at further depressed prices if we continue to see downward pressure in the market.
Currently, the 6-month T-Bill is yielding above 4.4%, and it’s important to know that T-Bills are about as safe as an investment can get as they are backed by the full faith and credit of the United States Government. Compare this to a Certificate of Deposit (CD), which is another shorter-term investment vehicle that is commonly referred to as “safe,” but is backed only by the financial institution that issues it (much higher likelihood of default).
Hopefully, this helps paint a picture of what we’re doing right now in fixed income portfolios, and you can see the three key values of this strategy: 1) we remove portfolio price fluctuation by eliminating bond funds; 2) we get to take advantage of high, and increasing, short-term interest rates; and 3) we get the optionality every 30 days to either continue to invest in physical bonds, or reallocate toward equities at better entry prices. If you have any questions or have some excess cash that you want to yield at higher rates with very little risk, give us a call in the office!