The Federal Reserve’s (Fed) continued support is proving to be a stabilizing force in the economy. Since March, the Fed has lowered their lending rate to almost zero, pumped trillions into the economy by purchasing Treasury and mortgage backed securities, and has taken the unprecedented step of backstopping corporate credit markets. These aggressive actions coupled with fiscal stimulus continue to help markets “get back on track.” This is visible in the fact that prices on high quality bonds and stock indices have been able to recover substantially.
As the economy recovers we see the Fed shift from “stabilization” mode to “accommodation” mode. With the recent surge in COVID-19 cases, the road to recovery may be longer than anticipated. However, we are confident that the Fed will continue to be supportive to reach its mandate of full employment and inflation around 2%.
Due to economic uncertainty, the consensus view is that “rates will be lower for longer” – this makes the current environment challenging for fixed income investors. The Fed funds rate at nearly zero has significantly impacted the treasury curve. Rates of 1- to 10-year Treasuries are at historic lows while longer term rates remain repressed. Treasury rates are important to consider when evaluating economic and inflation expectations and are used as a benchmark for quantifying risk.
Despite low interest rates, the U.S. bond market is still an important component of your portfolio and our economy. The U.S. bond market is the largest in the world with over $100 trillion in assets. Unlike the stock market, which focuses on public traded companies, the bond market is comprised of government Treasuries, mortgage backed securities, corporate bonds, and municipal bonds from state and local governments across the country. The spread variances within these sectors and the shape of the yield curve are economic indicators and are an integral part of our investment policy team discussions.
We will continue to selectively add positions to your portfolio that offer value in the current environment. We will be doing this carefully over time and will add positions that compliment your existing holdings by continuing to create a custom “bond ladder” to help diversify from interest rate risk. This allows us to reinvest at different times during the interest rate cycle.
To capture yield, our team is taking a modern, dynamic approach by using both traditional and “alternative” fixed income sources. One of these alternatives is preferred stocks which have both debt and equity components. These hybrid instruments or “baby bonds” yield between 3-5%. We are also considering adding high quality utility stocks and real estate investment trusts (REITs) — each of which provide dividends closer to what the bond market has provided in the past. For clients with higher risk tolerances we have also added a high-yield bond position. As the economy recovers, we will consider adding more holdings from this area.
One of the benefits of using individual securities is that it allows us to be adaptive in our fixed income approach. We can integrate “alternative” approaches into our overall strategy of buying high quality corporates, municipal bonds, Treasury bonds and TIPS. This differs from most bond funds which tend to only have a specific strategy or investment focus. As you may already know, Main Street does not use bond funds due to the added layer of fees, lack of transparency and duration risk due to their lack of maturity dates.
We hope you find this update helpful. Please let us know if you have any questions about your portfolio, wealth planning or have experienced any changes in your financial circumstances.
All of us on the team thank you for your continued vote of confidence!
Your Team at Main Street Research