The Flock to “Safety”
Over the last few months, much of the focus has been on the stock market’s sudden crash before its eventual rise. Now that we’re seeing a little more stability in the markets, some clients have begun questioning how the “safer” investments in their portfolios are performing during this volatile time.
Typically, diversified portfolios with investments such as bonds, treasuries, money markets, and gold, protect against the volatility of the stock market and it is our strongly held belief that all of our client’s portfolios should contain these investments. However, these investments are not without risks of their own. Very briefly, these risks can include:
Interest Rate Risk comes into play when the Federal Reserve raises interest rates, commonly dropping the value of currently owned bonds. Also, the demand for the existing bonds lowers, since investors could purchase new bonds at a higher yield. The opposite is true when the Federal Reserve lowers interest rates sending the demand for currently owned bonds up and increasing their price.
Reinvestment Risk. Investors risk reinvesting at a lower yield when a currently held bond or CD matures because interest rates might have fallen since the initial investment. Although reinvestment risk doesn’t affect the current price, those relying on consistent interest payments could see an impact on future plans.
Credit Risk is a factor because the yield on bonds depends upon the creditworthiness of the issuers. Particularly in volatile times, some issuers of bonds may not be able to make consistent/punctual interest payments and could ultimately default. The greater the uncertainty that a bond will be repaid, the higher the yield an investor will demand.
Inflation Risk. Yields may decrease if inflation increases. While money markets and treasuries are not likely to lose any principal, they will lose purchasing power if their value of increases is slower than the rate of inflation.
Liquidity Risk refers to the ability to sell an investment quickly and at a reasonable market value.
So, what have we witnessed this year?
When the Fed aggressively cut interest rates to stimulate the economy, investors expected to see their bonds rise in value. This didn’t happen. When the S&P 500 fell over 36%, the US Aggregate bond market fell 12%, short-term treasuries fell 3.2%, and gold fell 15.6%.
These declines were the result of a few factors. Investors fearing a long-term downturn began to wonder if even their “safe” investments were safe enough (credit risk). Ultimately deciding they weren’t safe enough, they desired cash. With so many bondholders wanting to sell at once, there weren’t enough willing buyers, which forced sellers to accept a lower price for their bonds thus driving down the bond market (liquidity risk).
Fortunately, through Quantitative Easing, the Fed stepped in to purchase bonds, helping to quickly stabilize prices. From each of their respective low points in mid-March, bonds, short-term treasuries, and gold have recouped most, if not all, of their losses. Furthermore, Federal Reserve Chair, Jerome Powell, has stated that the Fed will take any measures necessary to continue to support bond markets and money market funds.
While safer investments generally act as shock absorbers to lessen the impact of stock pullbacks, the perfect storm correlated most investment vehicles in the short-term. It is our view that with the Fed’s actions and with the stabilization of investors’ sentiment on the fixed-income market, the short-term volatility has mostly passed, and the long-term expectations for “safer” investments have returned.
Though every investment carries risks, we weigh those risks with consideration to when you require cash flow, your tolerance for such fluctuations, and how each investment fits into your overall financial plan. Our commitment to all of our clients is to continually monitor the markets in conjunction with your on-going needs to ensure that even in times of uncertainty, your long-term goals are not compromised.