If there’s one thing investors know about investing, it’s just how much investors don’t know.
First, a hawkish Federal Reserve goes dovish on interest rates, which markets love. But trade war talks with China sputter and stagger, which markets hate. General Motors Co. (ticker: GM) has begun massive layoffs; no one has a clue what the broken Brexit process will bear; the longest government shutdown in U.S. history is either over or taking a problematic pause.
And even the good news on interest rates that came from Fed-land may not be as hunky-dory as it seems.
“The market tends to hear what it wants to rather than what is really being said,” says Brad McMillan, chief investment officer for Commonwealth Financial Network. “So far, what the Fed has said is that it’s being patient with rates. … It did not say that policy will loosen. What the market heard may not have been what the Fed intended to say.”
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All this turmoil and topsy-turvy begs the question that’s always beneath the surface, but hardly subliminal these days: Where can investors place their portfolio bets with a modicum of reassurance? Enter the sphere of Treasury and corporate bonds and the promise it may hold — even if investors seeking a stable yield will want to hold on in a time of wintry economic headwinds.
“With the Federal Reserve essentially on hold, the economic expansion has a good chance of continuing longer than what the market was pricing in at year’s end,” says Nichole Hammond, senior portfolio manager at Angel Oak Capital Advisors in the Seattle area. And if the Chinese trade talks ever do get somewhere, “cyclically oriented sectors such as basic industries, capital goods, energy and consumer cyclicals look attractive.”
The most crucial difference between a corporate bond buyer and a shareholder is this: When you buy stock, you essentially purchase a stake of a company — you own a piece of it. But with a bond, you loan money and collect interest, just as a bank would, to whichever company (or government entity) issues it.
One equation in investing in the right bond centers on the financial rating of a company, or companies grouped in an entire sector. Three ratings agencies assign grades to bonds, with AAA or Aaa being the highest, also known as “prime.” When a bond falls below BBB- (Standard & Poors, Fitch) or Baa3 (Moody’s), it becomes junk as opposed to investment grade. The tradeoff for buying a junk bond is that a higher yield comes with the higher risk. Overall, ratings agencies evaluate a company’s prospective cash flows against its debt and other obligations to formulate a credit rating.
As for those sectors where bonds have experienced the most turbulence, count energy among them.
“For example, when oil prices crashed from 2014 into 2015, many energy companies, whose cash flow is tied to the commodity price, saw their credit ratings downgraded,” says Seth Hieken, executive vice president and director of proprietary strategies at The Colony Group.
In other instances, “a company’s products fall out of favor, threatening future cash flow, or a company may reveal a large potential liability from a lawsuit or investigation,” Hieken says.
[See: 8 Ways to Stay Safe Around Stock Market Bears.]
But even otherwise upright organizations run risks with the bond debt they sell. “We also often see decent businesses that are simply overleveraged as its managers push too hard for growth,” he says.
By contrast, “Companies that derive, 80 to 100 percent of their revenues directly from the United States shall fare better,” says Michael Cullen, managing director and head of investment grade credit and rates at 280 CapMarkets in Middleton, New Jersey.
“The U.S. economy is the gold standard at the moment with low unemployment, strong GDP and low inflation,” Cullen says. “Tariffs and foreign exchange rates due to the strong U.S. dollar will impact the bottom line of companies that have a global footprint.”
Although riskier bonds usually offer higher yield, those with low-grade ratings are seen as even riskier than normal, experts say.
Russell Investments’ 2019 Global Market Outlook concludes that “high-yield credit is expensive and losing cycle support, as is typical this late in the cycle, when profit growth slows and there are concerns about defaults,” writes Pete Gunning, global chief investment officer.
“As we come closer to the end of an economic growth cycle, we also see investors reducing risk by shifting from equities to bonds,” says Steven L. Skancke, chief economic advisor at Keel Point, a wealth management and investment firm with offices in the Washington D.C. area.
That trend holds true “across the spectrum of high-yield, investment grade corporates, and U.S. government and agency bonds,” Skancke says. Here’s the key: “If the goal is to preserve liquidity while capturing a guaranteed return, then a U.S. government bond consistent with when the liquidity is needed is a good place to start.” Among other things, he says, “the credit rating of the U.S. Government is AAA.'”
Now how many government shutdowns — and for how long — it would take to drag down a Treasury bond’s rating is another story.
[See: 10 of the Best Stocks to Buy for 2019.]
Regardless, investment markets don’t and won’t halt for anything or anyone. And if it’s reassurance you want, consider these parting thoughts from Skancke, who’s also a long-serving adjunct professor of economics and international affairs at George Washington University:
“For investors needing the certainty of funds over the next two years — retirement, college tuition, major family expenditure — having money set aside in short-term financial bonds could be a good investment,” he says.
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Why Investors Put Bonds in a Portfolio originally appeared on usnews.com
