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STA Weekly Report – A Note on Bond Performance in an Evolving Interest Rate Environment

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A Note on Bond Performance in an Evolving Interest Rate Environment
Weekly Technical Comment
September is Life Insurance Awareness Month!
401k Plan Manager

Like many investors across the country, you have probably noticed an increased level of unrealized losses in your bond portfolios. These losses have taken their toll on overall portfolio performance and investor sentiment this year, leading many investors to question their allocation toward fixed income securities.

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For the first time in a long time, we are amid an interest rate hiking cycle. The economy is growing, small signs of inflation are bubbling beneath the surface, and consumers continue spending. As baseline interest rates rise (i.e. the Federal Funds Rate), the risk-free rate of return becomes far more attractive. This causes investors to expect and demand higher rates of return on risk asset investments.

Source: RBCGAM

As you may know, interest rates and bond prices move opposite (inverse) to each other. To illustrate, let’s take the example of an investor who had purchased a 5-year AAA-rated corporate bond yielding 4.5% in 2014 when the yield on a risk-free 2-year treasury bill was 0.35%. At the time, that was a good deal as that investment would have had a yield 415 basis points higher than the risk-free rate while maintaining a relatively low-risk investment in a highly rated corporate bond. By the end of 2015, that same 2-year treasury bill could be purchased at a yield of just under 1%. The effective risk-free rate of return thus increased 2.5x. As a result, the investor who had purchased the 5-year AAA-rated bond in 2014 would have seen the market value of that corporate note reduced to reflect a drop in incremental value as the same AAA-rated bond would only be yielding 350 basis points greater than the risk-free rate.

Had the investor in the hypothetical illustration above tried to sell the above corporate bond on the open market before its maturity date, he would be likely to experience a capital loss because of the rise in underlying rates and the substantial drop in intrinsic value represented by that 4.5% note.

The good news is this however – Barring some type of negative credit event like a bond default by the issuer, the decline in market value would merely be temporary. The chart that follows, helps to illustrate how this works for both a bond initially purchased at a discount and for a bond initially purchased at a premium.


As the chart above shows, a bond purchased at a discount would see its price rise and converge toward par as the maturity date nears. Conversely, a bond purchased at a premium would see its price decline toward par as the maturity date nears. During the holding period in the above scenario, it is thus the coupon that an investor collects that should be of utmost concern as both premium and discount bonds will return the face (or par) value at maturity.

To take advantage of these bond characteristics however, investors need to make sure their advisor has a fixed income strategy that is both robust and disciplined.

At STA, we favor two key components of a fixed income management approach.

First, we believe the right way to approach bond investment is to invest in bonds with the objective of holding those bonds to maturity. During the holding period you receive interest (or coupon) payments along the way. Further, when a bond matures, and barring a default by the issuer, an investor also receives the full face value of that bond, regardless of the bond’s purchase price (premium or discount) or market value. In a rising rate environment like we have today, it is thus critical to hold fixed income securities to maturity as a guard against realizing capital losses stemming from interest rate risk.

Second, we believe bond investors are well served building a bond ladder which can have bonds maturing on a rolling basis, and making available proceeds that can be reinvested at prevailing interest rates. The chart below provides an example of how this strategy works.

Currently, we believe a shortened bond ladder is appropriate. By looking for shorter duration bonds, an investor is less susceptible to interest rate movements. The shorter a bond’s maturity, the less risky it is to the investor because there is a shorter period of time that interest rate changes can occur.

Source: Fidelity


The Little Engine that Could – A Mild Pullback…

…The major index ETFs are in long-term uptrends and short-term downtrends. There is no denying the long-term trend because we saw fresh 52-week highs in several major index ETFs over the last few weeks (SPY, QQQ, IJR, MDY). Note that the S&P SmallCap iShares (IJR) and the Nasdaq 100 ETF (QQQ) are still the leading gainers year-to-date with advances of 16.7% and 18%, respectively.

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Stocks pulled back over the last week or so with QQQ leading the pullback. So far, the pullback has been rather mild for SPY, IJR and MDY because they are down 1% or less. Selling pressure in the broader market has not been intense. QQQ is down around 2% over the last eight trading days and was the only one to notch a short-term oversold reading.

Stocks Still Outperforming Bonds – Risk On

Below is a chart that illustrates the ratio of the S&P 500 ETF (SPY) and the 7-10 year Treasury ETF (IEF). The reason I use the IEF vs. TLT (10-year treasury) is that the 7- 10 year is the best indicator as it is more in the “belly” of the curve – the most active area of Treasuries.

You will notice that stocks outperformed bonds from October 2017 to January 2018. Then there was a choppy underperformance of stocks relative to bonds, and since April stocks again have been outperforming bonds. You will also notice during the period from April until recently that the ratio chart has shown higher highs and higher lows. This is a positive technical indicator for the broader stock market and indicates a lack of fear by investors. Obviously, trends will change at some point, but currently the trend is still positive for the broader stock market.

Weekly Snapshot of Global Asset Class Performance

If you have any questions, please feel free to email me at


STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Mike Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)



Written by: Scott A. Bishop, MBA, CPA/PFS, CFP®

September is National Life Insurance Awareness Month. While many Americans recognize that it is important to protect loved ones with life insurance, far too many lack adequate coverage. National Life Insurance Awareness Month is intended to prompt Americans to assess their life insurance needs. Any thoughtful and compromise financial plan will consider protecting your family to help better assure your family goals are met in the event of a premature death.

To that end, please check out this linked article on Protecting Your Loved Ones with Life Insurance

This article discusses:
1. How much life insurance do you need?
2. What are the types of life insurance policies?
3. How do you choose and/or change your beneficiaries?
4. What type of insurance is right for you?
5. How often and how do you review your coverage?

If you haven’t reviewed your policies lately, please contact us at STA wealth so we can discuss how to best incorporate life insurance into your financial plan.



Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA Wealth Management, LLC. Please remember to contact STA Wealth Management, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. STA Wealth Management, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the STA Wealth Management, LLC’s current written disclosure statement discussing our advisory services and fees continues to remain available upon request.




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