Reaching for Yield? A Review of the October Municipal Market Commentary
In this month’s Municipal Market Commentary, I talked about the Federal Reserve Open Market Committee (FOMC) and its decision to hold short term interest rates near zero percent for a “considerable time after the asset purchase program ends.” This has been the Fed’s policy for a few years now.
With no change in the foreseeable future, individual fixed income investors may be tempted to reach for yield in the form of riskier investments. Before investors make a shift in their portfolio allocations, I wanted to highlight a few things about this Federal decision that will impact both the economy (macro perspective) and individual investors (micro perspective):
- The unemployment rate is a factor: One of the FOMC’s prime directives is to create and maintain a stable labor market. While unemployment rates fell to 6.2% in August from the 10% peak of the recent “Great Recession,” the needs of the labor market still rank high on the Federal to-do list.
- “On balance, labor market conditions improved somewhat further,” the Federal Open Market Committee said in its statement. “However, the unemployment rate is little changed and a range of labor market indicators suggest that there remains significant underutilization of labor resources.”
- Interest rates will rise in the long-term: While the FOMC is keeping rates low for now, most experts appear to be forecasting a rise in interest rates within the next two years. These higher short term rates, when they take effect, will be welcome from investors currently waiting on the sidelines. But what is the investor who can’t wait and is seeking higher yields and an income increase from their portfolio today to do?
- Invest in lower credit quality securities to increase yield; or
- Extend the maturity of a portfolio for higher returns.
Both of these approaches carry risk. Lower credit quality securities will typically have a higher default rate, and longer maturities will expose investors to the significant negative effect on the value of fixed income investments that are the result of rising rates.
As with many things in life, a yield oriented investment strategy should be done in moderation. Diversification, in both credit quality and maturity range, should be a part of every successful portfolio. Investors that only focus on yield may find that they’re exposed to market changes and circumstances that traditional diversification would protect against. Consult your financial advisor to help determine the right balance between yield and security for your portfolio.
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