Navigating Risk in Fixed-Income Investments

A Look at the Markets: S&P 500

On December 18th, the US Federal Reserve reduced interest rates by 0.25 percentage points to a target range of 4.25%-4.5%, marking its third rate cut of the year. The rate reduction was expected. However, the Fed signalled only two more cuts in 2025, fewer than markets had expected.

As a result, the S&P 500 dropped nearly 3%, while the Dow Jones Industrial Average fell over 1,100 points - its worst decline since August. Investors were disappointed by the Fed’s cautious approach, anticipating deeper cuts to stimulate the economy. The FED’s statement might also reflect concerns about potential inflationary policies from President-elect Trump’s incoming administration, such as tariffs and increased government spending.

This shows how central bank decisions and government policies can influence investor sentiment and stock prices - key factors for business professionals monitoring global markets.

Navigating Risk in Fixed-Income Investments

A Personal Journey Through Bond Investing

Bonds have often not featured strongly in my portfolio. In my younger years, a high-risk tolerance meant my portfolio was heavily weighted towards equities. I was comfortable with short-term market fluctuations, firmly believing that over the long term, stocks would outperform bonds.

As I grew older, when I should have been transitioning towards more conservative investments, historically low interest rates made bonds unappealing. Traditional advice suggested shifting to bonds, but the returns were so low and not without risk that a standard bank savings account seemed like the best option.

A Strategic Pivot: 2023 Bond Investment

In 2023, I made a calculated move into bonds, anticipating interest rate reductions. This decision underscores a fundamental principle of bond investing: the inverse relationship between interest rates and bond prices. After the significant rise in interest rates worldwide following the coronavirus pandemic and Russia’s invasion of Ukraine, I recognized the potential for interest rates to decline, which would positively impact bond prices.

Understanding Bond Risks: A Comprehensive Overview

Risk comes in two primary forms for bond investors:

1. Credit Risk: The Borrower's Reliability

The primary and most critical risk is the likelihood of the debtor defaulting on their payment obligations. Credit rating agencies address this risk by assigning credit ratings to bonds.

• Higher-rated bonds offer lower returns

• Lower-rated bonds promise higher potential returns

• Government bonds typically represent the lowest-risk category

2. Market Value Fluctuations

Bond valuations are influenced by interest rates, but the impact of interest rate changes may not always meet your expectations. Let’s illustrate this concept with a practical example.

Imagine a €1,000 bond with a 2% coupon, which generates annual returns of €20.

Now, let’s consider what happens if interest rates rise to 3%. Would the original bond become more or less valuable?

The answer is that the value of the old bond would decrease. New investors would have the chance to earn a 3% return on a new bond, which would lower the value of the old bond. If interest rates remained at 3%, the value of the old bond would continue to be lower than its face value but would gradually approach its face value at maturity.

Conversely, if interest rates were to drop to 1%, the value of the original 2% bond would rise to reflect the improved return. As it approaches maturity, the value would gradually approach its face value.

Key Takeaways for Bond Investors:

• Government bonds offer stability with lower returns

• Corporate bonds provide higher potential yields with increased risk

• Bond value fluctuates before maturity

• At maturity, investors typically receive the full face value if the borrower remains solvent

Bonds aren't just about immediate returns but about creating a balanced, risk-managed investment strategy.

Are you ready to include bonds or bond ETFs in your portfolio?

Disclaimer:
The content in this newsletter is for informational purposes only and should not be considered financial advice. Make investment decisions based on your personal circumstances, financial goals, and risk tolerance. Consider consulting an independent financial advisor if you need professional guidance.

SMART Goals for Financial Decisions

In our sister newsletter, Financial Fluency, this week, we delved into goal setting using the acronym SMART. Let’s explore how we can apply this acronym to make informed financial decisions.

I’d like to divide this topic into two parts. This week, we’ll focus on investing, while next week, we’ll examine profit-taking goals.

SMART Goals for Financial Decisions

Specific: After analyzing our performance for the current year, we will identify the specific areas where we want to allocate our investments for 2025. This decision may be based on a traditional portfolio split of 60/40 between equities and bonds, or it may be skewed towards one or the other if an area requires rebalancing. The chosen category should clearly specify the exact amount to invest (e.g., 200€ monthly or 10% of salary) and the investment period (e.g., monthly).

Measurable: To track our progress effectively, we need clear metrics. These could include monthly investment amounts or the number of different assets in our portfolio. Using specific numbers helps us stay accountable and adjust our strategy when needed.

It is important to deferential between the things we can control - for example how much we can invest and when - and the things we cannot control - for example the overall performance of the markets in 2025.

Achievable/Attainable: While your monthly target should be achievable, stretching yourself so that is not too easy will pay off in the long run. This is particularly true when you are young and can give your investments more time to work.

Relevant: Your investments must be relevant to your long-term goals whether that is saving for a deposit on a house or saving for a comfortable retirement.

Time-bound: Setting deadlines creates momentum and helps maintain focus. Consider both short-term milestones (monthly investment targets) and longer-term objectives (annual portfolio review dates). For instance, you might aim to set up automatic monthly investments by January 15th, 2025, or complete your portfolio rebalancing by the end of each quarter.

Key Takeaways for Implementation:

Start by reviewing your current financial position and setting clear investment targets for 2025. Remember that while we can't control market performance, we can control our investment discipline and regular contributions. Consider setting up automatic transfers to help maintain consistency in your investment strategy.

Next week, we'll explore specific strategies for taking profits and managing investment returns effectively. Until then, take some time to write down your SMART financial goals for the coming year.

Word of the Day: Attainable

Attainable - adjective - possible to achieve