In August of 2020, Federal Reserve Chair Jerome Powell announced a change in how the Fed views inflation. In the past, the Fed said it would consider adjusting short-term rates when inflation approached 2 percent. But in light of 2020’s many challenges, the Fed’s new policy may allow inflation to run above 2 percent for a period of time before any shift in monetary policy is considered.
For many, bonds are a critical component of their overall investment strategy. So, any change in Fed policy regarding inflation may influence a portfolio.
That's why it’s so important to understand that the market value of a bond will fluctuate with changes in interest rates. In other words, when interest rates rise, the value of existing bonds will typically fall.*
*Asset allocation is an approach to help manage investment risk. Asset allocation does not guarantee against investment loss.
There’s no doubt this will be a subtle change for many. But for bond investors, the policy shift may indicate that the Fed has given itself more flexibility in the future.
But, what does that mean for the outlook for the bond market as a whole? It’s unclear. However, lower levels of unemployment in recent years have not led to higher inflation. This new phenomenon runs counter to the Phillips curve, a concept which states that inflation and unemployment have a stable and inverse relationship.
With this data in mind and the changes announced by Chairman Powell, it could be argued that the Fed believes the relationship between unemployment and inflation has changed.
More About Bonds: How Are Bonds Taxed?
Bonds are sometimes used as an investment vehicle, but as with any investment, there are tax considerations as well.
The interest you receive from corporate bonds may be taxable, which means that those taxes impact a portion of your earnings. In addition, savings bonds and government-issued Treasury bonds may be exempt from state and local taxes, but they may be taxable on the federal level. On the other hand, municipal bonds may be tax-exempt on the federal level, but they may be taxed at the state and local level.
With this being said, it's always important to understand the tax implications of your investments. After all, it's not about what you make - it's about what you make after taxes!
Treasury Bonds vs. Municipal Bonds
Treasury bills, notes, and bonds may be exempt from state and local taxes, but they are fully taxable on the federal level.
Municipal bonds, on the other hand, are exempt from federal income tax. Municipal bonds also may be exempt of state and local income taxes for investors who live in the area where the bond was issued. However, if a bondholder purchases a municipal bond mutual fund that invests in bonds issued by other states, the bondholder may have to pay income taxes.
Keep in mind that if an investor sells a bond before maturity, it may be worth more or less than the initial purchase price. By holding a bond to maturity, an investor will receive the interest payments due plus your original principal, barring default by the issuer. Investments seeking to achieve higher yields also involve a higher degree of risk.
Schwab.com, August 27, 2020
Investopedia.com, May 19, 2019
Please remember that 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 made reference to directly or indirectly in this content, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for you or your portfolio. Due to various factors, including changing market conditions, 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 (article) serves as the receipt of, or as a substitute for, personalized investment advice from Searcy Financial Services, Inc.
The content of this letter does not constitute a tax or legal opinion. Always consult with a competent professional service provider for advice on tax or legal matters specific to your situation. To the extent that a reader has any questions regarding the applicability of any specific issue discussed in this content, he/she is encouraged to consult with the professional advisor of his/her choosing.
Published for the blog on October 5, 2020 by Searcy Financial Services, your Overland Park, Kansas Fee-Only Financial Planner and Investment Manager.