The Role of Fixed IncomeInvestment
The coronavirus impact on the global economy has been front page news all week. Anyone who is keeping even a casual eye on financial headlines is aware that equity returns have taken a direct hit with the biggest weekly stock market losses since 2008. As usual, we won’t predict whether the current correction will deepen or soon dissipate. But what was good advice in mild markets remains even better advice today.
Instead of expending valuable energy on perennial uncertainties, we suggest that a more practical approach to managing your portfolio is to optimize the components that are more readily within your control - the fixed income and equity portions alike. Today we will focus on the fixed income allocation of your portfolio.
The Role of Bonds in Your Portfolio
With a total-return approach, we typically want you to reserve your fixed income investments for their primary purpose, which is to provide a stabilizing counterbalance to your equity holdings, while offering a modest investment return – typically in that order.
Over the long-term, stocks have delivered higher returns than bonds, based in part on the different kinds of risk you’re assuming by investing in them. But to actually receive those higher expected returns, you must be prepared to sit tight during the wilder ride that equity risks entail.
Setting aside a portion of your investments in relatively high-quality bond funds or similar holdings is essential to helping you maintain your resolve during periodic stock market downturns. Taking on too much bond market risk detracts from that important role, and is not expected to add more value than could be achieved by building an appropriately allocated stock portfolio.
Even though it’s a good idea to take a “safety first” approach to your bond and bond-like holdings, we understand that it can be hard to see them earning next to nothing without wondering whether there is anything you can do to improve on things. But one way to come close to having your cake and eating it too is to invest in a diversified bond portfolio of relatively high-quality, short- to mid-term bonds.
Bonds Are Safer; but Not Entirely Safe
To further maintain your financial resolve in the face of complex and often conflicting fixed income news, it may help to understand that, compared to stocks, bonds have historically exhibited lower volatility and market risks, along with commensurate lower returns. But they do exhibit some volatility, as well as some market risk. Because bonds represent a loan versus an ownership stake, they are subject to two types of risks that don’t apply to stocks:
- Term premium – Bonds with distant maturities or due dates are riskier, so they have returned more than bonds that come due quickly.
- Credit premium – Bonds with lower credit ratings (such as “junk” bonds) are also riskier, and have returned more than bonds with higher credit ratings (such as investment grade and government bonds).
When reading bond market headlines about interest rates, yield curves, credit ratings and so on, these are the two risks and commensurate return expectations that are rising or falling along with the news. As such, as alarming or exciting as bond market news may become, compared to stocks, the levels of volatility and degrees of risk need not – and really should not – be as extreme as we must tolerate in equity investing to pursue higher expected returns. The decisions you make about the risks inherent to your bond holdings should be managed according to their distinct role in your portfolio.
Consider the Alternatives Depending on market conditions and your own circumstances, there may be times when other bond-like investments may fulfill the risk-dampening/modest-return role in your portfolio even more effectively than bonds or bond funds. Certificates of Deposit (CDs) may offer slightly higher returns for similar levels of risk.
But it’s important to look beyond just the face-value interest rate before taking a leap. A higher rate may also bring added risks – such as a longer lock-in period when you won’t be able to withdraw your money without incurring penalties. Different investments may also generate different taxable outcomes, so it’s worth comparing your choices on an after-tax basis.
Act on What You Can Control
Here are some proactive steps you can take to appropriately position your fixed income investing to withstand varied market conditions.
Just as there are various kinds of stocks, there are various kinds of bonds, with different levels of risk and expected return. Because the main goal for fixed income is to preserve wealth rather than stretch for significant additional yield, we typically recommend turning to high-quality, short- to medium-term bonds that appropriately manage the term and credit risks described above.
Are you keeping an eye on the costs? One of the most effective actions you can take across all your investments is to manage the costs involved. When investing in bond funds, this means keeping a sharp eye on the expense ratios and seeking relatively low-cost solutions. That doesn’t necessarily mean finding the cheapest fund out there. If a fund’s investment objectives do not align with yours, saving on the cost of investing in it won’t help. First identify the funds that do meet your goals, and then let the costs involved be one important factor in making a final selection.
For individual bonds, it becomes especially important to be aware of opaque and potentially onerous “markup” and “markdown” costs. While these are easily the subject of another article entirely, suffice it to say that they are always there – even if your broker tells you that there are no trading costs. What he or she really means is that there are no obvious trading costs. Markups/markdowns are the difference between the “wholesale” costs that bond brokers pay for the bonds and the “retail” prices you pay. To avoid paying more than you should for your bonds, it’s best to align yourself with an advisor or fund manager who has the experience and resources to keep a close eye on these and other hidden costs that may eat away at your end returns.
Are your solutions the right ones for the job? Whether turning to individual bonds, bond funds or similarly structured solutions such as Certificates of Deposit (CDs), your fixed income portfolio should strike a harmonious balance between necessary risks and desired returns – within the context of your own plans and according to the distinct role that fixed income plays within those plans.
Invest According to a Sensible, Customized Plan
If there’s one principle that drives all the rest, it’s the importance of having a personalized detailed strategic plan – preferably in the form of a written Investment Policy Statement. If you have a personalized plan, you have a cornerstone for any and all investment decisions you make, including building and maintaining an appropriate balance between stocks and bonds, as well as determining what to include within your bond portfolio.
In short, it remains good advice to invest according to what decades of empirical evidence has to say about earning long-term returns and mitigating related risks. That means not taking too much stock in what the headlines are screaming at you. It means observing and minimizing costs. It means focusing on your personal goals, and on ensuring that your portfolio is optimized toward achieving those goals – today, tomorrow and over the long haul.
If you’ve not taken the time to assess your total portfolio’s risk/reward balance lately, this is one of the most important steps you can take to ensure that your investments are doing all that they can for you.