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A Focus on Fixed Income

By September 28, 2015June 10th, 2016Investment Consulting

Anyone who is keeping even a casual eye on financial headlines these days is aware that fixed income returns have been a moving target for a while now – at home and abroad. The general consensus is that rates will rise eventually. With almost nowhere to go but up, they practically have to. But when, by how much and how quickly they will increase is anybody’s guess, as is what impact it will have on domestic and global markets when they do.

Instead of expending valuable energy on perennial uncertainties, we would suggest that the more practical approach to managing your portfolio – the fixed income and equity portions alike – is to optimize the components that are more readily within your control. Fortunately, there are a number of solid, evidence-based strategies we can suggest to guide your way.

Guiding Rule #1: Invest According to a Sensible, Customized Plan

If there’s one principle that drives all the rest, it’s the importance of having your own detailed investment plan – preferably in the form of a written and signed Investment Policy Statement. If you have a personalized plan, you have a touchstone 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 the absence of a plan, undisciplined investors instead struggle to predict how, when and if it’s time to react to unknowable events over which they have little control. While there is no guarantee that your plan will deliver the outcomes for which it’s been designed, we believe that it represents your best interests and your best odds for achieving your personal goals.

Guiding Rule #2: Let the Evidence Be Your Guide

With your personalized plan in place, a good next step is to embrace the decades of empirical evidence that helps us understand the overarching roles for which each investment is best suited.

Stocks – Stocks are the most effective tool for those seeking to accumulate new wealth over time. But along with higher expected returns, they also expose us to a much bumpier ride (volatility), and increased uncertainty that we may not ultimately achieve our goals (market risk).

Bonds – Bonds are a good tool for dampening that bumpier ride and serving as a safety net for when market risks are realized. They can also contribute modestly to a portfolio’s overall expected returns, but we don’t consider this to be their primary role.

Cash – In the face of inflation, cash and cash equivalents are expected to actually lose buying power over time, but they’re great to have on hand for near-term spending needs.

Thus, in performance and predictability, fixed income is meant to be “cooler” than stocks, but “warmer” than cold, hard cash:

  Expected Long-Term Returns Highest Purpose
Stocks (Equity) Higher Building wealth
Bonds (Fixed Income) Lower Preserving wealth
Cash Negative (after inflation) Spending wealth

By keeping your attention focused on these larger principles of stock/bond investing, it becomes easier to recognize that, even when your bond holdings are plodding along compared to the rest of your portfolio, the more important consideration is whether they are fulfilling their highest purpose in your total wealth management.

Guiding Rule #3: Bonds Are Safer; They’re 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 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/stock 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, as we’ll explore next.

Guiding Rule #4: Act on What You Can Control

So, where does all this leave you, the long-term investor who is diligently adhering to your carefully crafted strategy? Here are some proactive steps you can take to appropriately position your fixed income investing to withstand varied market conditions.

Are your fixed income holdings the right kind, structured according to your goals? 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. For individual bonds, it becomes especially important to be aware of opaque and potentially onerous “markup” and “markdown” costs. While these costs don’t typically show up in the trade report, they are very real, and can detract significantly from 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.

To achieve this delicate balance, it can make good sense to seek the assistance of an objective adviser to help you weigh your options, determine a sensible course for your needs, and implement that course efficiently and cost effectively. Your advisor also can help you revisit your plans whenever the markets or your own circumstances may cause you to question your resolve. Should you stay the course? Are updates warranted? It can help to have an experienced ally to advise and inform you before making your next moves.

Managing the Unmanageable Markets

In stock and bond investing alike, it would be preferred if we could invest according to how the market is going to respond to the next unknowable news. The only problem with that approach is that it can’t be done. As Manisha Thakor expressed in one of her Wall Street Journal “The Experts” posts: “Unless you have certain knowledge that the [US] Fed will be raising rates faster than the implied collective expectation (in which case the regulators would dearly like to speak with you), rather than spend your time guessing what the Fed will do and when, invest in a carefully constructed bond ladder that reflects your specific liquidity and risk needs.”

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. For bonds and stocks alike, these are the most reliable principles available to help us navigate uncertain markets as certainly as we’re able.