We are going to take a break from our Financial “Stop Doing” series this month to address a subject that is of both timely and timeless importance. What is fixed income and what role does it play in your investing?
Fixed income is a timely conversation, given the current climate of ho-hum returns and continued uncertainty over when or if these conditions may change. The general consensus is that rates will rise eventually. But when, by how much and how quickly they will increase is anybody’s guess [Interest Rates Are Rising (or Falling) – What Should I Do With My Bond Investments?], as is what impact it will have on the markets when they do. This has been tempting many investors to question whether to alter their fixed income strategies or even back away entirely until the coast is clearer.
Fixed income is also a timeless subject. Over the years and through varied conditions, I have often seen investors misunderstand the optimal role that fixed income should play in their portfolio. This causes them to choose inefficient tools for the task, trade in and out of their holdings at inappropriate times, and experience less confidence in the choices they do make.
Armed with understanding, it becomes easier to make sense of the never-ending onslaught of news and wide array of investment choices. Fortunately, a few basic principles can guide the way. Overall, they are based on optimizing the components of fixed income investing that are more readily within our control, and avoiding becoming hamstrung by those that are not.
Fixed Income Principle #1: Invest According to 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.
Fixed Income Principle #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.
Fixed Income Principle #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 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.
Fixed Income Principle #4: Structure Your Fixed Income Holdings for the Job at Hand
Just as there are various kinds of stocks, there are various kinds of bonds, with varied levels of risk and expected return. There also are ever-changing “spreads” between higher- and lower-risk bonds. Sometimes the spread is narrower, which means lower- and higher-risk bonds are offering similar expected returns. Sometimes the spread widens, and riskier bonds offer higher relative expected returns. Either way, the nice thing is that these “spreads” are easily observable in the current bond prices … no forecasting is necessary!
Regardless of wide or narrow spreads, 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. We also favor diversifying your fixed income holdings globally, by incorporating varied terms and credit ratings to accommodate wider or narrower spreads.
Again, we recommend embracing these and other investment principles that are within our control. 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.
If you are still tempted to sit out the current bond market awaiting greater clarity, consider this: Bottom line, we live in an unclear world. This is especially so when it comes to predicting how markets might react to better or worse news that we can’t yet know. The fixed income markets are certainly no exception to market uncertainty! We invite you to read our related Q&A, “[Interest Rates Are Rising (or Falling) – What Should I Do With My Bond Investments?],” for a more detailed exploration into the potential perils of bond market forecasting.