Fixed income can play an important role in your portfolio; but its role may vary according to your financial needs and concerns. If you’re looking to fixed income for safety, income, and more stability in your portfolio, you must weigh these priorities against your concerns over future interest rates, inflation, government debt, and other factors that might affect fixed income returns.
Striking this balance can be a challenge in any market environment, but especially now, as low interest rates have sent many investors on a quest for higher-yield bonds or alternative investments. Depending on your approach, this pursuit of yield may invite more risk—some of which may be hard to see or understand.
So, what’s an investor to do? How can you make prudent fixed income decisions while also addressing today’s low interest rates? Consider these principles:
Remember How Markets Work
The same core investment principles apply in any market environment. One key principle is that in a well-functioning capital market, securities prices reflect all available information. Today’s bond values reflect everything the market knows about current economic conditions, growth expectations, inflation, Fed monetary policy, and the like. So, according to this principle, the possibility of rising interest rates is already factored into fixed income prices.
This is one reason investors should view future interest rate movements as unpredictable. Even the market experts who have access to vast amounts of research have a hard time predicting the direction of interest rates. For instance, despite regular predictions of rising interest rates over the past two years, nominal yields on US Treasuries and longer-term bonds have continued falling and now are at historic lows.
Rather than trying to predict macroeconomic forces that are difficult to foresee, investors can look to the market to set prices and focus on the variables within their control.
Start with a Clearly Defined Goal
Fixed income choices should follow a broader investment strategy that defines the role of fixed income in a portfolio. The portfolio can then be customized to meet those specific goals while managing tradeoffs.
The chart below illustrates how portfolio objectives can influence a fixed income approach. An investor who wants to seek to avoid losing market value might have a different fixed income allocation from someone who wants to take a balanced approach, needs immediate income, or is seeking higher returns. Investors with different objectives typically have different tradeoffs regarding risk, expected return, and costs.
Know What You Own
Strive for transparency in a portfolio. This means understanding an investment manager’s basic strategy and knowing how the instruments held in the portfolio might respond in different economic, market, and interest rate scenarios.
Unfortunately, investors who chase performance often make their investment decisions based on the past performance and perceived popularity of the strategy. For example, some of the mutual fund categories experiencing the heaviest inflows of cash in the industry are in asset groups that have recently experienced higher than average yields. Higher yields are typically accompanied by higher risks. But do investors know what risks their managers are taking to deliver those attractive yields?
Understand the Tradeoffs
When reaching for higher yield, investors should carefully consider the potential effects of their decisions on expected portfolio performance and risk. In the fixed income arena, investors have two primary ways to increase expected yield and returns on bonds. They can:
- Extend the overall maturity of their bond portfolio (take more term risk).
- Hold bonds of lower credit quality (take more credit risk).
These may be reasonable actions. But pursuing higher income means accepting more risk, as measured by interest rate movements, price volatility, or greater odds of losing value if the issuer defaults. Higher yield can also bring potentially higher volatility. High-yield bonds typically exhibit more volatility relative to other bonds.
Ladder Your Bonds
Buy-and-hold investors can manage interest rate risk by creating a “laddered” portfolio of bonds with different maturities. When one bond matures, you have the opportunity to reinvest the proceeds at the longer-term end of the ladder. If rates are rising, the maturing principal can be invested at a higher rate. If rates are falling, your portfolio is still earning higher interest on the longer-term holdings.
Pay Attention to Costs
Investors typically do not realize that investment-related costs determine a large part of a portfolio’s yield and return. This applies especially to fixed income securities. In fact, research has shown that a bond mutual fund’s expense ratio helps explain much of its net performance—and funds with the highest expenses tended to have the lowest performance within their peer group.
Consider a Global Fixed Income Strategy
Investors have other tools to enhance risk and expected returns in fixed income. You can expand your opportunity set by moving beyond your domestic fixed income market to access yield curves in other country markets. By owning bonds issued by governments and companies from around the world, investors can enhance diversification in their fixed income portfolios. After hedging against currency risk, bond markets around the world have only modest correlations. (Correlation refers to how similarly two investments perform in the same period.) As a result, a global hedged portfolio should exhibit lower volatility than a single-country portfolio or a global portfolio that does not hedge currency risk, and offer the opportunity to take advantage of more attractive yield curves abroad.
No one really knows when and by how much interest rates will change. Many market pundits have forecasted an upward move for several years now. Investors looking for higher bond yields should understand the higher risks tied to their decisions. Most investors might be best-served by building a fixed income strategy to complement their broader portfolio objectives, understanding the sources of risk and expected return, building a bond ladder, paying attention to fees, and looking beyond their own country to capture yields in other countries’ markets.