Why Invest in Fixed Income
Fixed income securities (bonds) are a fundamental part of an investing plan for most investors. There are many types of bonds along with varied approaches to fixed income investing, each with their own advantages and levels of risk. Although stocks have historically outperformed bonds over the long term, there are a number of reasons to include fixed income investments in a diversified portfolio, including:
Fixed income generally offers higher yields than equities or other securities as well as regular coupon payments, providing bond owners a potentially attractive, regular income stream.
Some investors may not want to take a significant amount of risk with their portfolios. Bond prices, especially those of high-quality bonds, tend to be less volatile than other securities, typically offering investors a lower risk profile.
Fixed income securities have historically demonstrated a low correlation to equities (see below), meaning there is little relationship between how the two asset classes have performed over a given time. Therefore, owning fixed income securities along with equities adds a potential risk-reducing effect to an investor's portfolio.
Correlation Table (January 1998 - December 2008)
Source: Lipper; Bloomberg. Past correlations are no guarantee of future results. Correlation ranges from -1 to 1, with -1 indicating that the returns move perfectly opposite to one another, 0 indicating no relationship and 1 indicating that the asset classes react exactly the same. This is for illustrative purposes only and not indicative of any investment. US bonds in this example are represented by the Barclays Capital US Aggregate Index, Municipal bonds by the Barclays Capital Municipal Bond Index, corporate bonds by the Barclays Capital US Corporate Investment Grade Index, inflation protected Treasuries by the Barclays Capital US Tips Index, large-cap US stocks by the Standard & Poor's 500 Index, small-cap US stocks by the Russell 2000 Index, international stocks by the Morgan Stanley Capital International Europe, Far East, Australasia Index, and commodities by the S&P GSCI Index. An investment cannot be made directly in an index.
Spreading Market Exposure
High-quality bonds have historically performed well when other asset classes struggle. A low correlation to stocks generally makes bond owners less vulnerable to shocks in the equities markets. For instance, in the late 1990s, with the Internet and telecommunications bubbles at their peak, some investors questioned the need to invest in anything outside of equities. But when those bubbles burst shortly thereafter, fixed income securities held up much better than equities.
The chart below shows year-by-year performance of three hypothetical portfolios: an all-equity portfolio, a balanced portfolio consisting of 60% equities and 40% fixed income and a third consisting solely of fixed income securities. The chart shows that, in three periods of stock market distress, a 100% bond portfolio held up far better than an all-stock portfolio, and the 60/40 blend also fared better than the all-stock portfolio.
Amid Stock Declines, Bonds Have Persevered
Source: Lipper. Past performance is no guarantee of future results. All returns assume reinvestment of all distributions. All-equity portfolio reflects the returns of a hypothetical investment in the S&P 500 Index, the balanced portfolio represents returns of a hypothetical investment in a portfolio made up of 60% of the S&P 500 Index and 40% of the Barclays Capital US Aggregate Index and the fixed income portfolio represents a hypothetical investment in the Barclays Capital US Aggregate Index. It is not possible to invest directly in an index.
Risks Involved in Fixed Income Investing
Investing in fixed income securities entails specific kinds of risks. Interest rate risk affects all fixed income investing, and credit and cash flow risk relate more to specific individual investments.
Interest Rate Risk
A broad risk associated with buying and holding fixed income investments is interest rate risk—the possibility that the relative value of a bond will decline due to an interest rate increase. In general, as rates rise, the price of a bond will fall, and vice versa.
This includes default risk, which is the risk that a bond issuer, usually due to financial hardship, will be unable to fully repay the loan represented by the bond.
If an issuer is expected to have difficulty in meeting its payment obligations, its credit rating could be lowered, negatively affecting its value. This is known as credit quality risk.
Individual bonds are also prone to event risk—the possibility that a business, economic or political event will negatively impact the value of the investment. Event risk is largely a concern in corporate bonds, which are bonds issued by companies.
US Treasury securities—such as bills, notes and bonds—are debt obligations of the US government that are backed by the "full faith and credit" of the government and, therefore, are not subject to credit risk.
Cash Flow Risk
Though bonds have a stated maturity, some can be called away by an issuer ahead of its maturity date. Some fixed income securities, such as mortgage-backed securities, have embedded call options which may be exercised by the mortgage holder. The risk associated with the early return of principal on a fixed income security is called prepayment risk. In contrast, extension risk is the possibility of a security lengthening in duration due to the deceleration of prepayments. Both can diminish a bond's total return and alter its risk/return characteristics.
To help minimize cash flow risk, direct bondholders generally buy high-quality securities without embedded call options. While this does offset some risk, holding high-quality securities can cause investors to forfeit potentially higher investment returns.
How to Invest in Fixed Income
There are a number of ways for investors to gain access to fixed income assets, including by purchasing individual bonds, constructing a "ladder" of individual bonds, buying index products or owning shares in actively managed portfolios, such as fixed income mutual funds.
Because investors have diverse investment goals, there is no "one size fits all" approach to owning bonds. However, active portfolio management, led by an investment team and driven by professional analysis, can provide a solid foundation to the fixed income portion of many investors' portfolios.
Buying Individual Bonds
Fixed income securities, or bonds, are debt obligations of the issuer, such as a government, municipality, corporation, federal agency or other entity. In return for the proceeds raised from issuing the bonds, the issuer is obligated to pay interest to the bondholders. Bonds pay interest that can be fixed, floating or payable at maturity to the bondholder. Most fixed income securities carry an interest rate that stays fixed until maturity at a percentage of the face (principal) amount. Typically, investors receive interest payments monthly, quarterly or semiannually, depending upon the nature and the maturity of the bond. For example, a $1,000 bond with an 8% interest rate that pays interest semiannually will pay investors $80 a year, in payments of $40 every six months. When the bond matures, investors receive the full face amount of the bond—$1,000.
Investors often turn to fixed income securities when seeking a steady source of income, greater portfolio diversification or to preserve wealth. Some investors own individual bonds directly, often selecting them with the help of a financial professional. This offers transparency—investors know exactly what they hold—and makes clear a bond's maturity date and specific level of interest income.
Laddering Individual Bonds
Another way to own bonds directly is to construct a bond "ladder." In this structure, an investor holds a variety of bonds with staggered maturity dates so that a portion of the portfolio will mature each year. To maintain the ladder, money that comes in from maturing bonds is reinvested in bonds with longer maturities within the range of the ladder. This regular reinvestment in bonds at prices (and therefore yields) current at the time of reinvestment helps to reduce exposure to interest rate risk and helps to protect against inflation.
Up and Down the Ladder
Ladder investors take comfort in the fact that, should rates rise after they have bought some bonds, money will soon come available to buy higher-yielding bonds. Similarly, if rates decline, a ladder investor has locked in the higher rates in the ladder's more mature holdings.
Typical Ladder Structure
Where Ladders Fall Short
Difficult to Manage
Most individual investors do not have the experience or skills to manage a large, diversified ladder of individual bonds, many of which trade at prices of $1,000 or more.
Provide Insufficient Diversification
Ladder investors typically purchase and create ladders using high-quality vanilla bonds (e.g., US Treasuries and investment-grade corporates) as this provides them relatively more certainty (i.e., lower risk) with regard to coupon flow and return of principal at maturity. The trade-off for this certainty or lower risk is missing out on the potentially higher returns than can be achieved through investing in other types of bonds, such as high yield and emerging market debt as well as some securitized assets, e.g., asset-backed securities (ABS), mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS). Ladder investors are also generally biased toward short and intermediate maturities rather than long-term bond issues which typically offer higher yields.
Difficult to Measure Relative Performance
It is difficult to construct a benchmark to measure the performance of an investor's ladder strategy. Ladder investors therefore have virtually no way of gauging whether their returns are better, worse or the same as a comparable market bellwether.
Accessing funds invested in a ladder is difficult. If they need money, ladder investors either have to sell a bond prematurely or not reinvest funds received from a maturing bond. Either of these options can not only undermine a ladder strategy, but also possibly reduce the income it can generate.
Ladder investors may be unable to buy or sell bonds at opportune times, i.e., when prices are considered very low (buy) or very high (sell), as they are locked into buying and selling at specific times.
Unable to Reinvest Coupons
Bond ladder investors are typically unable to reinvest coupon proceeds, which denies them the benefits of earning compound interest.
The Benefits of Active Fixed Income Management
Bond Mutual Funds
With active portfolio management, a portfolio manager and team of research analysts select securities in an attempt to offer shareholders index beating returns along with prudent levels of risk. There are several strategies unique to active portfolio managers and unavailable to more passive forms of investing.
The three general areas where active management delivers value are: greater access to markets, fundamental analysis and advantages in the execution of trades on behalf of investors.
Because they pool assets of many investors, managed portfolios buy both a larger number and wider variety of fixed income securities than available to most individual bond buyers. This provides greater diversification—a strategy of owning dissimilar securities to help lower overall portfolio risk.
Active portfolio management channels the collective insight and analysis of a team of investment professionals and equips the portfolio manager with flexibility to make adjustments on behalf of shareholders. While companies generally issue one type of stock to denote equity ownership, a company or other entity may issue a variety of types of bonds. This greater choice can complicate selecting which individual bonds to purchase. Portfolio managers have the expertise to pick and choose among the range of fixed income securities that they believe have the best potential, and can dedicate the time and resources needed to monitor portfolio holdings to determine if better opportunities exist elsewhere.
Central functions of active fixed income management include performing credit research, undertaking detailed analysis, forecasting creditworthiness of individual securities and following larger fixed income trends. These can help minimize risk and exploit market opportunities, abilities largely absent from the laddering approach. In addition, active investment managers conduct sector and sub-sector analysis to determine which parts of the fixed income markets appear attractive enough to emphasize in the portfolio.
Active portfolio management is more nimble than laddering. To combat interest rate risk, portfolio managers may adjust the duration of a portfolio if their research supports it. For example, a manager may lengthen the portfolio's duration if the portfolio manager is of the opinion that interest rates are likely to fall. Duration measures the sensitivity of a bond's price to interest rate movements. However, similar to a laddering strategy, bond funds are able to buy new bonds paying higher interest, which will increase income payments over time.
Investment institutions that run managed bond portfolios have relationships with large bond dealers and regional specialists that typically enable them to buy bonds at lower prices than those available to retail clients. The advantages of speed and size when making trades help investment institutions keep costs in check, delivering value to the investor.
Bond Mutual Fund Risks
There are no guarantees when investing in a bond mutual fund. Bond funds continually buy and sell their shares to the public at the fund's daily determined net asset value (NAV). A bond fund's NAV will fluctuate based on the value of its holdings and current market conditions, especially the current level of interest rates. There is no maturity date that a bond fund can provide as a deadline for returning the full amount of your investment. In addition, it is not possible to determine an expected yield to maturity for a bond fund as you can with individual bonds. With a bond fund, you receive whatever the bond shares are worth at the time you redeem shares from the fund. It is therefore possible to sustain a capital loss from investing in a bond fund.
Even if the individual bonds in the fund are guaranteed by the government or insured through a private insurer, the value of a bond mutual fund investment can still rise or fall. Bond mutual funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC), the US Securities Investor Protection Corporation (SIPC) or by any other government agency, regardless of how a bond mutual fund is purchased—through a brokerage firm, a bank, an insurance agency, a financial planning firm or directly. They are also not guaranteed by the bank, brokerage firm or other financial institution where they are sold.
Consult your financial professional to help develop the fixed income component of your overall investment strategy.
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