Asset Classes-Fixed Income

Fixed Income:

Fixed income is primarily comprised of bonds and cash.  These securities are essentially debt where principal and interest are repaid over time.  Most of these securities have fixed interest rates, (and that is partly where the fixed income term comes from).

Fixed income typically has a lower total return and risk level compared to equity.  Long-term bond performance has been approximately 6%.  Future bond performance is likely to be much less because historic performance included increasing price levels and higher interest payments.  Future performance will be impacted by declining principal values and lower interest rate payments.

Fixed income is important in a portfolio to help provide downside protection, and to provide income.  Nevertheless, there are risks that need consideration for the Fixed Income portion of any portfolio.

Basics-The Inverse Relationship and Interest Rate Risk:  When a bond is purchased and held to maturity, then the return will be roughly equal to the interest rate (depending on the compounding frequency).  However, the value of the bond will change over time as interest rates change.  This means that if you purchase a bond and then decide to sell this bond before it matures:

The principal will go down if interest rates rise and

The principal will go up if interest rates decline.

A simple example is as follows:

You hypothetically purchase a 10 Year US Treasury Bond on June 30, 2016 for $1,000 with a yield of 1.49%.  By November 30, 10 year US Treasury bonds were trading at a yield of 2.44%.  If you wanted to sell the bond you purchased in June, you would not be able to sell that bond unless you sold it for less than $1,000 because no one would buy it unless it would yield approximately the going rate of 2.44%.  To make your bond provide an equivalent yield of 2.44%, you would have to reduce the bond value from $1,000 to approximately $900.

The reverse is also true where bond prices increase as interest rates decline.  This is what happened over the last 30 years where interest rates steadily declined.  These declining rates meant that you received your interest income and you also had a gain on the bond price appreciation.  Duration is an approximation that indicates how much the bond price would decline if there was a 1% change in interest rates.  For example, a bond that had a duration of 5 would theoretically decline by 5% if interest rates rose by 1%.

Credit Risk:  Bond prices are also impacted by credit quality and the risk of default.  A high-yield corporate bond that sold for $1,000 with a 6% yield would decline in value if the next year brought a recession.  In a recession, investors might demand a 7.5% yield to compensate for the increased risk of default.  In this case, the bond price would need to decline so that the bond’s interest payments would be roughly equivalent with the going 7.5% rate.  Explain highest quality bonds are rated at AAA and high-yield are rated below BBB.

Fixed income is different from equity because the investor simply holds the debt security and does not have an ownership stake in the company.  The expectation is to receive interest payments and repayment of the original principal.

Call Risk:  Bonds are often callable-when rates decline they get called or repaid before the final maturity.  Meanwhile,  you are left to re-invest the proceeds in a lower rate environment.  Callable bonds are priced to reflect this “call” risk, but the math is complex.

Although fixed income has risks, there is an interesting rule of thumb related to expected bond returns:  The current yield is a forecast of future returns.  In other words, if a bond is currently yielding 4%, a 4% annualized return is a good expectation for the life of the bond.  We can’t guarantee that this relationship holds for all bonds or for the future, but it does make intuitive sense.

Bonds don’t trade on an exchange likes stocks where prices are determined real-time.  As a result, small volume bond purchasers buy bonds at higher prices (and lower interest rate yields) and sell bonds at lower prices (and higher interest rate yields) compared to large volume institutional bond traders who benefit from economies of scale.  A bond portfolio also needs to be diversified, and this requires a number of bonds in a portfolio.  This means that most retail bond investors will get better investment performance by buying a bond mutual fund or ETF.  So, individual bonds should not be purchased until there is a large bond portfolio of at least $500,000 or usually much more.

Fixed Income clearly has risks related to credit quality, the maturity structure/duration, call risk, and poor pricing for individual investors.  As a result, fixed income investing is usually best accomplished through a mutual fund or an ETF.  Bond funds are available either as broadly diversified holdings, or specific asset class funds.  For smaller investors, a broad-based multi-sector fund is a good starting point.  For larger accounts, the fixed income exposure can be implemented through a mix of the different categories.

Listed below are brief descriptions of major bond categories:  More content to come soon.

US Treasuries 30 days to 30 years and Agencies:  Huge current principal risk for long maturities.

Mortgage Backed Securities:  Strong credit quality but refinancing risk.

Treasury Inflation Protected Securities-TIPS.  US Treasury Securities that increase the principal each year to account for inflation.  As a result, TIPS offer potential inflation protection.

Municipal Bonds:  Bonds typically issued by local municipalities.  Interest is exempt from federal taxation and it is also exempt from state taxation if the bond was issued in your home state.

Investment Grade Corporate Bonds:  Corporate issuance by investment grade companies.

High Yield Corporate Bonds:  Legitimate asset class with a higher risk/return profile than investment grade corporate bonds.  The “junk” term is a misnomer as long as you take into consideration the tradeoff between the higher interest rate and the higher risk.

Floating Rate Notes:  Non-investment grade short-term notes that float.  These notes make sense in a rising rate environment as long as the economy stays out of a deep recession.

Foreign Developed Market Bonds:  Consideration needs to be given to foreign exchange hedging.

Emerging Market Bonds:  Sovereign and Corporate bonds in both hard dollar and local currency.