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The Fixed Income Dilemma

While we all have been told that a mixture of equities (stocks) and fixed income (bonds) is sensible –like having a balanced diet — many investors have been questioning this adage, given the historically low yield of fixed income. In the current ShopTalk article we’ll examine whether you should eliminate or reduce fixed income exposure.

What is Fixed Income’s role in a long-term asset allocation strategy?

It is relatively easy to accept the wisdom of including fixed income in one’s portfolio when the yield is 4-5%; it is a bit harder to stomach at a 1.7% yield¹. Are fixed income investments simply not doing their fairshare of work for my investments? Should I dump my fixed income holdings?

To address this question, let’s go back to fundamentals. When an investor constructs an allocation from an assortment of different asset classes, she chooses assets that are uncorrelated (or at least less than perfectly correlated) with other assets, while expecting all the included assets to contribute positively to the overall portfolio’s return. While each asset should contribute to the overall return, the intelligent asset allocator accepts that not all assets will perform equally. For example, while fixed income returns have historically been less than half of equity returns, nearly every reasonable allocation includes a generous portion of this asset so as to significantly reduce overall volatility.

The key purpose of an asset allocation is to accommodate an individual investor’s capacity and appetite for risk. Before lowering — or eliminating — the fixed income portion of a portfolio, investors should ask themselves if this would be consistent with their risk tolerance.

Many investors partially accept the above argument. But doubts about the wisdom of holding fixed income in today’s low interest rate environment still abound. Another worry many investors are dealing with is:

Why wouldn’t I try to time my fixed income investments and sit out periods of rising interest rates?

Trying to time interest rate movements is as difficult as trying to pick individual equity investments.  For investors who are convinced of the overall logic of index investing, this means avoiding the temptation of listening to investment pundits who claim they can predict short and medium term movements in interest rates.

The last three years have convincingly -re-enforced this position.  Despite the drumbeat of market prognosticators claiming that interest rates were about to soar and that bond investments were about to crash, in reality the interest rates have been quite steady and bond investments have maintained (and, in fact, increased) their value.

Clearly if someone had an individual bond that yielded, say, 2%, and interest rates took a quantum jump to 4%, the price of their bond would fall dramatically. But this worse-case analysis assumes that (1) interest rates will rise dramatically and suddenly, and (2) the investor has a single – or vastly undiversified – fixed income portfolio.

Most sensible fixed income investors have an assortment of bonds with different maturities². As interest rates climb – gradually! – the face value of the older, low yielding bonds will decrease, while new bonds are purchased at higher yields. While history never repeats itself – today’s fixed income situation is quite anomalous – nevertheless it is instructive to remember what happened to the overall fixed income performance during the rising interest rate environment of the 70s and 80s. The following chart – thanks to our friends at Vanguard Research – illustrates this quite nicely³:

Fixed Income Dilemma

Fascinatingly, even while the older, lower yielding bonds suffered capital losses, the better yields of the bonds added later more than compensated for these losses. Although counterintuitive at first glance, this makes sense: the reinvestment of bond income accounts for the lion’s share of total returns for many bond funds. As the article states:

“The impact of price fluctuations can be more than offset by staying invested and reinvesting income, even if the future is similar to the rising-rate environment of the late 1970s and early 1980s.”

 

Is there anything I can do better with my fixed income investments?

The research shows that following a few key principles will probably result in better performance – with lower volatility – for many investors:

  1. Stay with investment grade fixed income instruments – avoid “junk” bonds (and funds).
  2. Maximize diversity and minimize cost by implementing a fixed income portfolio from bond index funds (or their cousins – ETFs). Avoid individual bonds.
  3. Diversify among a number of fixed income asset classes, including:

–        government (US and international)

–        corporate

–        tax free, municipal.

Stay tuned: We will summarize the research that points to the above principles in subsequent ShopTalk articles.

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¹ SEC yield 2/28/2013 on a representative fixed income investment, Vanguard’s Total Bond Market ETF (BND)

² Either via a bond fund or a bond ladder. While both techniques are similar, it is 3 Factor Indexing’s opinion that bond funds are more cost effective for most investors. We will be addressing this important subject in subsequent ShopTalk articles.

³ From Joseph David PhD, Roger Aliaga-Diaz PhD, Vanguard Research 3/2010. The research article assumed

“[the investor] fully funds a $1 million investment in the Barclay’s Capital U.S. Aggregate Bond Index Index on January 1, 1976. We do not account for any expenses or taxes. Interest-on-interest return is calculated as the remainder after subtracting both income and capital returns from the total return. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Source: Vanguard calculations based on capital, income, and total return data reported by Barclay’s Capital.”

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Past  performance is not a predictor of future performance.

*3 Factor Indexing LLC has conducted extensive analysis concerning portfolio performance. Please refer to our website at  http:3factorindexing.com/important-disclosure/ for details and disclaimers regarding a statements concerning performance, and the various assumptions we have made in our analysis.

The views and information contained within this article are provided for informational purposes only and are not meant as investment advice. They represent the author’s current good-faith views at publication time and are subject to change without notice. As with any strategy, it is important for an investor to fully understand the strategy prior to investing; seeking advice from a professional advisor can be a good place to start.

The information that is provided herein has been compiled to the best of our ability. However, the authors makes no warranty of any kind, expressed or implied, and will not be held responsible, or liable for errors, or omissions resulting in any loss or damage caused or alleged to be caused, directly, or indirectly, by information contained in3 Factor Indexing’s publications.

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