Fixed Income 101: A quick review of the role fixed income investments play in your portfolio
- Personal Finance
Most likely you have a good handle on how stocks and other equity investments work: Your stock shares represent a portion of ownership in a company and if the company prospers and the stock becomes more desirable, the value of those shares increases. If the company encounters financial trouble, your stock can lose value.
Bonds and other “fixed income” securities are an entirely different type of investment. Instead of representing ownership in a company, as stocks do, bonds represent debt—money borrowed by a company, municipality, or U.S. government entity. In return, the bond issuer agrees to:
- pay bondholders a fixed rate of return on a fixed schedule and
- return the bond’s face value at the specified maturity date.
A variety of choices with different risk characteristics
The fixed income securities you hear about most often are U.S. Treasury bonds and notes, corporate investment grade bonds, municipal (“muni”) bonds, and money market funds. These are the ones financial advisors most commonly recommend for the fixed income portion of client portfolios.
There are other fixed income choices that can be included too, depending on your needs and risk profile. On one end of the risk spectrum are FDIC-insured certificates of deposit (CDs), offered by banks. Like U.S. Treasuries, they are among the safest short-term fixed income investments. On the other end are high-yield (a.k.a. “junk”) bonds, typically issued by less credit-worthy companies. They are much riskier fixed income securities, with a volatility profile more closely resembling stocks.
Most fixed income securities are more stable investments than stocks because your principal is returned when it matures. Furthermore, the risk of losing your principal is low, unless the company or entity fails or goes bankrupt, and defaults on their loan obligation. (Puerto Rico’s recent bond default and the Orange County, Calif., debt meltdown are two well-known examples.)
Importantly, lower risk also means lower returns in most cases. It’s not unusual for the annual yield of a fixed income security to be in the 2% to 5% range. Recently, as the Federal Reserve has continued its strong role in managing interest rates, annual yields and returns have been lower than in previous economic cycles.
More protection if the issuer runs into trouble
Yet, even when a company or municipality is on shaky ground, the risk of losing money with fixed Income securities is still lower than with stocks because:
- Fixed income debtholders/bondholders have a priority claim over shareholders on company assets.
- In a worst-case scenario such as a company’s bankruptcy or dissolution, debtholders usually get some of their money back, while equity investors/shareholders often lose their entire investment.
Income and diversification benefits
So why do most investment professionals recommend including a fixed income element in your portfolio? Two key reasons: Predictable income and diversification.
1. Steady, predictable income, plus principal preservation
The interest you receive from fixed income securities is usually paid semi-annually on scheduled dates to provide a steady stream of income. In addition, because the principal amount invested is returned when the bond “matures” (or is “called” back by the issuer), the value of your initial investment is preserved as well.
The more predictable, less volatile returns of fixed income investments may be beneficial to investors who are concerned about the risk of equity or alternative investments. They are also important to investors in retirement who don’t want to risk losing principal and need a safer, conservative investment that provides liquidity, stability, and regular income payments.
2. Portfolio diversification to diminish risk, enhance performance
Because they are a different kind of investment, fixed income securities usually react differently than stocks to changing market and economic conditions. That makes them an excellent choice for diversifying your portfolio. When stocks and other equity investments lag, bonds often contribute positively to portfolio returns.
They can also help reduce portfolio volatility over time. In fact, although the prices of fixed income securities in the U.S. do fluctuate with interest rates and economic cycles, they haven’t seen the extreme volatility that stock/equity investments have experienced.
As the chart below shows, fixed income investments (as represented by the Bloomberg Barclays US Intermediate Government/Credit Index) helped smooth out volatile returns by outperforming the stock market (represented by the S&P 500®) in each of the four recessions since 1973.*
|11/1/1973- 3/31/1975||7/1/1981 - 11/30/1982||3/1/2001 - 11/30/2001||12/1/2007- 6/30/2009|
|1973 Oil Crisis||
|Dot-Com Bubble & September 11th Attacks||Subprime Mortgage Crisis|
|BBgBarc US Govt/Credit Interm TR USD||6.65%||22.71%||6.79%||4.40%|
|S&P 500 TR USD||-13.09%||10.01%||-7.18%||-24.16%|
What about bond prices and rising interest rates?
One fixed income topic that gets a lot of news coverage—thanks to the Federal Reserve’s role in setting interest rates—is the effect of rising interest rates on bond prices. Simply put: When interest rates rise, the price of bonds will drop.
This happens because, as interest rates paid by newly-issued bonds increase, older bonds that pay less interest become less valuable. So the prices of the older bonds must drop to make their yields more competitive with the yield of new issues. Subsequently, the longer a bond has to maturity (the longer its “duration”), the more sensitive it is to any changes in interest rates.
Unless you intend to buy and sell individual bonds to try to profit from these price changes (like a bond mutual fund manager does), the changes in interest rates over time won’t have much effect on individual bonds that you purchase for income and hold until maturity. That’s important to keep in mind, because bonds are a crucial part of a balanced portfolio and—even as interest rates change—they can continue to generate a stable income stream and mitigate overall portfolio risk.
Learn more about What Bond Investors Need to Know in a rising rate environment in our Sector Spotlight.
Supply and demand influence prices too
Just as interest rates can affect bond prices, so can supply and demand. In fact, one of the concerns outlined in Boston Private’s Fixed Income Commentary for Q2 2018 was the declining demand for U.S. corporate bonds by foreign buyers over the last three years as interest rates rose. As noted in the commentary, “a reduction in debt supply coupled with steady demand” is needed to help boost bond returns in the year ahead.
Credit ratings reflect ability to repay debt
Moody’s, Standard and Poor’s, and Fitch are rating agencies that assign credit ratings to corporate and municipal bonds. These ratings also affect their desirability and price because they indicate the likelihood that the issuer will repay the debt. As shown in the chart below, lower rated bonds have a higher risk of default.
- Investment grade corporate bonds with the highest credit ratings—anywhere from AAA/Aaa to BBB-/Baa3—are considered safe, conservative investments that will be repaid. These bonds usually have lower yields and less volatility.
- Riskier, high yield “junk” bonds—with ratings between BB+/Ba1 and CC/Ca—are considered more likely to default, but they pay higher interest to entice buyers to purchase them.
The only fixed-income securities that have virtually no credit risk are U.S. government-issued Treasury securities, such as Treasury notes, Treasury bills, and Treasury bonds. This doesn’t mean that the securities won’t lose value—it just means that they are free of default risk because they are backed by the “full faith and credit” of the U.S. government.
Working with your advisor on the fixed income strategy that’s right for you
While you can purchase most fixed income securities either individually or by buying shares in a mutual fund or ETF, your Boston Private advisor will usually recommend purchasing them individually. This gives your advisor more flexibility in creating a fixed income investment strategy that reflects your personal timeline and risk profile, as well as your unique income and liquidity needs.
That strategy may include pursuing techniques such as bond “ladders” or “barbells” that can smooth the effect of rate changes as your bonds mature and the money is reinvested. For more on these and other ways Boston Private’s investment management team works to optimize the fixed income allocation in your portfolio, talk with your Boston Private advisor.
- Personal Finance