A Focus on Fixed Income

10/13/2015

There is a joke circulating online that, if you commit a crime and you need to hide the evidence, you can stash it on page two of a Google search. At least 90% of the time, nobody looks there. In fact, about half of our clicks are bestowed on the first two hits we see.

The serious implication behind the satire is that it remains at least as easy as ever to be overly influenced by what others have decided should be the most important information we receive. Behavioral finance has identified any number of ways we tend to give too much weight to just these sorts of hits that popular curators feed us. The results can tempt us into believing that leading financial news – the Chinese economy, global oil prices, interest rates, and so on – should be the driving force behind our next market moves.

We are here to remind you: If it’s headline news, it’s already been incorporated into market pricing. Even if we could predict the outcomes (we cannot) it is too late to act on them – so we do not…

A Focus on Fixed Income

Anyone who is keeping even a casual eye on financial headlines these days is aware that fixed income returns have been a moving target for a while now – at home and abroad. The general consensus is that rates will rise eventually. With almost nowhere to go but up, they practically have to. When, by how much and how quickly they will increase is anybody’s guess, as is what impact it will have on domestic and global markets when they do.

Instead of expending valuable energy on perennial uncertainties, we would suggest that the more practical approach to managing portfolios – the fixed income and equity portions alike – is to optimize the components that are more readily within our control. Fortunately, there are a number of solid, evidence-based strategies we employ to guide the way. 

Guiding Rule #1: Invest According to a Sensible, Customized Plan

If there is one principle that drives all the rest, it is the importance of having your own detailed investment plan – preferably in the form of a written and signed Investment Policy Statement. If you have a personalized plan, you have a touchstone for any and all investment decisions you make, including building and maintaining an appropriate balance between stocks and bonds, as well as determining what to include within the bond portfolio.

In the absence of a plan, undisciplined investors instead struggle to predict how, when and if it is time to react to unknowable events over which they have little control. While there is no guarantee that a plan will deliver the outcomes for which it has been designed, we believe that it represents our clients’ best interests and the best odds for achieving personal goals.

Guiding Rule #2: Let the Evidence Be Your Guide

With a personalized plan in place, a good next step is to embrace the decades of empirical evidence that helps us understand the overarching roles for which each investment is best suited.

Stocks – Stocks are the most effective tool for those seeking to accumulate new wealth over time. But along with higher expected returns, they also expose us to a much bumpier ride (volatility), and increased uncertainty that we may not ultimately achieve our goals (market risk).

Bonds – Bonds are a good tool for dampening that bumpier ride and serving as a safety net for when market risks are realized. They can also contribute modestly to a portfolio’s overall expected returns, but we do not consider this to be their primary role.

Cash – In the face of inflation, cash and cash equivalents are expected to actually lose buying power over time, but they are necessary to have on hand for near-term spending needs.

Thus, in performance and predictability, fixed income is meant to be “cooler” than stocks, but “warmer” than cold, hard cash.

By keeping attention focused on these larger principles of stock/bond investing, it becomes easier to recognize that, even when the bond holdings are plodding along compared to the rest of the portfolio, the more important consideration is whether they are fulfilling their highest purpose in total wealth management.

Guiding Rule #3: Bonds Are Safer; They Are Not Entirely Safe

To further maintain financial resolve in the face of complex and often conflicting fixed income news, it may help to understand that, compared to stocks, bonds have historically exhibited lower volatility and market risks, along with commensurate lower returns. However, they do exhibit some volatility, as well as some market risk. Because bonds represent a loan versus an ownership stake, they are subject to two types of risks that do not apply to stocks:

Term premium – Bonds with distant maturities or due dates are riskier, so they have returned more than bonds that come due quickly.

Credit premium – Bonds with lower credit ratings (such as “junk” bonds) are also riskier, and have returned more than bonds with higher credit ratings (such as government bonds).

When reading bond market headlines about interest rates, yield curves, credit ratings and so on, these are the two risks and commensurate return expectations that are rising or falling along with the news. As such, as alarming or exciting as bond market news may become, compared to stocks, the levels of volatility and degrees of risk need not – and really should not – be as extreme as we must tolerate in equity/stock investing to pursue higher expected returns. The decisions that are made about the risks inherent to bond holdings should be managed according to their distinct role in the portfolio, as we will explore next.

Guiding Rule #4: Act on What You Can Control

So, where does all this leave you, the long-term investor who is diligently adhering to your carefully crafted strategy? Here are some proactive steps you can take to appropriately position your fixed income investing to withstand varied market conditions.

Are your fixed income holdings the right kind, structured according to your goals? Just as there are various kinds of stocks, there are various kinds of bonds, with different levels of risk and expected return. Because the main goal for fixed income is to preserve wealth rather than stretch for significant additional yield, we typically recommend turning to high-quality, short- to medium-term bonds that appropriately manage the term and credit risks described above.

Are you keeping an eye on the costs? One of the most effective actions we can take across all investments is to manage the costs involved. When investing in bond funds, this means keeping a sharp eye on the expense ratios and seeking relatively low-cost solutions. For individual bonds, it becomes especially important to be aware of opaque and potentially onerous “markup” and “markdown” costs. While these costs don’t typically show up in the trade report, they are very real, and can detract significantly from returns.

Are your solutions the right ones for the job? Whether turning to individual bonds, bond funds or similarly structured solutions such as Certificates of Deposit (CDs), fixed income portfolio should strike a harmonious balance between necessary risks and desired returns – within the context of your own plans and according to the distinct role that fixed income plays within those plans.

Managing the Unmanageable Markets

In short, it remains good advice to invest according to what decades of empirical evidence has to say about earning long-term returns and mitigating related risks. That means not taking too much stock in what the headlines are screaming at all of us. It means observing and minimizing costs. It means focusing on your personal goals, and on ensuring that your portfolio is optimized toward achieving those goals – today, tomorrow and over the long haul. For bonds and stocks alike, these are the most reliable principles available to help us navigate uncertain markets as certainly as we are able.

Until then, thank you for your trust and confidence.

Byron E. Woodman, Jr.                                             

President                   

Lee C. McGowan, CFP®

Managing Directo