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Using fixed income to build a balanced portfolio
WITH stock markets having shown increased volatility in the past year, many investors are making it a priority to build resilient and balanced portfolios. With the potential for volatility to continue, it is a perfect time to revisit the question: Why fixed income?
Fixed income serves four key roles in a portfolio: diversification from equities, capital preservation, income and inflation protection. Many investors could benefit from evaluating whether their bond holdings are meeting these goals.
1) Diversification from equities
Your bonds shouldn't behave like stocks when volatility hits.
When volatility occurs, it's important to have investments within a portfolio that are designed to provide resilience. That is the essence of why investors seek balanced, diversified portfolios. When one part of a portfolio struggles, another part can pick up the slack.
A large part of the fixed income universe can be a good building block to help dampen volatility and create durable portfolios. In particular, higher quality bonds tend to hold up well when stocks suffer losses. This stability can help enable an investor to rebalance when equities are priced more attractively and to take advantage of market cycles. This approach can help investors achieve long-term investment and savings goals.
2) Capital preservation
A durable portfolio needs a strong foundation.
Unlike equities, high-quality fixed income securities can serve as an all-weather foundation for a portfolio. This advantage can be seen even when looking at medium-term rolling returns for bonds or bond funds with capital preservation as their chief objective.
Although losses can occur over the short term, history shows that fixed income investments, in particular high quality ones, can offer a measure of stability over time. Historically, they have demonstrated a very strong track record of protecting capital. Short term periods of loss have tended to be minor in comparison with declines in equities.
Bonds issued or guaranteed by stable governments or corporations with good business models and solid balance sheets can be key building blocks for a capital preservation strategy. The more risk averse an investor is, the larger the capital preservation component of their portfolio is likely to be.
It's called fixed income for a reason.
Another way fixed income fundamentally differs from equities is its explicit income component. Bonds carry predictable income streams in the form of coupons, so long as the issuer remains solvent. While the yield will fluctuate with the price, coupons on fixed rate bonds typically do not change. This steady source of investment income can play an important role for many investors, such as retirees who may rely on it for monthly living expenses.
However, in a market environment where credit valuations are still arguably high in historical terms, there is cause for caution. Investors may potentially take on too much equity-like risk by allowing high-yield corporates to dominate their bond allocations. In a classic 60-40 portfolio (composed of 60 per cent equities and 40 per cent bonds or other fixed income offerings), for example, allocating up to a quarter of the 40 per cent fixed income to income might be considered reasonable for some investors. Investors should work with their advisers to determine the appropriate allocations for them.
4) Inflation protection
Even modest inflation can erode wealth over time.
Inflation has ebbed and flowed lately. Still, economic growth and a tight labour market should be supportive of inflation over time. Even if inflation were to remain stuck near the US Federal Reserve's modest 2 per cent target for a decade, that would reduce a portfolio's purchasing power by 18 per cent over those 10 years.
While some investment vehicles can provide indirect protection against inflation, an inflation-linked bond fund, such as TIPS (Treasury inflation-protected securities), can more explicitly preserve purchasing power. The principal value of TIPS adjusts with changes in the consumer price index (CPI) so that as inflation rises, the principal value increases to preserve purchasing power. Inflation-linked funds can provide more precise protection for purchasing power, especially when inflation is unexpectedly strong.
5) Seeking further diversification at a fixed income level
For long-term investing, balance is key. This also requires diversification among fixed income allocations.
Developed market sovereign bonds generally cover the core function of a fixed income allocation: the high quality of the bonds brings more stability to income and capital preservation. However, with interest rates at historical lows, investors may want to look elsewhere for a yield pick-up. Investment grade corporate bonds can offer a yield advantage but are more exposed to fluctuations in equity markets.
As important as income stability and capital preservation are, investors may not want to sacrifice all opportunities for yield in their fixed income portfolio. Asset classes such as high-yield corporate bonds and emerging markets debt can bring another element into fixed income investments. However, they do come with additional risk.
Capital Group takes a blended approach through its global high income opportunities strategy to access these markets. The strategy was developed with the vision that these higher-returning fixed income sub-asset classes offer similar risk-return profiles, but follow different cycles - so by investing flexibly across those sub-asset classes, investors could have greater diversification and yield, and benefit from more consistent returns.
Is now the time to be in fixed income?
After some years of increasing policy rates, the US Federal Reserve (Fed) has hit pause on hikes, which has been supportive for fixed income. However, the combination of rich valuations in corporate bonds and asymmetric risks from slowing global growth calls for a more defensive and generally high quality portfolio that is well protected against a rise in market volatility.
Some opportunity can be found in the recent change in Fed policy which could further extend the economic cycle and provide support to risk asset prices. In this environment, while a defensive stance is prudent, opportunities can still be found in other areas of fixed income. A bottom-up, research driven approach gives investors the freedom to search for yield without exposing themselves to unnecessary risk.
Remember, no matter how market conditions may evolve, bond allocations that provide elements of all four key roles can bring balance to portfolios and help investors achieve better long-term outcomes.
- The writer is investment director, Capital Group