The role of fixed interest or bonds in a portfolio


There are three main subsets of the fixed interest asset class:

Government Bonds
Corporate Bonds
Inflation Linked-Bonds

Two factors explain the majority of returns from a fixed interest portfolio as follows:

Credit Risk - The quality factor describes how low-grade obligations have higher expected returns than high-grade obligations.

Duration risk - The term factor describes how long-term bonds have higher expected returns than short-term bonds.

We believe, however, that these premiums have not been large enough historically to reward the additional risk. Therefore, we believe fixed interest is best kept short in maturity and high in credit quality.



Watch this video to see where bonds fit into your portfolio




Investors sometimes use bonds to meet current and future income needs and many use the income payments, especially in retirement, as a substitute for a regular salary.

But, while bonds pay steady income, using them expressly for that purpose can add risks to your portfolio that you didn't plan on.

Using bonds in this way (to meet future cash needs or generate income) differs from the more traditional asset allocation approach, where bonds are used to diversify a portfolio and reduce overall risk.

In the former approach, bonds are seen as a de facto insurance policy that "immunizes" retirement goals from investment risk. Fixed income payments are used to cover the bills and this frees up the rest of a portfolio to pursue growth through riskier investments. If the riskier stuff doesn't pan out, the thinking goes, you still have the bonds to support your expenditure. If the riskier stuff goes up, you might not even need the bonds. Either way you win.....

The problem is that the pursuit of income in this way can add additional risks to the portfolio that are especially significant for those in retirement.

At the end of the day, financial security is really about your total wealth, not the marginal income that you receive every six months. If investors focus on the income paid out, they may either accept a low relative income when yields are low.

Equally, investors facing declining incomes from falling interest rates, tend to chase higher yields in order to maintain their income moving into progressively longer term and lower credit funds in an attempt to maintain yields.

Investing in fixed income can therefore be a moving feast

Getting enough cash out of bonds in an attempt to pay the bills usually means extending maturities, going lower in credit quality, or both. This increases yield, but it also increases risk. Historically, longer-term bonds have been more volatile than shorter-term bonds, and without much added return to show for it.

It's not entirely clear why this is the case. It may be because institutional investors (like insurance companies) use long-term bonds to meet future obligations such as employee pensions. They have a pretty good idea of the size and timing of their payouts based on mortality tables, so they simply match the duration of their bonds to their expected liabilities. When the bonds mature, the proceeds pay off the obligations.

In this limited framework, volatility along the way doesn't matter. Therefore, the way long-term bonds are priced might not be determined mainly by volatility but by factors related to the liability streams of instituional investors.

Whatever the explanation for the lack of a significant risk premium from longer term bonds, what we do know is that institutions use bonds in exactly this way, and that it might even make sense—for them.

Retail investors by contrast are finding more often that their income in not adjusted for "real" inflation - by which I mean that even if their pensions are notionally index-linked the measure of retail price inflation rarely reflects the true cost of living for an individual especially in retirement (one explanation for this is that the generally accepted measure of retail price inflation includes mortgage payments and most retired investors clear their mortgage debts.

With both early retirement and increasing life expectancy, investors need to consider their income requirements in "real terms" adjusted for their real cost of living (based on their consumption preferences) over a reasonably long time frame.

In other words, individual investors shouldn't try to emulate the Institutional investors.

So, should investors really worry about whether their income comes from dividends or from capital growth?

Imagine two portfolios with the same average return, say, 5%pa. Now imagine Portfolio A has a volatility as measured by its standard deviation of 1% and none of its 5% average return comes from income.
Meanwhile, Portfolio B has a standard deviation of 18% and all of its 5% average return comes from income. Which portfolio would you want to hold?

Financial theory teaches that for two portfolios with roughly equivalent average return, the portfolio with lower variance will have the greater terminal wealth.

The goal for investors is therefore to maximize return for a given level of volatility.

Whether we like it or not, bonds are not surgical instruments which can be applied to a specific purpose. They are simply components of an overall portfolio.

To treat them as something else - like an income cash cow —can undermine your primary goal as an investor.

One reason investors will want to maximize their return for risk is because spending needs in retirement are not entirely predictable. People aren't like insurance companies—they don't know all their future liabilities.

As I always point out, if you get out your birth certificate - there is no "best before date" on the back. Issues like life expectancy, health care, and other costs can change suddenly and dramatically. Equally, investors might need more money than their bonds provide in yield and therefore  holding bonds in pursuit of pure income can put their investment capital at risk.

Finally, remember that "cash" is "cash" irrespective of where it comes from

Unless you're a big pension plan, the conclusion I reach is that it probably makes sense for investors to hold high-quality (i.e government or quasi-government bonds rather than corporate debt) and short-term bonds with maturities up to 5 years.

This approach pursues total expected return instead of pure income, and in the past has generated less volatility than investing in longer-term bonds for a higher yield as can be seen in the chart above.

An additional benefit is that short-term bonds seem to offer better inflation protection, which as I have suggested is a crucial benefit for individual investors in retirement.

But this still leaves the million dollar question - How do investors meet the bills in retirement?

Rather than seeking to invest in high yield junk bonds, research by Merton Miller and Franco Modigliani says that money is money, whether it comes from a dividend or from capital growth. There's no practical or theoretical reason for any investor to prefer one above the other.

With this in mind, perhaps the best way to meet a desire for a regualar "income" might be simply to steadily redeem assets.

Let's call this approach a "synthetic dividend". Investors should regularly review their overall portfolio and use redemptions to "rebalance" for example selling those assets which have appreciated relative to their target weights.

In this model investors constantly sell profits from risky assets such as equities or property and transfer the  "income" into Bond funds. When funds are needed  for expenditure purposes they sell bonds and transfer the proceeds to the bank.

For many investors the suggestion that they should draw their spending requirements from their investment capital instead of from income can be a tough pill to swallow.

After all, regular payments feel more "secure" — especially to investors that are no longer bringing home a salary. Equally, if you have a fixed amount of capital - the suggestion to spend some of this finite pile can sound risky.

Conclusion

So, investors can use a short-term bond fund to manage liquidity and offset other risks in their portfolio but the form of their cash-flow for income purposes is less important than the impact on their wealth over time.

There will always be funds on the market offering investors a higher-yielding strategy to tempt them to part with their money and and take on a lot of extra risk that might not pay off.

We recommend that  investors should approach this problem with an overall "risk budget" that they are willing to "spend".

They can therefore reduce the bond risks they take and redirect the "saved risk" towards equities, where history suggests the average return is stronger over time.

For the avoidance of doubt - we are not advocating that older or retired investors load up on stocks. On the contrary, because retirees depend on their investments more, they should deploy them more conservatively—which is why a portfolio of short-term, high-quality bonds and a focus on a strong tradeoff between risk and return are rules to retire by.


Global Short-Dated Bond Strategy

With global bonds, there is the concern of foreign currency exposure. Efficient-market research conducted on exchange rates found the same random walk phenomenon as found in the stock market. Exchange rates move unpredictably. Currency exposure tends to increase the volatility of a fixed interest portfolio, while there is no reliable evidence to suggest that the expected return of exchange rates (assuming monies are invested in short-term currency deposits) is generally anything other than zero. Our belief is that currency exposure should be hedged in global bond portfolios. Generally, investors pursue global portfolios in order to diversify. Statistically, diversification should result in lower portfolio volatility due to the combination of uncorrelated assets. With currency exposures hedged away, the goal of diversification is attained. 

Please click on the image to view details of a fund we currently recommend to our clients

Inflation-linked bond strategy

Whilst we like the concept of Inflation-linked bonds, these are not the same as short-dated government bonds. These bonds give a hedge against inflation but because the maturity tends to be very long they are therefore much more affected by changes in the real interest rate – meaning there are still lots of uncertainties around these bonds such that if the real interest rate rises, they go down in value.

This video explains: