The Effect of the More Modest Returns of Fixed Income Investments
We know that fixed income investments basically only keep up with inflation, unless you are going with risky fixed income investments, which really isn’t a good idea. While we do get compensated for the added risks we take on when we do so, the idea behind fixed income is to protect your wealth, not risk it, and if we want to add risk we can so so with securities more appropriate such as stocks.
With fixed income, we’re looking to either balance the risks that we take with other components of our portfolio such as our stock market positions, or may want to avoid such risks, and fixed income investments, provided that they are of a high quality and low risk, provide that opportunity.
In a real sense, investing in riskier and lower quality fixed income securities defeats the purpose of this investment, as it really does function as a hedge, or should at least. There are additional risks beyond default risk with fixed income, interest rate risk and inflation risk in particular, so it’s not that these investments are without risk, and far from it actually.
When we add too much default risk to them, they can even become untenable, where prices are going the other way and you now don’t even have the benefits of being compensated properly for the default risk.
Think buying bonds from a country who is struggling and things get worse, and the risk of default becomes quite a bit higher but you’ve only been paid for a more modest default risk, and at the same time interest rates are rising which devalues the premium you were paid even more.
So this should have us wanting to focus on high grade fixed income investments, but these investments really don’t pay much more than inflation overall. With the best ones, you just keep up as long as inflation doesn’t go up, and while you may profit a bit if inflation goes down, it isn’t by a particularly meaningful amount typically.
If you’re outpacing inflation by a good amount, getting an average of 7 or 8% return with a stock fund for instance, then having to pay 1% back in management fees isn’t going to be seen as that big of a deal.
Given that you really couldn’t diversify very much on your own, and these funds provide all the diversification you desire, there really isn’t any good alternative to these funds provided that you do seek this diversification.
Diversification is really only needed when one passively manages one’s investments, as the best way to protect against drawdowns is to look to sell the investments when risk goes up, not just to spread the risk around like diversifying within an asset class does. This does not even protect us against market risk, but it does protect us against the risk of making poor choices and refusing to sell when things go badly.
When we are only shooting for returns that are less than half this though, 3% or so, and we’re paying 1% for this diversification, and we’re really only staying even with inflation, this will mean that our capital will be depreciated in a real sense through these management fees.
What We Really Get for our Money with Fixed Income Funds
The value that funds really provide is the ease of diversification, and we are sold on the idea of this with fixed income just as we are with other types of funds.
Diversification isn’t really a benefit with fixed income funds though, or at the very least not as much of a benefit as some may want us to think, those who sell these funds in particular.
What we end up doing when we mix in different qualities and grades of investments in fixed income funds is add some that we would not otherwise want to invest in should we be just going with them.
It would not make any real sense for instance for someone who was looking to protect their capital to put all of their money in junk bonds or in preferred shares of companies that aren’t doing that well, in spite of the opportunities for greater returns that these less than desirable investments offer.
We may think that by balancing these risks off with higher quality investments, including some which are considered to be risk free such as U.S. treasuries, we can enjoy the best of both worlds, but if the intent here is to protect our capital, going out of our way to take on more risk than we need to and to protect our capital less does not seem like all that great of an idea.
We can assume though that we are compensated for this additional risk though, by way of the higher yields, and this process will ultimately be efficient, but if this is the case, there is no real advantage to taking on the risk and being compensated if it does even out.
If this is the case, there is no real benefit to adding higher risk components to a fixed income portfolio, as you get paid more but the chances of your not collecting it or even losing goes up as well, presumably in proportion if these markets are indeed close to efficient.
Even if there is an advantage to doing this, and there may be a slight one, we also have to consider what price we are paying to enjoy whatever slight advantages we can realize through all this diversification.
The highest grade investments here don’t really need diversification, because they are pretty much all driven by the same macroeconomic forces, and markets are very well connected, especially these days.
If we could invest in fixed income funds without costs, then this may indeed be attractive, but the reality is that this does cost money in terms of management fees, and fees that comprise a more significant proportion of returns than other forms of funds.
If you’re only getting 3% on average from a fund, and it costs you 1%, then your return has now been cut by a third. If you’re living off the income here, this is also like your income being cut by a third, which for many is pretty significant indeed.
It’s not that it won’t cost you money to invest in fixed income securities yourself, but provided that you’re planning on holding on to them, this can be done at considerably lower cost.
The management fees that funds charge do result from management, but we have to ask ourselves if such a degree of management is necessary or desirable, given that we can instead just buy very low risk fixed income securities and achieve our goals without needing all that management.
This is not to say that fixed income funds aren’t a good idea, but we at least need to consider the alternatives and decide what is best for us, and not just go with the crowd or the advice our advisor provides, which never will be for us to go it without them of course.
Fixed income funds, like all funds, are an incredibly easy way to invest in fixed income securities, and therefore are going to be preferable to a great many individual investors regardless of how much deliberation they make over the alternatives.
It’s always a good idea to consider all of our options though, because that’s the only way we will have much of an idea of whether a particular approach to investing is right for us, and a lot of this is a matter of something conforming to our needs in particular and not just one that a lot of others may like or go with.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
Contact Eric: eric@marketreview.com
Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.
