The Role of Fixed Income Investments in Portfolios
Fixed income investments are securities whose primary function is to deliver a fairly reliable source of income to investors. The fixed part of fixed income denotes that these investments generally pay interest at regular intervals, as is the case with most investment grade bonds.
There are three main classes of investments provided by financial securities, which are growth, income, and savings. Depending on one’s investment strategy, one may hold a certain percentage of one’s assets in these three categories, which can range from having all of one’s investments in growth, to having all of one’s assets in savings.
The main function of the growth segment of one’s portfolio is capital appreciation over time, for instance buying and holding stocks with the objective of selling them at a higher price at a later date. The growth segment can also include looking to profit from securities that decline in value as well, with the objective still being the growth of one’s capital.
In this case one would look to buy the loaned securities back at a lower price, and all these strategies involve buying low and looking to sell higher, even though in the case of short selling the stock is sold first and bought later.
With the savings segment, the goal is preservation of capital, and both the other two segments, growth and income, can depreciate, but the savings components of one’s investments generally don’t, to any significant amount anyway.
Risk and return are inversely related, and the growth segment has the highest rate of both risk and return, with the savings having the lowest risk and return, and the income class being in the middle with both.
Risks and Time Horizons with Fixed Income Investments
Risk tends to decline with a given investment over time though. Stocks can be risky in the short term, meaning the risk of selling at a loss if they are only going to be held for a short time, but over the long term, the ups and downs of the market tend to even out, and the longer you hold them generally, the less likely you would be to have to take a loss.
The same is true for the most part for the income segment, but fixed income investments are more reliable with shorter horizons, especially with interest bearing bonds. Provided that the bondholder does not default, which is very unlikely as long as you stick with high quality interest bearing securities, you are assured of a certain payment over time as per the conditions of the investment.
This adds quite a bit of stability to these securities, and more so than it may appear. Some investors look at just the price movement of bonds to assess their risk, and while there is risk with bonds, you also need to take into account the yields they provide when you compare them to other classes, the more volatile growth segment and the more conservative savings component.
So you don’t just want to look at price here when you see a chart of a bond’s performance or the performance of an income fund that contains bonds or other fixed income investments, what you want to look at is the effect of price downturns with these investments affects the ultimate value, the total yield, what you are left with when you sell given the current conditions.
For instance, if both a stock and a bond’s price declines by 5%, the bond has outperformed the stock because you get an interest payment with the bond, where with the stock you may or may not get a dividend payment.
Of course the price you get only matters if you are looking to sell, or selling is on the horizon, the same way as you would look at any investment, and investors never want to make the mistake of getting overly concerned with short term fluctuations when they are in it for the longer term, as this is of limited or no relevance.
Fixed Income Investments as a Hedge
Although speculators do trade bonds short term, people primarily use them for income generation purposes and to hedge other more risky investments. Often when investors are moving out of stocks as the stock market struggles, they will move assets to fixed income due to their greater stability.
Bonds are naturally more stable than stocks because of their fixed income component, a guaranteed rate, as opposed to no guarantees at all with stocks.
With stocks or other growth oriented investments, since the growth of one’s capital is the primary objective, if that is going the other way due to declining markets, one may seek the safety of other types of investments, ones that actually tend to do well in declining economic conditions, where fixed income securities do better than things like stocks do.
When this happens, one must be aware of the need to stay the course though, and if one bought stocks with the intention of holding them longer term, very often it is wise to stick to that strategy. You may not want to expose too much of your portfolio to these greater risks, and therefore holding a certain percentage in less volatile investments such as bonds can be a wise move.
For instance, if your stock portfolio declines, and you are holding half stocks and half bonds, bonds do not tend to go down in turn and often will go up in these situations. So not only has the downturn, the risk, been dampened by the bonds, it can offset some of the losses, partly from your bonds going up in value and partly from the interest payments you receive, making your overall portfolio less risky.
Again though, this depends on your time horizon, and with long ones, where there is no intention to react to short to even medium term market fluctuations, balancing your portfolio with fixed income investments may not be necessary. Given that fixed income investments provide more stability but less growth potential, if the greater stability is not required, the price of less expected return over time may not be a bargain.
Fixed Income and Interest Rates
While fixed income securities don’t move up and down with the business cycle, they are very interest rate sensitive. They pay out a certain interest rate over time, and this interest rate is dependent upon the overall interest rates at the time of issue, so when they move up and down this does affect the value of the bonds.
Inflation tends to appreciate stock prices overall, even net of inflation. It has the opposite effect with bonds, at least when it causes interest rates to increase. It’s the differential in rates between the time of issue and the present that matters here, not what the actual rates are.
This affects not just the price of the securities, but their utility as well. Consider a case where you buy a bond paying 3% per year. Interest rates rise one percentage point. This will cause the price of the bond to go down, if it is traded that is, because people don’t want to pay as much for it now, because there are other bonds that they could buy, new issues, that have their interest rates up to date, at 4% in this case.
So if you sell the bond, you’re going to have to take a price that has been lowered to reflect this. The income you make from it is also affected, as interest rates and inflation move together, and now your 3% a year has less buying power, as does the principal amount of the bond as well if redeemed or traded.
The reverse happens when interest rates go down, bonds sell for more and their interest rates buy more. This is especially important to account for if you derive a lot of your income from fixed income securities, as many retirees do.
This won’t matter much either way if the interest rate fluctuations are minor, but major movements can be pretty significant. In today’s very stable low interest rate environment, fixed income investments take on even more value, especially compared to some of the big movements up in interest rates that we saw in past decades.
Relying On Fixed Income Securities As Income
The closer one gets to retirement, the more prominent fixed income securities should be in one’s portfolio, and the transition here should not be an abrupt one, as in being all in growth and one day retiring and switching over to fixed income.
The reason is that as the time horizon shortens with growth based portfolios, the greater risk they hold, even if one has held them for many years and already realized a big profit on them. This is a mistake a lot of investors make, and not all financial advisors pay enough attention to this either.
The horizon here isn’t calculated from when you first bought the stocks, it is always the difference between the present and when you expect to sell. So that period has to be long enough, and when it isn’t, moving more toward the better stability in shorter timeframes of fixed income is the clear way to go.
Ultimately, if you are looking to take profits as income, then at this time you should be more heavily weighted in safer investments like income and savings. If you have enough invested in fixed income such that you can live comfortably off the interest they provide, then having your entire portfolio in this class of investments can make sense.
If not, you may want to have some in savings so that you aren’t so prone to needing to sell the bonds at inopportune times, if you need to cash in a portion each year for income purposes. The savings can be relied upon during these times, to lower the risk of selling the bonds at a loss or when it would be more advisable not to.
Fixed income securities can be a great idea at any time in one’s life though, particularly if one’s risk appetite demands that one seek to balance one’s investments with a component that is more conservative and more stable.