Safety and Return with Fixed Income

While the main goal of fixed income investments is to seek a predictable and reliable form of income, a fixed rate of interest actually, one of the main reasons why people purchase fixed income investments is to look to significantly reduce the risk involved in investing.

If you invest in something that provides a certain amount of interest then this of course limits the amount of money you can make from these investments to this certain amount, which is the price you pay for this investment security.

Safety and Return with Fixed IncomeYou may still lose your principal though, if the bond issuer defaults, if the company goes out of business, or if the bank becomes insolvent, and this default risk does play a substantial role in fixing the interest rates that the security pays out.

How much safety an investment has and how much return one can achieve with them are very correlated, at least in terms of the perceived risks. We can never predict the future of course, and we are limited to forecasting it, and the risks that are priced into these investments are based upon these forecasts, the market perception of what these risks may be manifest in the risk premium that gets paid out to them.

The idea though with all fixed income investments is to seek reliability of returns, which includes both the amount and the likelihood of it being paid out and one’s principal not being lost. So this class of investments is already disposed toward that, where we then select among various investments in the class to achieve our desired balance between risk and return.

In doing this, we must seek to define what level of safety we require, and safety should always be the primary concern, much like managing risk with any investment needs to be primary. If and only if the investment is deemed safe enough for our purposes should we even be looking at achieving our goals of return, because otherwise we would not be pursuing these returns safely enough.

Determining the Level of Safety We Require

With that said, fixed income investments are generally safe enough to suit the purposes of most fixed income investors, with differences tending to be not particularly meaningful in a lot of cases. This doesn’t mean that we don’t need to pay attention to such things, and we do want to avoid uncomfortable situations and even ones we may later come to regret.

When one buys a fixed income investment, the risk at the present time is priced in, risks that are perceivable at the time of purchase. The rate becomes set, and this is the rate we are stuck with over the life of the investment.

Changing circumstances will define the value of the investment if we sell it, where it may be worth more or less depending on these changes, but the return itself will remain fixed since this is built into the terms of it.

There is both good and bad sides to this arrangement, as it is nice to know that we are going to collect a certain amount of interest over time from our money, but there are risks to this, most notably that this income stream may become less valuable, from inflation for instance. There are also changing risks of default, where an investment may be seen as very low risk when you buy it, but over time may become more risky, with your return not adapting to accommodate this added risk.

The best we can do is assess the future as well as we can though, but this potential of added risk needs to be accounted for, and we should be striving to still be in a good position if our income flow does become devalued, and perhaps also have an exit plan should the desirability of the investment decline enough.

It is by no means an easy task to look to assess our need for safety in a practical way such that we can choose well between the various types of fixed income investments, and this is the main reason why a diversified approach is often sought, especially when it comes to looking to limit default risk.

Diversification and Risk with Fixed Income Investments

This may or may not be the best approach though, especially if we are more risk averse and may not want to include riskier investments in our fixed income portfolio, ones that we normally would not choose if not for the fact that they are included in a basket of investments.

Those who sell these baskets of investments, in a fixed income fund for instance, will tout the benefits of both seeking to increase one’s overall returns while managing the added risk of doing so by diversifying, where you can seemingly have the best of both worlds.

This really depends on whether a given component may in itself be suitable, and it’s not always a good idea to mix in unsuitable ones, and if the default risk of a certain investment is high enough that we would need to balance it off with more stable investments, we may wonder whether that’s a better idea over simply avoiding investments that are unsuitable in themselves to a given investor.

Fixed Income Risk is Mostly Macro Risk

Most of the risk that we take on with fixed income investments is based upon macroeconomic conditions, ones that all fixed income investments are all subject to. For instance, the risk of inflation is going to impact all fixed income interest streams, and if you lose a percent to inflation, you’re going to lose this percent regardless of the particular types of fixed income investments you hold.

Fixed income investments rarely default, and the safer ones really never do, U.S. treasuries for instance or bonds issued by other governments where defaults during the life of the investment are virtually zero. It’s not that it isn’t possible for the U.S. government to default on its debt obligations, or that the end of the world might come, but both have similarly meaningless degrees of risk these days.

Even with riskier fixed income investments, like corporate bonds or preferred shares, or bonds issued by less stable governments, it’s not that defaults hit us out of the blue, and the sort of crisis that precipitates such events occur slowly enough to give investors ample opportunity to react.

Risks from macroeconomic conditions also play out gradually, but the difference here is that these risks aren’t really investment specific, they are global, and therefore what you choose really isn’t going to impact this risk much, since all boats are raised or lowered together.

Some investors just do not want to take on default risks of a higher level though, and given that the main goal of fixed income investments is to reduce risk to more meaningless levels, this is understandable. We don’t want to be excessively risk averse here though, although this is not just a matter of number crunching, and peace of mind can factor into this as well.

If an investor simply feels more comfortable in more conservative investments, that’s certainly worth something, and if we can achieve our investment objectives without worry rather than having to worry that’s actually pretty important.

Many fixed income investors don’t really account for macro risk enough though, even though they may be well preoccupied with the threats of default risk, and given that macro risk tends to be a much bigger monster comparatively speaking, it is something that we do need to be aware of.

Fixed Income Risk and Length of Term

The way that macro risk plays out with fixed income investments has to do with the term of them, where longer term investments pay better returns but involve more of this sort of risk. If you buy a 1 year treasury for instance, we usually have a pretty good idea of what’s going to happen over the next year where economic conditions go, but over 30 years, things are far more uncertain.

This added risk is priced in to some extent of course but this is really set by the market, by how much more these investments need to pay out to attract enough interest from the market.

Especially with those investors who are more risk averse, we may wonder whether or not this extra premium would be worth it to them, especially if they rely on the real value of the income derived to live on.

These longer term investments can be sold though if desired, so it’s not as if one is completely committed to the term, but this involves risks as well, and significant ones. If you end up selling the investments at a capital loss, this is going to affect your ability to receive the interest payments you need on your further investments.

Investment advisors will often advise that we ladder our fixed income investments, choosing ones of various lengths from short term to long term, and while that may be a better strategy than just going with the higher yielding long term ones, it may be that we do not want to expose any portion of our fixed income portfolio to these long term risks.

The current trend of rates does matter here as well, and in conditions where rates are rising, we should wish to be more conservative than in conditions when rates are stable or declining. Even among those who choose to simply hold these investments to term, there is still a potential opportunity cost, where one could have instead bought shorter term investments and captured better rates along the way as they go up.

The market for long term fixed investments is driven a lot by institutions, who don’t have to put food on their table from them, where if we do we need to be more aware of the impact of these additional risks and especially if we are subject to being made uncomfortable by them.

Instead of laddering, those who rely substantially in the income flow from their fixed income investments need to exercise much more caution than this, and this means having a stronger preference for shorter term investments over longer term ones, even though the returns will be less.

Once again, this is all about achieving one’s investment goals with these investments with the goal of safety first, and safety means more than just losing your money when something defaults.

Eric Baker

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: [email protected]

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