Home Personal Finance How to Avoid Mistakes When Balancing Your Fixed Income
How to Avoid Mistakes When Balancing Your Fixed Income

How to Avoid Mistakes When Balancing Your Fixed Income

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Fixed income, an investment that pays regular income in the form of interest, a coupon payment or preferred dividend, can play an important role in an investment portfolio. But its role may vary according to an investor’s financial needs and concerns. For example, many investors look to fixed income for safety, income, and more stability in their portfolios. They must weigh these priorities against their concerns over future interest rates, inflation, government debt, and other factors that might affect fixed income returns. If you want to learn more about fixed incomes (or even fixed deposits), then you could easily check out something like this website here https://www.gobear.com/my/fixed-deposit for more information.

Striking this balance can be a challenge in any market environment, but especially now, as low interest rates have sent many investors on a quest for higher-yield bonds or alternative investments. Depending on your approach, this pursuit of return on your investment may invite more risk—some of which may be hard to see or understand.1

So, what’s an investor to do? How can you make prudent fixed income decisions while also addressing today’s low interest rates? Consider these principles:

Remember How Markets Work

The same core investment principles apply in any market environment. One key principle is that in a well-functioning capital market, securities prices reflect all available information. Today’s bond values reflect everything the market knows about current economic conditions, growth expectations, inflation, Fed monetary policy, and the like. So, according to this principle, the possibility of rising interest rates is already factored into fixed income prices.

Fixed-Income-2.1

Know What You Own

Strive for transparency in a portfolio. This means understanding an investment manager’s basic strategy and knowing how the instruments held in the portfolio might respond in different economic, market, and interest rate scenarios.

Unfortunately, investors who chase performance often make their investment decisions based on the past performance and perceived popularity of the strategy. For example, some of the mutual fund categories experiencing the heaviest inflows of cash in the industry are in asset groups that have recently experienced higher than average returns. Higher returns are typically accompanied by higher risks. But do investors know what risks their managers are taking to deliver those attractive returns?

Understand the Tradeoffs

When reaching for higher returns, investors should carefully consider the potential effects of their decisions on expected portfolio performance and risk. In the fixed income arena, investors have two primary ways to increase expected yield and returns on bonds. They can:

  • Extend the overall maturity of their bond portfolio (take more term risk).
  • Hold bonds of lower credit quality (take more credit risk).

These may be reasonable actions. But pursuing higher income means accepting more risk, as measured by interest rate movements, price volatility, or greater odds of losing value if the issuer defaults.

Pay Attention to Costs

Investors typically do not realize that investment-related costs determine a large part of a portfolio’s return. This applies especially to fixed income securities. In fact, research has shown that a bond mutual fund’s expense ratio helps explain much of its net performance—and funds with the highest expenses tended to have the lowest performance within their peer group.2

Consider a Global Fixed Income Strategy

Investors have other tools to enhance risk and expected returns in fixed income. You can expand your opportunity set by moving beyond your domestic fixed income market to access yield curves in other country markets. (Yield curves plot interest rates of bonds with equal credit quality, but different maturity dates, at a set point in time.) By owning bonds issued by governments and companies from around the world, investors can enhance diversification in their fixed income portfolios. After hedging against currency risk, bond markets around the world have only modest correlations. (Correlation refers to how similarly two investments perform in the same period.) As a result, a global hedged portfolio should exhibit lower volatility than a single-country portfolio or a global portfolio that does not hedge currency risk, and offer the opportunity to take advantage of more attractive yield curves abroad.

Summary

No one really knows when and by how much interest rates will change. Investors looking for higher bond yields should understand the higher risks tied to their decisions. Most investors might be best-served by building a fixed income strategy to complement their broader portfolio objectives, understanding the sources of risk and expected return, paying attention to fees, and looking beyond their own country to capture yields in other countries’ markets.

 

About the Author

Tom-Damasco

 

 

 

 

Working with a financial advisor may help simplify your financial picture and provide you with piece of mind.

Tom Damasco is the co-founder and CEO of MPM Wealth Advisors. He has worked with individuals and small businesses around the country to create clear, holistic and customized investment plans aimed at achieving his clients’ financial goals and lasting from generation to generation. Consultations and second opinions are always complimentary. Visit www.mpmwealth.com to learn more or schedule an appointment.


 

This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale. Investing risks include loss of principal and fluctuating value. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors.

Endnotes

  1. When interest rates rise, the value of an existing bond declines; when rates fall, existing bond values rise. The market adjusts a bond’s price to match the yield available on a new instrument. Investors who hold fixed income securities with longer maturities are exposed to the amplified effects of term risk. A long-term bond is more exposed to rate changes than a short-term instrument, and usually (but not always) offers a higher yield to compensate investors for the extra risk. Also, lower-coupon bonds are more affected by interest rate changes than higher-coupon bonds. For example, if rates move 1%, a bond that pays 3% will experience a greater gain or loss than one paying 5%.
  2. The study examined monthly alpha and expense ratios for bond funds in the CRSP survivorship-bias-free mutual fund database from January 1992 to December 2011. Source: Dimensional Fund Advisors.

 

 

Chelsea Heintschel
Chelsea Heintschel

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