Evaluating Your Fixed Income Needs

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.

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. Junk bond issuance hit a record $350 billion in 2012, with many of the issues carrying fewer protections for bondholders. Investors also flocked to high-yielding alternative investments, such as energy partnerships and venture capital funds. This combination of unchecked risk appetites, low interest rates and high bond prices may present danger for investors who are pursuing yield in markets they do not understand.

Buyer Beware

In a recent Wall Street Journal column, “How Apple’s Fall Bit Bondholders, Too,” Jason Zweig described how many investors may have been duped by complex investments known as “equity-linked structured products.” Equity-linked structured products are issued by investment banks and essentially are bonds that can turn into stocks of other companies. They pay high interest, typically monthly, for one year or less. If the stock that the products are linked to rises or stays close to its price at the time the bonds were issued, investors get all their money back when the bonds mature.

The downside, however, is this: If the stock falls more than about 20%, the bonds can morph into shares of the fallen stock. The buyers, who are usually individual investors, must then hold the security until the original maturity.

In 2012, Apple’s shares skyrocketed to new highs – and some of the largest investment banks sold more than $722 million in “bond-like” investments as a cheap way of betting against the stock. Unfortunately, with the recent performance of Apple’s stock, many investors will experience losses exceeding 25% or more. As Zweig points out in his column, “The implosion of these investments is a reminder that there is no such thing as high yield at low risk. Complexity always favors the seller, not the buyer. And the house always wins.”

Balancing Your Fixed Income Decisions

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:

1. Remember How Markets Work

Today’s bond values reflect everything the market knows about current economic conditions, growth expectations, inflation, Fed monetary policy and the like. As such, we believe the possibility of rising interest rates is already factored into fixed income prices.

This is one reason investors should view future interest rate movements as unpredictable. Even the market experts who have access to vast amounts of research have a hard time predicting the direction of interest rates. For instance, despite regular predictions of rising interest rates over the past two years, nominal yields on U.S. Treasuries and longer-term bonds have continued falling and now are at historic lows.

2. Understand the Tradeoffs

When reaching for higher yield, 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. At Truepoint, we believe fixed income’s primary purpose in the portfolio is to provide stability to the total portfolio. If our clients are looking to increase their risk/return objectives, that is better accomplished through increasing their allocation to equities.

Implementing a Global Fixed Income Strategy

Investors have other tools to enhance expected returns in fixed income. Truepoint expanded our clients’ opportunity set in early 2010 by moving beyond the domestic fixed income market to access yield in other countries’ markets. 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 demonstrate 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, and offer the opportunity to take advantage of more attractive yield abroad.

Summary

No one really knows when and by how much interest rates will change. Many market pundits have forecasted an upward move for several years now. Investors looking for higher bond yields should understand the higher risks tied to their decisions. Investors will be best served with a fixed income strategy that complements 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. Over time, staying invested for a long-term objective is more important than timing investments, even in a low-rate environment.