Fixed Income: In a Fix
Typically, the construction of an investment portfolio
has begun with an approximate balance of 60% in equities and 40% in fixed
income instruments. Fixed income
generally means bonds, but that includes bond funds and exchange-traded funds holding
bonds. The equity portion is intended to
be the driver of capital appreciation over extended periods of time and the
fixed income portion is supposed to provide stable, albeit more moderate ongoing
rates of return.
The theory behind this approach is that as the time
periods measured have lengthened, the relative risk of holding equities has
diminished while the returns they have generated have been higher than those of
other asset classes. What equities do in
the short term, even a year or two, is often anybody’s guess.
To the extent that fundamental analysis can
help toward determining future equity values, investors need to look ahead
three, four, five years or more before reasonably expecting that the odds will
be on their side. In the short run,
psychology is more likely to be the driving force behind stock movements.
Bonds and other fixed income instruments are more dependable,
but not necessarily more promising. There
are several basic considerations to keep in mind. If everything else is constant, the higher
the quality rating, the greater the safety.
When safety is higher, however, the interest to be paid will be lower.
Bond ratings from Standard & Poor’s range from AAA
down to D. Although a school grade of B might
have been OK, bonds rated at BB or below are known as bad bonds. It gets worse going down the scale.
Another important consideration is maturity. The longer the maturity, the longer the time
when problems may develop, which is why longer maturities generally have higher
interest yields. That is the problem we
face today.
Over the last 40 years, prevailing interest rates have
fallen steadily from the mid-teens to just above zero. Barring the unlikely possibility that they will
go lower (and into negative territory), they will either stay where they are or
rise in the future. When rates rise,
bond prices will fall.
The problem for investors is that the combination of
extraordinarily low current rates and the prospect of rising inflation suggests
the likelihood of higher interest rates over the next few years. So in the wake of the recent four-decade rally
in bond prices as rates dropped, we are facing the probability of a marked
about face and far more limited worthwhile opportunities in that asset class.
For that reason and despite the greater volatility of
equities, there is a concerted movement toward an increased equity component
and a proportionate reduction on the fixed income side.
N. Russell Wayne, CFP®
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