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®