Fixed Income Principles


With interest rates near historical lows, many investors are concerned about their fixed income investments. Not only are bonds offering meager returns, but an increase in prevailing interest rates could cause them to lose value. In evaluating your fixed income holdings, it may be helpful to consider the following principles.

Interest Rate Movements are Unpredictable

Academic research has shown that interest rate movements are difficult to predict. Forecasts by leading economists are all over the map. Even when there is consensus, the experts often get it wrong. For example, a 2009 Wall Street Journal poll of fifty prominent economists found 43 predictions that the yield on the 10-year U.S. Treasury note would rise in 2010 with an average estimate of 4.13%, and only two predictions that the yield would fall. In fact, the yield on the 10-year note fell in 2010 reaching a low of 2.95%. The take-home lesson is that you should generally avoid making fixed income decisions based on interest rate forecasts.

The Risk-Return Trade-Off

As in all properly functioning capital markets, there is a strong link between risk and return in the bond markets. In order to capture higher expected returns with your bond holdings, you typically have to assume a higher degree of term risk or credit risk. Term risk refers to the fact that bonds with longer maturities are more sensitive to changes in prevailing interest rates than shorter maturity bonds. In most cases, the value of a bond drops when prevailing rates go up. This effect is muted for short-term bonds and amplified with longer maturities. Investors who assume greater term risk are usually compensated with higher yields. For most investors, it is not worth going beyond intermediate maturities, however, because the yields do not increase enough to compensate for the higher risk.

Credit risk reflects the financial strength of the bond issuer. U.S. Treasury bonds are backed by the full faith and credit of the U.S. government and can therefore offer lower yields than other bonds and still attract investors looking for a safe haven. Corporate bonds have to offer higher yields to find willing investors due to the risk of default. Corporate bond issuers in poor financial condition have a higher default risk, and therefore must offer higher yields than financially stable corporate issuers.

Investment Strategy Drives Fixed Income Decisions

There are a variety of reasons for holding bonds in your portfolio, each of which leads to a somewhat different bond strategy. For example, a young, risk-tolerant investor who has committed most of her portfolio to stocks might prefer low-risk bonds, whose primary function is to reduce the volatility of her returns. On the other hand, an older investor interested in generating income might extend his bond maturities and accept greater credit risk on some of his bonds in order to increase the yield. An investor who is concerned about inflation should consider inflation-protected bonds, while an investor with a taxable account might be better served with tax-exempt municipal bonds. Most investors fall into several of these categories and are best served with a combination of bond strategies.

Individual Bonds vs. Bond Funds

At Shearwater Capital, we generally prefer bond funds over individual bonds because funds offer greater diversification and better pricing. Buyers of individual bond positions worth less than $1 million each are subject to unfavorable odd-lot pricing. We particularly like DFA’s approach to fixed income investing, in which they vary the credit and term risk to maximize expected returns within defined risk parameters. DFA also uses a flexible and patient trading approach, resulting in superior buy and sell prices. This is explained in detail on the DFA website: https://my.dimensional.com/tools/on_demand/57696/.

Conclusion

Our goal is not to eliminate risk in fixed income investing, but to manage it. This is accomplished by diversifying your bond holdings across different maturities, industries, countries and currencies. Most importantly, your bond strategy should reflect your investment goals, time horizon, risk tolerance, and personal financial considerations. This is a sound approach to managing your fixed income investments in an uncertain interest rate market.

Jeffrey J. Brown, MD CFA Principal, Shearwater Capital

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