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 yield may invite more risk—some of which may
be hard to see or understand.
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So, what’s an investor to do? How can you make prudent
xed income decisions while also addressing today’s low
interest rates? Consider these principles:
REMEMBER HOW MARKETS WORK
e same core investment principles apply in any market
environment. One key principle is that in a well-functioning
capital market, securities prices reect all available
information. Today’s bond values reect everything the
market knows about current economic conditions, growth
expectations, ination, Fed monetary policy, and the like.
So, according to this principle, the possibility of rising
interest rates is already factored into xed income prices.
is 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 US Treasuries and longer-term
bonds have continued falling and now are at historic lows.
Fixed income can play an important role in a 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.
Balancing Your Fixed Income
November 2012
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 ef-
fects 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%.
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OPENCIRCLE WEALTH PARTNERS
Rather than trying to predict macroeconomic forces that
are difficult to foresee, investors can look to the market to
set prices and focus on the variables within their control.
START WITH A CLEARLY DEFINED GOAL
Fixed income choices should follow a broader investment
strategy that defines the role of fixed income in a portfolio.
The portfolio can then be customized to meet those specific
goals while managing tradeoffs.
The chart below illustrates how portfolio objectives can
influence a fixed income approach. An investor who wants
to seek to avoid losing market value might have a different
fixed income allocation from someone who wants to take a
balanced approach, needs immediate income, or is seeking
higher returns. Investors with different objectives typically
have different tradeoffs regarding risk, expected return,
and costs.
KNOW WHAT YOU OWN
Strive for transparency in a portfolio. is means
understanding an investment manager’s basic strategy
and knowing how the instruments held in the portfolio
might respond in dierent economic, market, and interest
rate scenarios.
Unfortunately, investors who chase performance oen 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
inows of cash in the industry are in asset groups that have
recently experienced higher than average yields. Higher
yields are typically accompanied by higher risks. But do
investors know what risks their managers are taking to
deliver those attractive yields?
UNDERSTAND THE TRADEOFFS
When reaching for higher yield, investors should carefully
consider the potential eects of their decisions on expected
portfolio performance and risk. In the xed income arena,
investors have two primary ways to increase expected yield
and returns on bonds. ey can:
Extendtheoverallmaturityoftheirbondportfolio
(take more term risk).
Holdbondsoflowercreditquality(takemorecreditrisk).
ese 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.
As shown in the graph below, higher yield can also bring
potentially higher volatility. Note that high-yield bonds (as
represented by the Barclays US Corporate High Yield Index)
have exhibited more volatility relative to other bonds.
2. CRSP data includes indices of securities in each decile as well as other segments of NYSE securities (plus AMEX equivalents since July 1962 and
NASDAQ equivalents since 1973). The Barclays US Corporate High Yield index measures the performance of fixed-rate, non-investment grade
debt. The Barclays US Aggregate Bond Index measures the performance of the investment grade, US dollar-denominated, fixed-rate taxable bond
market. The BofA Merrill Lynch One-Year Treasury Note Index measures the performance of US Treasury notes. The index is representative of the
universe of fixed-rate, non-investment grade debt. Indices are not investment products available for purchase.
Indices are not available for direct investment; therefore, their
performance does not reflect the expenses associated with the
management of an actual portfolio. Past performance is not a
guarantee of future results. Barclays data provided by Barclays
Bank PLC. CRSP data provided by the Center for Research in Security
Prices, University of Chicago. BofA Merrill Lynch Indices are used
with permission; copyright 2012 Merrill Lynch, Pierce, Fenner &
SmithIncorporated; all rights reserved. Merrill Lynch, Pierce, Fenner
& Smith Incorporated is a wholly owned subsidiary of Bank of
America Corporation.
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HIGHER YIELD OFTEN COMES WITH MORE VOLATILITY
Monthly Growth of Wealth, July 1983–July 2012
For illustration purposes only.
INVESTMENT OBJECTIVE HELPS DETERMINE
FIXED INCOME’S ROLE IN A PORTFOLIO
OBJECTIVE ROLE OF FIXED INCOME
Avoid losing money
Capital preservation
Keep portfolio in balance
Volatility customization
Meet income needs
Liability management
Seek higher returns
Total return
CRSP Deciles 1-10 Index (market)
Barclays US Corporate High Yield Index
Barclays US Aggregate Bond Index
BofA Merrill Lynch 1-Year Treasury Note Index
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10
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1983 1987 1991 1995 1999 2003 2007 2011
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OPENCIRCLE WEALTH PARTNERS
PAY ATTENTION TO COSTS
Investors typically do not realize that investment-related
costs determine a large part of a portfolios yield and return.
This applies especially to fixed income securities. In fact,
research has shown that a bond mutual funds 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.
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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. 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. 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. Most investors might be best-served
by building a xed 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.
3. 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.
For more articles, visit our website www.opencirclewealth.com
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This information is for educational
purposes only and should not be considered investment advice or an offer of any security for sale.
OpenCircle Wealth Partners is an investment advisor registered with the State of Connecticut
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.