Just like an anchor keeps a ship stable and secure in turbulent waters, fixed-income investments serve as a stabilizing force within investment portfolios. In rough seas, equity investments can experience significant fluctuations, and in those times of turbulence, everyone needs an anchor or liferaft to weather the storm. Investors cannot overlook a portfolio’s fixed-income investments, as they are a very useful tool in managing volatility.
Fixed-income instruments are typically used in a portfolio to reduce volatility and provide more consistent steady returns and income for clients. During times of market volatility, bonds can offer significant protection to portfolios, depending on credit risk. And with bond yields higher today than in recent years, the cash flow can be meaningful. The fact is during those many years spent in a low-yield environment during the previous cycle, the stability provided came at the cost of muted return expectations. Thanks to higher yields, the opportunity cost is lower now.
From our perspective, the fixed-income portion of the portfolio consists of cash, corporate bonds, government bonds, securitized instruments, as well as preferred shares. The proportion between these broad groups largely depends on the desired role of fixed income within a diversified portfolio. To further aid in the portfolio analysis approach, we focus on three key aspects to aid in the analysis.
The credit composition of a portfolio’s bond allocation is critical. More credit enhances the cash flow and returns expectations but at the cost of less stabilization during troubled times. During the low-yield world of the past decade, many portfolios increasingly took on more credit in search of a satisfactory cash flow yield. This has likely muted the defensiveness of many bond allocations.
It is important to analyze the credit composition of individual fixed-income mandates to get a sense of the total exposure within a portfolio. It’s easy to get into the weeds when dissecting credit exposure, but from a portfolio approach, we’re less interested in individual company exposure or specific credit ratings but rather use larger buckets, breaking them up into investment grade (AAA to BBB), high yield (BB or lower) or not rated.
Using this simple framework makes it quick and easy to see a portfolio’s overall exposure and perhaps if it is overly tilted towards credit. In this environment, investors unwilling to take on any credit risk nearly guarantees a low-return outcome. However, tilting too far into preferred shares or high-yield bonds offers more attractive yields but exposes clients to a much higher drawdown risk and a higher correlation to equities.
One of the more interesting shifts in the bond market over the past 18 months is the fact that duration management in portfolios matters again. Bond market benchmarks themselves have changed over time, as you can see in the chart below. Over the past 20 years, yields have fallen amidst that time frame (and most recently risen back to “normal”), but the duration, a measure of the sensitivity to interest rates, has increased from a little over six years to over eight years, settling in around 7.5 currently. In other words, broad index exposure now takes on more interest rate risk than 20 years ago; however, with the current recovery in yields, investors are once again compensated for taking on that additional risk.
Determining the appropriate overall duration of a portfolio largely depends on the outlook for interest rates. For instance, in a rising rate environment, a shorter duration is more appropriate to minimize interest rate risk. Typically, portfolios are compared with an appropriate baseline duration to determine the extent of rate exposure embedded within the portfolio.
Geographic exposure is straightforward. Our preferred approach focuses on just three broad buckets: Canada, the United States, and international, where we bucket everything else. Perhaps more so than with equities, most Canadians have a large home country bias within their fixed-income allocations. While this makes sense from a liability-matching standpoint, the potential pool of investments in Canada is rather limited, especially in credit markets. Thus, it is important to look outside of our borders to some degree for a broader range of corporate bonds.
Limiting foreign exposure within the fixed-income portion of the portfolio is often advocated to mitigate currency risk and potential volatility stemming from fluctuations in currency markets. Additionally, it helps minimize exposure to political and regulatory risks while also enhancing portfolio management transparency through readily available information.
Advisors have a wide array of available investment options to construct a diversified fixed portfolio. The available vehicles have grown considerably over the past few years with a wide array of new ETFs, private debt funds, and liquid alternatives geared toward the credit space.
Besides all the products available, using individual bonds in a laddered strategy, for instance, can also be an effective and highly cost-effective option. Large tilts within any of these key exposures should follow a well-thought-out strategic rationale with a clear understanding of what exactly the exposures want to achieve. The tricky end goal is to combine investments across the fixed-income spectrum to achieve optimal portfolio diversification.
Insights with Purpose
At Purpose, we are attempting to change the status quo within the investment industry – namely the enigmatic standards by which the industry operates. We are an open book when it comes to portfolio design and discussions surrounding our outlook and strategies. We want to make managing portfolios simpler for advisors and act as a sounding board for ideas. We start by running portfolio comparisons between your portfolios and ours. Not to say ours is right and what you are doing is wrong, but to understand the differences and have discussions surrounding the rationales. We aim to keep this discussion going quarterly, and this is not a one-and-done service. We want to build our relationships with advisors so that the end client has a satisfactory investment experience.
If you want to know what exposures your equity portfolio is tilted toward, feel free to reach out to our team at firstname.lastname@example.org
As the great Peter Lynch once said, “Know what you own and why you own it.”
— Brett Gustafson is a Portfolio Analyst at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
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