Fixed-income in a portfolio?
Fixed income traditionally appeals to people looking for conservative investments that offer security of capital. Over the past three years, investors have also seen fixed-income investments as an attractive alternative to poorly performing equities.
How much of a portfolio should be invested in this asset class really depends on the individual investor’s tolerance for risk.
How do interest rates affect fixed income?
Interest rates in the developed markets have been at record low levels, so we’re expecting rates to rise. The U.S. economy grew 8.2% in the third quarter of 2003. If that strong growth continues, the U.S. Federal Reserve will likely raise rates to control inflation.
The U.S. growth will stimulate the Eurozone economy, enough perhaps for the European Central Bank to also raise rates, although probably less aggressively.
With rates so low in recent years, bond prices have been relatively high. But all things being equal, when interest rates go up, bond prices fall.
What are some ways to manage fixed-income investments in a rising interest rate environment?
Fixed-income investments make money either in absolute terms or relative to other fixed-income investments. In absolute terms, bond investors can make more money in a rising rate environment by holding defensive investments such as floating rate bonds. These have a coupon that moves with short-term interest rates; if rates go up, so do your payments.
Another example is a Treasury Inflation Protected Security (TIPS), which adjusts the principal value of the bond in step with inflation every six months. Its semi-annual interest payments are then calculated on this inflation-adjusted principal, which means you also receive more interest as inflation rises. At maturity, you receive the par value or the inflation-adjusted principal, whichever is higher.
Another strategy is to hold only short- and long-term bonds in your fixed-income portfolio (called a “barbell” strategy). If 10-year bonds are yielding, say, 4.5%, and short-term bonds (less than two years) are yielding 1.5%, you can get a fairly good average rate of return.
Performance?
Holding corporate bonds that offer higher yields than government bonds can help boost performance. If the yield “spread” (the difference between the rates) gets smaller, you’ll end up with a positive performance relative to the government bond, no matter what interest rates are doing. But you need to identify those bonds that are trading at wider-than-normal spreads.
