What is Fixed Income?
New traders are naturally drawn to the allure of equities (and consequently away from more stable investment options like fixed income). There is good reason for this: in the long run, stocks provide the highest level of returns of commonly held investments. A few stocks in history have demonstrated short-term returns that can turn a small investment account into a ticket to early retirement. The possibility of realizing these meteoric returns is what lures so many individuals to investing in the first place.
Fixed income doesn’t serve this purpose. I think of it more as the stay-at-home defenseman of an investment portfolio. Fixed income is comprised of the debt of corporations, governments, and individuals (in the form of mortgage-backed securities). Given that debt holds a senior position to equity and is therefore safer, the returns on fixed income are lower (and less volatile) than the returns on equities.
Benefits of Diversification into Fixed Income
When stock market returns are higher, fixed income will be a drag on portfolio performance. However, when stocks are falling (such as with the 35% peak-to-trough drawdown in the S&P 500 from February 19, 2020 to March 23, 2020), investors will thank themselves for holding fixed income as a source of diversification. During the same period of that 35% drawdown, the US aggregate bond market was only down 1%. A $1 million portfolio invested entirely in an S&P 500 ETF would have been worth $650,000 at the end of this period. A 60-40 portfolio with 40% invested in an aggregate bond ETF would have been worth $786,000. The benefits of diversification speak for themselves.
Stock market drawdowns do not pose as much of a risk to younger investors, who still have considerable human capital in the form of future earning power. However, once an investor is getting close to the time in which they will rely on their investment portfolio to fund their life, diversification becomes much more of a necessity. When an investor is drawing funds from their portfolio, he or she is susceptible to something called sequence of returns risk. Imagine that you had $1 million in your investment portfolio and you need $40,000 per year to finance your retirement. You believe that your portfolio can yield 4% in income per year, allowing you to finance your life without eating into your principal. While the years leading up to your retirement saw the stock market produce good returns, it has just experienced a 35% drawdown. Even a 4% income yield won’t come close to paying you the $40,000 a year you need to live, so you will have to gradually sell off your investment portfolio. You therefore won’t be able to finance your retirement in perpetuity. There are many retirement-age investors who have just had the rug pulled out from under them by this bear market. This is when it’s helpful to be holding an adequate fixed income position.
The Drawback of Fixed Income
Investors used to be able to realize significantly higher returns these type of positions. This was largely a function of the interest rate environment. You may have heard all of the talk of interest rates in the press lately. Largely in response to COVID-19’s effect on the economy, The Bank of Canada has cut the prime rate from 3.95% to 2.45%. A lower prime rate has a cascading effect on other interest rates as the intent is to lower the cost of borrowing money in order to keep the economy from plunging into recession. Lower interest rates lead to lower returns on these positions. The returns on fixed income are determined almost entirely by the interest rate at origination (for example, the interest rate environment at the time when a bond was issued). While returns on fixed income are lower, we also live in a much lower interest rate environment, so real returns on fixed income haven’t been affected as much as people that lived through the high yield period of the 1980’s may assume. Investors should focus on real returns rather than nominal returns because the primary goal of investing is preserving buying power.
Diversify Your Holdings
Just as with stocks, your fixed income positions should be adequately diversified. Corporations have been known to default on their debt obligations; even sovereign nations can fail to make payments on the bonds they issue (take Argentina, which just defaulted on its sovereign debt for the ninth time). If you are a younger investor, your fixed income position will likely be relatively small; an aggregate bond ETF will provide you with adequate diversification without having to hold numerous bond issuances. Remember that the income earned on fixed income will be taxed as ordinary income. If possible, you should therefore hold your fixed income positions in registered accounts to reduce your tax burden.
Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.