Op-Ed: Fixed Income doesn’t equal bonds anymore. It’s time to pivot

Frustratingly, when investors do endeavor to learn more about bonds, and subsequently get discouraged when trying to buy individual bonds at posted yields or get lured into guaranteed investment certificates with seemingly good risk/reward yet little awareness of the inherent illiquidity and reinvestment risk, they get turned off fixed income yet again. Then they tend to canvass the name brand bond managers to select a bond fund only to run into core, core+, strategic, global, yield enhanced, high yield, private and on and on labels that mostly tend to do similar things including “shortening duration to protect from rising rates”, which is akin to smoking a little less.

Some investors do understand the notion that bond prices go up when interest rates go down, and that what is good for the economy is often bad for bond prices, and that most bonds trade over-the-counter rather than on an exchange, and that a corporate bond’s yield is the sum of a government bond yield and a credit spread. Yet too few do understand fixed income and those that don’t are loath to expose that fact, so they tend not to ask, choose poorly, and simply move on. Frustrating, unfortunate, and unnecessary since there are proven partners who can help.

Good investment advisors and good fixed income managers can help with a lot of that, but the reality is that there is only so much that even good managers can do with traditional bonds, and the fixed income part of a portfolio can’t just relent and accept that. The 35-40% of a portfolio that the textbook tells you should be in fixed income is there for more than its return alone. It is indeed there to generate an effective return while it also reduces total portfolio risk and performs when the equity / growth part of the portfolio underperforms. Fixed income needs to produce income, create safety, cause diversification, and provide portfolio ballast.

The good news. Leading advisors, pension funds, and consultants like the ones I mentioned above have re-established the make-up of an effective fixed income allocation. One might say they have pivoted the fixed income allocation, thereby improving the total portfolio. If interest rates were much higher, where they could produce sufficient return and where their yield had sufficient room to fall (which causes bond prices to rise) when needed to effectively offset weakness in equities, maybe then those experts will call for more than the current 5-10% in bonds. Until then, this updated 35-40% of the portfolio called fixed income should be a personalized selection of several of the following investments: distinct interest rate exposure, distinct corporate credit exposure, mortgages, real estate, infrastructure, and private debt. It may also include a small allocation to high yield bonds, the right market-neutral equity strategy, and potentially a portfolio of blue-chip dividend stocks as a substitute for traditional fixed income. A simple example of the performance, volatility and correlation stats for these type of funds is illustrated in the chart above.

It’s worth noting that some fixed income managers have developed the tools and expertise to use bonds while delivering beneficial exposures for a portfolio as a replacement for a bond or traditional bond fund. They are often referred to as fixed income alternatives. For example, these funds can eliminate the effect of the volatile interest rate portion of a bond, while delivering coveted and less volatile exposure to Canadian corporate credit spreads. These funds have proven to perform in all interest rate environments, not only when rates are stable or falling like traditional bond funds require.