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Introduction
Active management of risk in fixed income portfolios can minimise the number of months that investors experience negative returns over a multi-year investment period.
As a defensive asset class, fixed income can be a valuable addition to investment portfolios, with the potential to provide predictable income, capital preservation and diversification from equities.
Not set and forget
The old adage of ‘don’t have all your eggs in one basket’ applies equally to fixed income as it does to equities. Diversification across a range of fixed income securities is essential.
And unlike fixed term investments, fixed income isn’t a ‘set and forget’ strategy. A diversified fixed income portfolio requires active management to protect against three principal risks – credit risk, interest rate risk and inflation risk.
Allocate selectively
to diversify credit risk
Similar to how equity investors diversify portfolios by purchasing shares of companies in different industry sectors, fixed income portfolios will often be spread across a range of companies and sectors too.
Fixed income specialists, called credit analysts, select the best value corporate fixed income securities by assessing factors such as a companies’ balance sheet strength, management’s track record and industry dynamics, for example. They adjust portfolios as the outlook of companies, and industry sectors change, and as risk-adjusted value relative to similar corporate fixed income securities shifts.
Even if individual investors have those analytical skills, fixed income securities generally trade in minimum sizes of $500,000 or $1,000,000. This makes it difficult for individual investors to create sufficiently diversified portfolios while actively managing credit risk.
Diversified strategies
to manage interest rate
and inflation risk
Fixed income securities come in a range of maturities – from one year to 30 years or longer. One way to manage interest rate risk is to sell long-dated fixed income to buy short-dated fixed income when interest rates are expected to rise and vice versa.
Some securities pay interest rates that adjust with the movements in market interest rates, similar to variable rate home loans. This is another way to guard fixed income portfolios against the detrimental effects of rising interest rates. (You can find out more about interest rate risk in our recent article here).
Active management of interest rate risk can minimise the number of times that fixed income portfolios experience negative returns.
Inflation-linked bonds also have adjustable coupon payments. At each coupon payment, the original investment amount is adjusted up or down according to the prevailing rate of inflation. The interest payment is based on the inflation-adjusted investment amount. This ensures that income and repayment of principal at the maturity date keep pace with inflation.
Active and skilled
management required
No matter the economic outlook, movements in interest rates and inflation, and individual companies’ prospects, careful allocation across the spectrum of fixed income securities and active management ensures fixed income investment provides what it should. That is predictable income, preservation of capital and diversification from equities.
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Knowing when and what proportion of the defensive part of your portfolio to allocate to cash, floating rate credit, fixed interest, higher yielding securities is not a simple process. Together we’ll navigate uncertainty.
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