How to create a modern fixed income portfolio

Fixed income investment usually lags behind the fast-paced stock market in our thinking, its daily actions and the promise of superior returns. However, if you have retired or are about to retire, fixed-income instruments must become dominant. At this stage, capital preservation and guaranteed income flow have become the most important goals.

Today, investors need to mix things together and get exposure to different asset classes in order to maintain high incomes in their portfolios, reduce risk, and stay ahead of inflation. Even Benjamin Graham, the father of the great value investing, suggested a portfolio of stocks and bonds for later investors.

If he were alive today, Graham might sing the same tune, especially after offering new and diversified products and strategies to investors seeking income. In this article, we will develop a roadmap for creating a modern fixed income portfolio.

Key points

  • Studies have shown that stock returns are higher than bond returns, but the difference between the two is not as big as people think.
  • As people enter retirement, fixed-income instruments become more important to preserve capital and provide a guaranteed source of income.
  • Using the bond ladder is a way to invest in a series of bonds of different maturities to prevent you from having to predict future interest rates.

Some historical views

From the beginning, we have been taught that stock returns exceed bond returns. Although historically this has proven to be correct, the difference between the two returns is not as big as one might think.What’s this American Financial Journal The report comes from a study, “Long-Term Bonds and Stocks” (2004). The study used more than 60 staggered 35-year intervals from 1900 to 1996 and showed that after accounting for inflation, the stock return increased by approximately 5.5%.

On the other hand, the actual rate of return on bonds (after inflation) is about 3%. However, according to MaryAnn Hurley, vice president of fixed income at DA Davidson & Co, investors need to be aware that fixed income yields are at historically low levels compared to the yields before 2008 and are unlikely to recover.

As you approach retirement, the importance of fixed income will increase, and saving capital through a guaranteed income stream becomes a more important goal.

Long-term bonds fail

At the turn of the 21st century, one of the most important changes in fixed-income investment is that long-term bonds (a bond with a maturity time of more than 10 years) have given up their previous considerable returns.

For example, take a look at the yield curves of major bond categories on July 18, 2019:

Treasury bond yield

Several conclusions can be drawn by looking at these charts:

  • Long-term (20 or 30-year) bonds are not a very attractive investment; in the case of US Treasury bonds, the current yield on 30-year Treasury bonds does not exceed 6-month Treasury bills.
  • Highly-rated corporate bonds provide attractive yields for U.S. Treasury bonds (5.57% to 4.56% for 10-year terms).
  • In taxable accounts, municipal bonds can provide attractive tax-equivalent yields for government and corporate bonds, if not better. This requires additional calculations to confirm, but a good estimate is to divide the coupon yield by 0.68 to estimate the impact of state and federal tax savings (for investors within the 32% federal tax range).

Since the short-term yield is so close to the long-term yield, there is no point in reinvesting in long-term bonds. Locking your funds for another 20 years to get a negligible additional 20 or 30 basis points is not enough to make the investment worthwhile.

Hurley said that a flat yield curve indicates a slowdown in the economy. “If you invest in bonds with 7 to 15 years, although the yield has hardly rebounded, when the short-term securities mature, the yield of the longer-term securities will also be lower, but the decline is less than that of the industry with the shorter curve.” Hurley said. “When the Fed relaxes policy, the yield curve will become steeper, and short-term interest rates will fall more than long-term interest rates.”

Fixed income investment opportunities

This provides an opportunity for fixed-income investors, as they can be purchased for a period of 5 to 10 years and then reinvested at the prevailing interest rate when these bonds mature. When these bonds mature, it is also a natural time to reassess the economic situation and adjust the investment portfolio as needed.

Lower yields may induce investors to take more risks in order to achieve the same returns as in previous years. The current relationship between short-term and long-term yields also illustrates the utility of the bond ladder. Laddering is investing in 8 to 10 individual issues, with one due every year. This can help you diversify and avoid having to predict future interest rates, because the maturity date will be spread across the yield curve, and as your visibility becomes clearer, there will be opportunities to readjust each year.

Diversified investment portfolio: five ideas

Diversification as a form of risk management should be the idea of ​​all investors. On average, the various investments held in a diversified portfolio will help investors obtain higher long-term returns.

1. Stocks

Adding some stable, high-dividend-paying stocks to form a balanced portfolio is becoming a valuable new model of late investment, even for people who have entered the retirement age. Many large mature companies in the Standard & Poor’s 500 Index have yields that exceed the current inflation rate (approximately 2.4% per year), with the added benefit of allowing investors to participate in the company’s profit growth.

A simple stock screener can be used to find companies that offer high dividend payments while meeting certain value and stability requirements, such as companies that are suitable for conservative investors seeking to minimize special (stock-specific) and market risks. The following is a list of companies with the following sample filters:

  • Scale: A market value of at least 10 billion U.S. dollars
  • High dividends: All dividend yields are at least 2.8%
  • Low volatility: The beta coefficient of all stocks is less than 1, which means that their trading volatility is lower than the overall market.
  • Fair valuation: All stocks have a P/E ratio or PEG ratio of 1.75 or lower, which means that growth expectations have been reasonably priced into the stock. This filter removes companies that artificially increase dividends due to deteriorating earnings fundamentals.
  • Industry diversification: A basket of stocks from different industries can minimize certain market risks by investing in all parts of the economy.

It is true that compared with fixed income instruments, investing in stocks has considerable risks, but these risks can be reduced by diversifying within the industry and keeping overall stock exposures below 30% to 40% of the total value of the portfolio.

Any myth about the boring and underperformance of high-dividend stocks is just a myth. Considering that between 1972 and 2005, the annualized return on dividend-paying stocks in the Standard & Poor’s Index was more than 10%, while the return on stocks that did not pay dividends during the same period was only 4.3%. Stable cash income, lower volatility and higher returns? They don’t sound so boring anymore, do they?

2. Real Estate

There is nothing more suitable than providing a good rental income to improve your life in the old age. However, instead of turning to landlords, it is better to invest in real estate investment trusts (REITs). These high-yield securities provide liquidity, are traded like stocks, and have the added benefit of being a different asset class from bonds and stocks. REITs are a way to diversify modern fixed-income investment portfolios, which can withstand the market risk of stocks and the credit risk of bonds.

3. High-yield bonds

High-yield bonds, also known as “junk bonds”, are another potential route. It is true that these debt instruments that provide higher than market yields are difficult to invest individually with confidence, but by choosing bond funds with consistent operating performance, you can use part of your investment portfolio for high-yield bond issuance as a boost Income return.

Many high-yield funds will be closed-end, which means that prices may be higher than the fund’s net asset value (NAV). When investing here, look for a fund with almost no premium to get an extra margin of safety.

4. Inflation-protected securities

Next, consider Treasury Inflation Protected Securities (TIPS). They are a great way to withstand any inflation that may occur in the future. Their coupon rates are moderate (usually between 1% and 2.5%), but the real benefit is that prices will be systematically adjusted to keep up with inflation.

It should be noted that TIPS is best stored in a tax preference account, because inflation adjustments are made by increasing the principal amount. This means that they can create a lot of capital gains when they are sold, so keep TIPS in the IRA, and you will add some solid resistance to inflationary shocks with the security that only U.S. Treasuries can provide.

5. Emerging market debt

Much like high-yield bonds, emerging market bonds are best invested through mutual funds or exchange-traded funds (ETFs). Individual issues may lack liquidity and are difficult to study effectively. However, yields have historically been higher than the debt of advanced economies, providing good diversification and helping to contain risks in specific countries. Like high-yield funds, many emerging market funds are closed-end, so look for funds that are reasonably priced compared to their net asset value.

Example combination

This sample portfolio will provide valuable exposure to other markets and asset classes. The following portfolio was created with safety in mind. It is also preparing to participate in global growth by investing in stocks and real estate assets.

The size of the investment portfolio needs to be carefully measured to determine the best level of cash flow, and it is important to maximize tax savings. If it turns out that the investor’s retirement plan requires regular “withdrawal” of principal and receipt of cash flow, it is best to visit a Certified Financial Planner (CFP) to help with the allocation. CFP can also run Monte Carlo simulations to show you how a given investment portfolio reacts to different economic environments, changes in interest rates, and other underlying factors.

Whether to use funds

You may have noticed that we have recommended fund options for many of the above assets. Deciding whether to use the fund will depend on how much time and effort investors want to invest in their portfolio — and how much they can afford.

A fund that aims to reduce income or dividends by 5% each year is giving up a large part of an already small cake, with an expense ratio as high as 0.5%. Therefore, when choosing this route, look out for funds with long-term records, low turnover rates, and most importantly, low fees.

Bottom line

Fixed income investments have undergone tremendous changes in a short period of time. Although some aspects have become more tricky, Wall Street has responded by providing modern fixed-income investors with more tools to create custom portfolios. To be a successful fixed-income investor today may mean jumping out of the classic-style box and using these tools to create a modern fixed-income portfolio that is suitable and flexible in an uncertain world.

Every type of investment listed here is risky-isn’t it always there? However, the diversification of asset classes has proven to be a very effective way to reduce the overall portfolio risk. For investors seeking protection of their income principal, the biggest danger is to keep up with inflation.The wise way to reduce this risk is to diversify in high-quality, high-yield investments, rather than relying on standard bonds


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