In this chapter, we address the roles of fixed-income investments in a portfolio and offer recommendations on credit quality and maturity. We also discuss inflation-protected securities and investing in municipal bonds.
The main roles of fixed-income assets in a portfolio are reducing portfolio risk to the level appropriate for the investor's unique circumstances and providing a reliable source of cash flow. Therefore, fixed-income assets should generally be limited to AAA/AA investment grades. When we refer to ratings, we are referring to what can be called a "natural" rating: those not enhanced by either an insurer adding their guaranty or by collateral acting as a credit enhancement (as is the case with most asset-backed securities). Historically, credit risk has not been well rewarded.
Bank certificates of deposit (CDs) can also offer competitive rates relative to other high-quality, short-term–fixed-income assets. To eliminate credit risk, CDs under a single account name at a single bank should not exceed the Federal Deposit Insurance Corp. (FDIC) limits. For additional information, please see the FDIC's "Guide to Deposit Insurance Coverage."
Hybrid securities such as high-yield bonds, convertible bonds, preferred stocks, and emerging-market bonds should be avoided. They all have equity-like risks managed more efficiently with direct investments in equities.
Short-term bonds have the benefit of less volatility and lower correlation to equities. Long-term bonds should provide higher returns to compensate for the additional risk. The question is whether investors are compensated for taking on additional risk by extending the maturity of fixed-income assets. We evaluated the use of short-term bonds (one-year Treasuries), intermediate-term bonds (five-year Treasuries) and long-term bonds (twenty-year Treasuries), finding that the most efficient maturity depends on the investor's overall asset allocation.
For portfolios with the commonly used allocation of 60 percent equities (split 60 percent domestic and 40 percent international) and 40 percent bonds, the highest Sharpe ratio (risk-adjusted return) has been achieved with five-year Treasuries. Extending maturities to twenty years produced higher returns, but a lower Sharpe ratio (a result of their higher volatility and higher correlation to equities). While risk-seeking investors might prefer the portfolio with long-term bonds, most investors are risk averse.
Short-term bonds have less volatility and lower correlation to equities than long-term bonds. Shifting from long-term to short-term does not allow an investor to increase the Sharpe ratio by increasing the equity allocation to achieve higher returns with the same volatility. The shorter maturity does not allow the investor to take more risk on the equity side of the allocation.
Another thing risk-averse investors should consider is that the longer the maturity, the longer "left tail" (larger losses) in the distributions of annual returns.
The appropriate maturity varies depending on the equity allocation. At equity allocations below 80 percent, five-year Treasuries produced the most efficient portfolios, though long-term bonds produced the portfolios with the highest returns. At high equity allocations (80 percent or higher), the portfolio with long-term Treasuries produced the highest return and highest Sharpe ratio.
At high equity allocations, the higher returns from longer-term bonds dominate the effect of the higher standard deviation: The volatility of equities is the dominant factor in the portfolio's volatility. At high fixed-income allocations the reverse is true: The high standard deviation of longer-term bonds dominates the higher returns.
Investors focusing on volatility, and not risk-adjusted returns, should minimize maturity risk.
Investors with a high fixed-income (low equity) allocation should hold shorter-term bonds to minimize overall portfolio risk.
Investors highly exposed to inflation risk should hold short-term nominal return bonds or Treasury inflation-protected securities (TIPS).
Investors with a high equity allocation should consider holding longer-term bonds (assuming the yield curve is positively sloped), as the volatility of the portfolio will be dominated by the equity holdings. The higher the equity allocation, the more duration risk one should consider taking.
Investors seeking higher returns who are willing to accept the risks of longer-term bonds should consider extending maturities, so long as the yield curve is positively sloped (so that they are compensated for taking incremental risks).
Investors who have an allocation to collateralized commodities futures should consider extending maturities. Commodities have negative correlation to longer-term bonds, acting as a hedge against the inflation risk of longer-term bonds.
Investors more exposed to the risks of deflation than inflation, such as commissioned sales people, should consider extending maturities of nominal return bonds.
Investors with known fixed-rate, long-term liabilities should consider matching those liabilities with long-term fixed instruments.
Investors concerned about reinvestment risk should consider extending maturities.
Application: Younger investors with fixed income allocations may be able to tilt toward longer-term fixed income if their job income can be expected to increase with inflation. Those living on fixed-income sources should generally avoid longer-term bonds.
Taxable fixed-income investors, except those in the lowest tax brackets, should prefer to hold municipal bonds. However, there are times when even investors in the lowest tax brackets should consider owning municipal bonds.
Because the yield curve for municipal bonds is generally steeper than for taxable bonds, it may be appropriate to extend the maturity of municipal bonds further than would be the case for taxables.
Inflation-protected securities are also known as real return bonds because they provide a guaranteed real (inflation adjusted) return. Real return bonds offered by the U.S. Treasury convey the following benefits:
Insulating investors from risks of unexpected inflation.
Having real returns less volatile than real return of nominal return bonds of similar maturity.
Lower correlations to equities than nominal return bonds, making them more effective diversifiers of equity risk. In fact, the correlation of TIPS to equities has been negative.
No credit risk.
The U.S. government issues two types of real return bonds: Treasury inflation-protected securities (TIPS) and I-bonds. TIPS are sold at auction and receive a fixed, stated real rate of return. The principal is adjusted for inflation before the fixed-interest payment is calculated. Like TIPS, I-bonds provide a fixed real rate of return and an inflation-protection component. While the instruments are similar, there are some differences. The fixed rate on an I-bond is announced by the Treasury in May and November and applies to all I-bonds issued during the subsequent six months. Like zero-coupon bonds, their total return (fixed rate plus inflation adjustment) accrues in value. I-bonds increase in value on the first of each month and compound semiannually. They pay interest for up to thirty years. They can be bought and redeemed at most financial institutions. The redemption value can never go below par. All income is deferred for tax purposes until the investor withdraws funds from the account holding the bond. Due to limitations on the purchases of I-bonds, we will focus our analysis on TIPS.
Academic papers analyzing TIPS benefits all reach a similar conclusion: TIPS should dominate the fixed-income portfolios of most investors, at least for assets in tax-advantaged accounts.
The future liabilities of most investors are real liabilities: the costs of goods and services rising with inflation. For such investors, nominal bonds become the risky asset. The risk shows up if future inflation is greater than expected. For such investors, TIPS should dominate their tax-advantaged, fixed-income allocations.
Since TIPS have negative correlation to equities, the greater the equity allocation, the more investors should prefer TIPS.
The future liabilities of some investors are nominal in nature. Consider a defined-benefit pension plan, the future obligations of which are fixed in nominal dollars. For such a plan, the riskless instrument is a Treasury bond matching the maturity of its known fixed obligations. Owning inflation-indexed bonds creates the risk of having insufficient assets to meet obligations. The risk develops if future inflation is less than expected.
Investors whose labor capital is likely to rise with inflation might consider a higher allocation to nominal bonds. While investors are working, it is likely that their wages will at least keep pace with inflation. There is less need for TIPS, which provide protection against unexpected inflation.
Investors more exposed to the risks of deflation than inflation should prefer long-term nominal return bonds.
If taxes are of particular concern, investors with few dollars in tax-deferred accounts may prefer short-term municipal bonds. If the municipal bond yield curve is steep, they should also consider extending maturities.
Short-term, high-quality fixed income investments and TIPS are similar in one important respect: Both protect an investor against increases in inflation. TIPS provide direct protection. Because they mature in the near future, short-term, high-quality fixed income investments provide indirect protection: Higher inflation leads to higher short-term rates. An important difference between the two is that TIPS lock in a real rate of return while the real rate of return on short-term fixed income will fluctuate. So, TIPS— not short-term fixed income—should be considered the risk-free investment for long-term investors. Academic research concludes that for tax-advantaged accounts, TIPS should dominate the fixed-income portion of the portfolio, unless the risk premium for unexpected inflation is high (greater than fifty basis points).
There is no liquid-futures market for inflation, so we cannot directly observe the market's estimate of inflation or precisely know the size of the risk premium for unexpected inflation. We can suggest at least a way to estimate its size. First, suppose TIPS yield 2.0 percent and nominal Treasuries yield 4.5 percent. The 2.5 percent difference reflects both expected inflation and an uncertainty premium in the yield of nominal bonds. Next, look at the consensus forecast of inflation by economists provided by the Federal Reserve Bank of Philadelphia (www.phil.frb.org/research-and-data). If it is 2 percent, the difference of 0.5 percent (2.5 percent minus 2.0 percent) is an approximation of the uncertainty premium.
Because TIPS come in various maturities, investors need to decide on a strategy. If they invest in a mutual fund or exchange-traded fund (ETF), they need to know the average maturity of the fund's holdings. If the fund is managed as an index of TIPS, the maturity will average around ten years. Investors purchasing individual TIPS must decide on a specific maturity. One strategy is to build a laddered portfolio of individual TIPS, diversifying maturity risk. Another is to shift maturities based on current yields and their relationships to the long-term real return of nominal bonds. Table 5.1 is a tool for determining the portion of fixed income to be represented by TIPS and their maturities when purchasing individual TIPS. You can create your own, but some table is needed to maintain investment discipline.
Table 5.1. Decision Table for Allocation and Maturity of TIPS
Real Yeild on TIPS (%3) | Allocation of Total Fixed Income to TIPS (%) | Maturity of TIPS in years |
|---|---|---|
>3 | 75–100 | Twenty + |
>2.5<3 | 50–75 | Fifteen |
>2<2.5 | 25–50 | Ten |
>1.5<2 | 0–25 | Five |
>1.5 | 0 | Two years or less |
To learn more about TIPS, read Chapter 2 of The Only Guide to Alternative Investments You'll Ever Need. To learn more about fixed-income investing in general, read The Only Guide to a Winning Bond Strategy You'll Ever Need.