The new divide in fixed income investingDec 17, 2018

Of all the investing sports, fixed income was often considered one of the most boring to watch. Not anymore! As central bankers look for ways to back their way out of the unprecedented rounds of monetary policy easing coupled with the looming threat of inflation, the approach to fixed income investing is not as straight forward as it once was.

Crossroads

The portfolio construction conundrum

During my ongoing discussions with advisors, I often hear that one of their biggest challenges is figuring out how to manage their fixed income allocation in the current interest rate environment. They want to know if they should be hunting for higher yields or if they should continue to play defense in anticipation of increasing interest rates.

I understand why fixed income allocation is suddenly challenging. For a long time, bonds were called upon to generate steady, yet unspectacular income streams and to provide ballast in a diversified portfolio for when equity markets became stressed. Unfortunately the days of simply structuring a bond maturity ladder and reinvesting upon maturities are in the past. Now new regulations and new product developments provide more options for advisors when accessing their desired fixed income exposures.

A divided camp

Today, advisors are mainly divided into two camps. In one group are the advisors who are searching for yield. They are causing the industry flows we are seeing into the global, high yield, and bank loans categories. This has pushed their client portfolios deeper into the credit and currency markets. If rate volatility picks up and persists, this approach may ultimately prove to be too risky.

In the other camp are advisors that are trying to dampen interest rate risk altogether. They are now holding higher levels of cash, GICs, and short-term bonds in their models. With this approach they encounter a different type of risk. If they are too conservative and the rising rate cycle is short lived, their clients will benefit very little from bond price movements.

Either way, we are seeing traditional core fixed income allocations give way to a more active, unconstrained and specialized approach to fixed income models.

Back to fundamentals

Barely a day goes by without debate around when the 30+ year bull-run for fixed income investors will end. If you’re too focused on short term moves in the rates market, you are missing the point when it comes to building an effective fixed income model. The most important step in portfolio construction is to go back to the basics of client goal setting.

Remind yourself of the fundamental questions like: what is the purpose of the allocation to fixed income, what portion of the bonds are earmarked for income generation, and is the goal of your fixed income allocation to provide overall portfolio support when equities sell off? I believe taking a goals-based approach to your fixed income portfolio is the best way to help your clients meet their financial goals. Once you’ve focused on a goals-oriented approach, there are plenty of investment options that can help your clients build the portfolio they want.

David Andrews comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

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