The Value of Fixed Income

Blog post #415

What is the importance of fixed income to your overall portfolio?

How do we add value to your fixed income allocation?

Are you paying proper attention to the interest you are receiving on your cash, particularly at your bank?

The part of your portfolio that is invested in fixed income is primarily to provide you with stability and safety, as well as income. We determine your fixed income allocation based on your age, your need and ability to take risk, as well as your time horizon, for various goals. High quality fixed income investments, such as investment grade individual corporate and government bonds, CDs, municipal bonds and bond mutual funds do not experience the same type of short-term volatility that comes with investing in stocks.

The less willing you are to have volatile swings in your portfolio, the greater we would recommend your allocation to fixed income. The fixed income investments provide you with stability, like the foundation to a house. 

When we structure the fixed income portfolio for you, our objective is for these investments to provide a market rate of interest for a high-quality security, with the primary objective being the return of your principal. For example, if a typical investment grade, high quality 5 year corporate bond is paying 3.5%, we would not purchase a 5 year bond that is paying 6.5%, as the financial markets are saying that the second issuer is much riskier, as it is paying a large premium to attract investors.

Risk and reward are correlated. If you don’t get paid back on the bond at maturity, the benefit of the higher interest yield would not be worth it in the long run. In fixed income, we do not want to take on that additional risk. That is why we do not buy junk or high yield bonds and recommend that you don’t either. If you have accounts elsewhere, are you sure that you do not have any junk bonds in your portfolio?

When clients have adequate funds for us to structure a diversified portfolio of individual fixed income securities, we do that. We evaluate their tax rate, to see if municipal bonds would make sense for their taxable accounts. We would evaluate the financial markets, comparing the various interest rates and risk factors, such as corporate bonds v government bonds and CDs. To purchase an investment grade corporate bond, the issuer must be paying a greater interest rate, as the government bonds and CDs have minimal default risk.

When we structure individual securities for a fixed income portfolio, we have many guidelines and principles, all with the goal of striving to reduce your risk. We only invest in high quality, investment grade instruments. We strongly believe in diversification. We strive to diversify across issuers, and limit how much of any bonds would be held by any single issuer. There are certain sectors, industries and states that we avoid, as we perceive them to be too risky. When we purchase municipal bonds, we diversify across many states, to spread your risk geographically. We purchase these securities with the objective of holding them to maturity. We are not trying to make bets on the direction of interest rate rates, as that is very difficult to predict.

If we are able to purchase individual securities in this manner, we can eliminate a tier of fees you may incur, which is the expense ratio of bond mutual funds. There are also other benefits we provide, as you are not exposed to gains that may be incurred when others sell the bond fund, as well as permanent losses that can be incurred in bond mutual funds, when interest rates rise.

Through our back-office firm, we closely monitor the credit ratings of all the fixed income securities that are held on behalf of our clients. If securities are downgraded, due to a deterioration of the financial quality of the issuer, we would consider selling the bond prior to maturity, to reduce or minimize a loss of principal.

For accounts that do not have adequate assets to develop a diversified individual fixed income portfolio, we would use a bond mutual fund, as having adequate diversification is of primary importance.

The fixed income portfolios we have discussed above is usually part of your long term savings. For your short term cash or savings, you should still carefully monitor what interest rate you are receiving at your bank or other accounts. Many banks are still paying close to nothing on many checking, savings or money market accounts. Unlike Fidelity Investments, our primary custodian, many brokerage firms are not paying money market rates on cash or sweep accounts. 

We can provide you with money market accounts or alternatives to cash, as well as fixed income investments that offer liquidity, generally within a few days, on conservative fixed income investments. We strive to be as efficient as possible with your assets, including your cash. Together, let’s determine what the right amount of cash and fixed income is best for you.

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