Why Fixed Income 4 Roles Your Bond Portfolio Should Play
FeaturingMike Gitlin, head of fixed income
Fixed income serves four key roles in a portfolio: Diversification from equities, capital preservation, income and inflation protection. Many investors would benefit from evaluating whether their bond holdings are meeting these goals.
With stock markets showing increased volatility in the past year, building resilient and balanced portfolios should be a priority for investors. After all, todays backdrop of simmering trade tensions, moderating growth and tighter central bank policy all add uncertainty to the outlook. Volatility isnt going away anytime soon.
With that in mind, nows a perfect time to revisit the question: Why fixed income? Fixed income serves four key roles in a portfolio: Diversification from equities, capital preservation, income and inflation protection. Many investors would benefit from evaluating whether their bond holdings are meeting these goals.
According to Morningstars best-fit index methodology, which uses a quantitative method to determine which index a fund most closely resembles, roughly 88% of intermediate-term bond mandates offered in the U.S. did not behave like a true core fund. Instead, for the three years ended December 31, 2018, most of these funds behaved more like a credit index, according to Morningstar data.
Style drift like this, in addition to other pitfalls, can be addressed by refocusing on the four roles that fixed income is designed to play in a portfolio.
T Rowe Price Global Multi
Courtesy of T. Rowe Price
- Fund category: World bond USD hedged
- Assets under management: $1.8 billion
- SEC yield: 2.9%
- Expenses: 0.64%
T. Rowe Price Global Multi-Sector Bond Fund makes our cut for one of the best bond funds for 2022 because of its actively managed, “go anywhere” style that provides shareholders with far-reaching opportunities.
When yields are low and the prices for domestic bonds are looking to be under pressure in 2022, active management with broad diversity and the potential for high yields looks attractive. PRSNX pays off on all fronts in this regard, albeit with higher risk from lower credit-quality bonds.
With a 30-day SEC yield of 2.9% and 12-month return of 0.89% through Nov. 30, 2021, PRSNX was well ahead of the iShares Core U.S. Aggregate Bond ETF yield of 1.5% and 12-month return of -1.33%. And 2022 is not likely to look too different from 2021 with regard to low yields and low- to below-zero returns for funds that hold U.S. bonds.
Slightly more than half of PRSNX’s portfolio is invested in foreign debt instruments, with most of the rest in U.S. bonds, and convertible debt making up a tiny remaining sliver. Most of its bonds are government and corporate debt, and mortgage-backed and asset-backed securities.
Included in its top 10 issuers , which make up 33% of the portfolio’s holdings, are Germany, China, Chile and Hungary.
- Fund category: Muni national long
- Assets under management: $19.1 billion
- SEC yield: 1.5%
- Expenses: 0.17%
Invest In A High Yield Etf
This very low interest rate environment persists. One of the good things about cheap money and the search for yield is that many higher credit risk companies have borrowed at low rates for longer, so they are less likely to default in the short term. Consider adding one of these ETFs for higher yield iShares Global High Yield Bond ETF or the BetaShares Active Australian Hybrids Fund .
IHHY gives access to high yield bonds issued in developed markets. It has many underlying securities, although principally invests in another iShares fund. Its one year return to 31 October 2021 was 8.44% and since inception in 2015, 5.61%. However, the fund has seen a significant price decline since the end of October 2021, as the graph shows. Practically all of the investments are sub investment grade.
HBRD is not strictly a high yield fund as such, as many of the Australian hybrid securities in the fund would be investment grade. However, its net one year return to 29 October 2021 was 4.34%, a high yield in this environment. Its return since inception in 2017 is just over 4%.
A word of warning, if you are investing in global high yield you may want to check any exposure to the Chinese property sector, particularly Evergrande. For more information, see Evergrande, One Of The Worlds Largest Property Developers, Struggles To Meet Debt Obligations.
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Fixed Income Back To Basics
The broad and growing appeal of fixed-income investments has caused an explosion in the type and range of products available. Understanding the vast range of fixed income products can be overwhelming for both new and experienced investors alike.
The best place for most investors to start is at the beginning, with the basics:
- What is a fixed-income Investment?
- Why invest in fixed-income securities?
- What are the risks?
- Important considerations for Canadian taxpayers
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One Last Suggestion But Its Not An Etf
ETFs are great for the ease of investment and the low minimum investments amounts to access a diversified portfolio. Earlier this year I interviewed Gaby Rosenberg who started the Blossom App, especially for millennials and young women. The app invests in a fund run by Fortlake Asset Management. While its not an ETF, it has ETF qualities, low minimum investments and a diversified portfolio amongst other attributes. Find out more by listening to the podcast or go to the Blossom app website.
Corporate Bonds And Debentures
Corporate bonds and debentures have earned a large place in the Canadian fixed income market. Because they offer a higher rate of interest than similar federal, provincial or municipal securities, they are an attractive option for investors willing to assume issuer credit risk and potential call features in return for higher yields. A corporate bond is secured by the pledge of specific assets a corporate debenture is backed solely by the reputation and credit worthiness of the issuer.
Most corporate debt issues available through CIBC Investors Edge are unsecured debentures and are backed by the general credit of the issuer. Limited secured issues are also available, albeit at possibly lower yields. Like government securities, corporate debentures are available in a broad range of maturities and generally pay interest semi-annually. Many investors will recognize corporate debentures issued by well-known telecommunication companies, industrials, banks and other corporations. With such a wide selection available, independent credit rating agencies provide their opinions to assess the safety of individual issuers.
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What Are Fixed Income Funds
Fixed income funds can offer a way to achieve diversification, even with a small investment.
Fixed income as an asset class comprises a variety of different types of securities bonds are the most commonly known kind. In the marketplace, fixed income and bonds are usually used interchangeably to refer to the same thing. Other examples of fixed income instruments include mortgage-backed securities, asset-backed securities and convertible debt.
For many investors, a fixed income fund is a more efficient way of investing than buying individual fixed income securities. Fixed income mutual funds are just like stock mutual funds, in that you put your money into a pool with other investors, and a professional invests that pool of money according to what he or she thinks the best opportunities are. Some fixed income funds aim to mimic the broad market, investing in short- and long-term fixed income securities from a variety of issuers, such as the Canadian government, government agencies, corporations and other more specialized securities. Other fixed income funds, such as a short-term fund or a high-yield fund, focus on a narrower slice of the debt market.
What Comprises Fixed Income Investment
It is important to understand that fixed income funds are not a different category of funds in the mutual funds domain. Their identity is defined by their investment style and expected returns. Some common fixed income generating products are:
Exchange Traded Funds
These are funds that are listed and traded on the stock exchanges. Nifty, S& P, BSE Sensex are some of the indexes these funds associate with. ETFs can be traded in the cash market on a day to day to basis with Gold ETF being one of the popular choices among its offerings.
Debt funds invest in safer instruments like government bonds, corporate bonds and related securities. These are low risk, low return, stable investment platform that do not invest in volatile stock markets.
Money Market Funds
Investment in money market funds take the direct brunt of any increase in interest rates and are therefore best suited for short periods investment like upto 90 days. They generate a steady income and include commercial papers, short term certificates of deposits, bankers acceptance, etc.
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Types Of Fixed Income
The terms fixed income and bonds are often used interchangeably but in fact, bonds are only one type of fixed income investment in a family which includes guaranteed investment certificates , and money market securities. Typically, these products generate a predictable stream of interest income and/or promise of a future lump sum payment and can be a great way to achieve diversification in your portfolio.
How Fixed Income Investments Work
Fixed income investments focus on providing a reliable stream of income. The most common fixed income investments are usually bonds, which are fixed term loans issued by companies and governments looking to raise money. UK government bonds are called Gilts, whilst in the US government bonds are known as Treasury Bills, or T-Bills, and German federal bonds are referred to as Bunds.
A bond issuer will pay investors a fixed rate of interest for a set period, at the end of which the loan is repaid. Investing in individual bonds can be particularly risky, as their fortunes rely on the specific issuer, whether a corporation or government, and therefore in case of insolvency they may fail to repay your investment and you could lose money.
As a result, many investors opt to put their money into funds that invest in bonds. This helps reduce the risk because rather than just buying bonds from a single issuer, your money is spread between range of different fixed income holdings. Some bond funds will invest solely in a basket of bonds issued by companies, while others will focus purely on government bonds, and some will invest in a combination of these. As with all investments the rule of thumb is that the higher the potential return on offer, the riskier the investment. Bonds which are rated from AAA down to BBB by credit ratings agencies such as Standard & Poors or Moodys are classified as investment grade and are deemed to be lower risk.
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What Are Some Of The Best Government Fixed Income Investment Options Available In India
Since the focus of Fixed Income Investments is primarily Safety, Liquidity and Returns, we have shortlisted schemes that are offered by the Government of India or PSUs.
Public Provident Fund
This is one of the more popular schemes for long term investment that is backed by the Government of India. It has attractive interest rates that are also fully tax exempt. The investment duration is for 15 years with the option to extend the same in blocks of five years. There is taxation benefit under Section 80C of the Income Tax Act where interest is tax free. The maximum investment amount in a year is INR 1.5 lakh.
Voluntary Provident Fund
Another fixed income investment option is the Voluntary Provident Fund that is but the contribution towards the provident fund account by the employee. This is a good option for risk averse investors to accumulate long term wealth.
Listed PSU Bonds
These are bonds that are issued Government backed entities and have very low risk of defaulting. The income generated by means of interest on these bonds is completely exempt from Income Tax. The capital gains, in case of any, are, however, taxable.
Senior Citizen savings Scheme
This is a good bet for investors over the age of 60, low tax bracket, and seek a regular stream of income. The time frame for this investment is 5 years which can be further extended by another 3 years. A maximum of INR 15 lakh is allowed as investment.
Pradhan Mantri Vaya Vandana Yojana
Sukanya Samriddhi Yojana
High Yield Municipal Bonds
If you fall into a higher tax bracket, you have the option to invest in high-yield municipal bonds. These are bonds issued by government entities with lower credit ratings. Funds that invest in this area can offer yields about 1.52.5% above funds that focus on investment-grade, pre-tax based municipal bonds .
While volatility is higher in this part of the market, those who invest longer-term have been paid for the higher risks they take. High-yield munis have performed better than investment-grade bonds over the past decade.
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Whats Really At The Core Of Your Fixed Income Portfolio
With interest rates remaining near historic lows and unprecendented stock market volatility, now is an opportune time for bond investors to take a closer look at what comprises the core of their fixed income portfolios. Many investors look to core bonds U.S. investment grade bonds, including corporate, mortgage-backed, Treasury and agency debt as a portfolio diversifier and reliable source of income.
A popular approach to gaining this fixed income exposure is to invest in a passive index strategy designed to track the Bloomberg Barclays US Aggregate Bond Index . While more than 35 years of falling rates have benefitted indexed and active fixed income investors alike, active core and core plus strategies have generally outperformed over time. Notably, the index itself has quietly morphed since the financial crisis, resulting in a different go-forward exposure profile. As the rate environment evolves, the indexs changes may become more evident, and investors holding a passive Agg strategy are likely to find their portfolio behaving differently than it had in the past.
The US Agg has changed
The Bloomberg Barclays US Aggregate Bond Index simply referred to as the Agg has a long history and is solidly entrenched as a benchmark for fixed income performance. But, that doesnt mean it can or should be viewed as a proxy for a holistic, well-diversified bond portfolio going forward.
The Agg has access to only half the U.S. market
Important Considerations For Canadian Taxpayers
With any investment, what you get to keep after taxes is more important than what you earn. Canada Revenue Agency has very specific rules governing the tax treatment of the interest paid to you on your fixed-income investments. All payments due to you are considered taxable in the year they are declared, regardless of whether you actually receive the income. Therefore, for investments like stripped bonds, which accrue interest that is not received until maturity, tax planning holds special challenges. Tax-sheltered funds like RRSPs and RRIFs are good vehicles to hold special types of fixed-income securities. You should consult your tax advisor with specific questions about the effects of taxation on your investments.
Make sure to speak with your CIBC Wood Gundy Investment Advisor to find out if fixed income investments are appropriate for you and your long-term financial plans.
Use our Find An AdvisorOpens a new window in your browser. tool to locate a CIBC Wood Gundy Investment Advisor near you and take the first step to achieving the financial future you want.
The information contained herein is considered accurate at the time of posting. CIBC and CIBC World Markets Inc. reserve the right to change any of it without prior notice. It is for general information purposes only.
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What Are The Potential Benefits Of Fixed Income
Depending on your financial goals, fixed income investments can offer many potential benefits, including:
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