How to Build a Smarter Fixed Income Portfolio: Boost Returns, Lower Risk, and Beat Inflation
Bonds come in the form of varying durations and underlying issuers.
When it comes to constructing a fixed income allocation within your portfolio - what are some frameworks to begin thinking about?
For starters - there’s two primary goals when it comes to fixed income in portfolios:
Reduce the volatility of your investment portfolio (acting as a ballast).
Provide a rate of return above inflation.
In every investing scenario, we want the highest return per year unit of risk.
Bond returns have three components:
Bond yield
Expected capital appreciation/depreciation over the holding period (buying at discount/premium relative to par value)
The realized return due to future interest rate changes
Bond yield and expected capital appreciation are known and observable when you purchase the bond (known as the forward rate). Because we can’t accurately predict how interest rates will change over the duration of your holding period, the realized return is unknown until the period ends.
Eugene Fama’s work found that forward rates contain reliable information about future differences in expected bond returns.
In understanding fixed income asset pricing, there are academically researched and supported fixed income drivers of returns:
Wider term spreads generally lead to larger term premiums as defined by intermediate minus short-term bonds. In a normal yield curve environment, you’d expect higher yields on longer term maturities relative to shorter term maturities. This is known as the term premium.
Wider credit spreads generally lead to larger credit premiums as defined by the difference in yields between high-quality government bonds and corporate bonds of varying credit ratings. For companies that have lower credit quality, investors would expect to be compensated with higher returns. This is known as the credit premium.
Global bonds issued in different currencies offer opportunities for higher expected returns and reduced volatility. The shape of various country yield curves is different from the yield curve of your native country - countries that offer higher similar duration currency-hedged current yield returns relative to your native country can offer higher returns. This is known as the currency premium.
There are various papers to support these ideas in practice for fixed income investors, but this methodology is best carried out by Dimensional Fund Advisors (DFA).
What this means for you is that you can systematically and dynamically best position your fixed income portfolio to generate the highest expected return.
In practice, bonds have a low correlation to stocks and this is what helps lower the overall risk to your portfolio - which is ideal.
Along the spectrum of maturities, generally speaking, long-term bonds offer higher correlations to stocks and increased volatility making them less of an effective diversifier.
Most long-term debt instruments are held in pension plans where you have a fixed long-term obligation where you’re looking to create a match between the term of that liability and the term of your assets (known as duration matching).
This eliminates interest rate risk (idea that your bond price will fall as interest rates rise, or vice versa) and reduces surprises.
Looking at bonds through the lens of risk-adjusted returns as measured by the Sharpe Ratio - or the risk-free rate minus the return of the measured asset class divided by the standard deviation, there’s a balance we’re looking to strike which is commonly found between the 4 years to 6-year duration mark.
Less than 4 years in maturity and there’s some steepness of the curve that we’re missing out on, and greater than 6 you may be taking on more volatility and not being as effectively compensated for that risk.
Because this is the sweet spot, it makes sense for the following:
Considering the shorter end of the yield curve to increase returns above inflation with less volatility than the longer end of the curve.
Consider Dimensional strategies to implement the term, credit, and currency factor with variable credit, variable maturity, and global fixed income investing
In a world where uncertainty is the norm, a thoughtful, evidence-based approach to fixed income ensures that your bonds do exactly what they’re intended to do: protect, stabilize, and grow your wealth over time.