5 Focus Areas For A Fixed Income Plan

5 Focus Areas For A Fixed Income Plan

Basketball coaching great John Wooden once co-wrote a book titled, “A Game Plan for Life.” The title of the book summarizes what any experienced coach would echo: A solid game plan gives you the best chance for success.

Portfolio management parallels coaching in many ways; namely, managing portfolios involves assembling a team, developing a strategy and carrying it out. Like coaching, the game often shifts, and decisions need to be made during the game. Great coaches, like great portfolio managers, need to both prepare and execute.

The current interest-rate environment, however, is like being a coach but not knowing which sport your team will play next season. Obviously, there are drills and preparation that would be optimal for a basketball season, but what if football will be the sport instead?

Given this situation, we would guess Coach Wooden's game plan would be to focus on overall athletic preparation, teamwork and building confidence through experience. Likewise, he would probably advise to be prepared to do some serious coaching during the game.

Our suggestion for the current fixed-income environment is not much different.

In the current fixed-income environment, we recommend a well-diversified portfolio of fixed-income instruments, focusing on the overall environment of opportunities and risks that may play out.

Likewise, we recommend that investors focus on what level of risk to take and where to take risk.

Identifying Portfolio Attributes

We typically look at our fixed-income portfolios in reference to the following areas that may impact results. Likewise, we make our decisions at the portfolio level on where we would like to focus our exposure.

  • Volatility
  • Inflation
  • Foreign Exchange
  • Spreads
  • Rates

After using multiple versions of fixed-income portfolio framework over the last 13 years, we have settled on the above structure as our most efficient way of outlining the fixed-income attributes of our portfolios.

By labeling these attributes, we feel we can better frame our portfolio decisions and have a healthier grasp on how different market environments will impact our portfolios.

Volatility

Some fixed-income investments are inherently more volatile over time than others. For example, high-yield debt is expected to be more volatile over time than short-term U.S. Treasurys.

When including high-yield debt into a fixed-income portfolio, it is important to understand it can have similar impact on overall portfolio volatility as adding stocks. While stocks and high-yield bonds have their own inherent attributes and correlation matrices, their absolute volatility can be similar over time.

Inflation

Fixed-income investments will have unique responses to changes in inflation levels. The best example in this area may be Treasury inflation-protected securities (TIPS) bonds.

While TIPS bonds have a built-in inflation adjustment, some other types of fixed-income investments may not perform well in a period of rising inflation, and may perform better in a period of inflation that falls short of expectations. Therefore, overweighting TIPS bonds may increase the portion of your return that is driven by levels of inflation in the markets.

It is important not to simply look at TIPS bonds as checking off the box to protect against inflation risk. Portfolio managers must recognize that TIPS bonds will increase the overall sensitivity of a portfolio to inflation levels (high or low), meaning a portfolio heavy in TIPS bonds could be impacted significantly by changes in inflation that may have little impact on other portfolios.

Foreign Exchange

Through much of the first decade of the millennium, foreign-exchange impact was seen as simply a booster to international investment returns. Since the impact was positive for investors holding foreign bonds while being off the radar for investors holding only U.S. debt, many investors largely ignored foreign-exchange impact.

Over the last three years, foreign-exchange impact has been incredibly impactful. As the U.S. dollar (USD) skyrocketed, international investments were hit with a foreign-exchange haircut. So far in 2016, non-USD exposure has been a boost to returns.

While we take foreign-exchange risk on the equity side of our portfolios, we favor currency-hedged ETFs for broad-based fixed income. A popular currency-hedged international ETF is the Vanguard Total International Bond Index Fund (BNDX | B-57). Our decision to use currency-hedged ETFs was driven primarily by two things:

  • We don’t feel many investors can correctly forecast currency levels, especially in the short term
  • We don’t want foreign-exchange risk to dwarf the total risk spectrum of an investment

Given the current low rates on developed foreign bonds, the fluctuations from foreign exchange movements can easily decide more than 75% of an investment’s return. We feel more comfortable focusing on other factors.

In certain areas, such as emerging market debt, the cost to hedge currency risk is prohibitive. As these positions tend to have a higher yield, we currently feel comfortable taking currency risk in this area.

Rates

With interest rates throughout much of the world near historic lows, we feel it is important to look very closely at the impact interest-rate movements can have on a portfolio.

The easiest and most common way to measure interest-rate risk is through duration. While some investments—like TIPS—may require duration adjustment, we feel duration is a solid base measurement for monitoring interest-rate impact.

We tend to use the duration of the U.S. Aggregate Bond Index, which is currently 5.5, as a benchmark rate. We will then set our desired duration levels relative to the index level.

Given the low levels of current rates, we would encourage investors to pay close attention to rate impact. Likewise, it is important to make sure your portfolio is routinely run through a proven duration modeling exercise.

Spreads

In the current market environment, we tend to favor spread impact. We define spread impact as the impact different credit levels will have on portfolio results. For example, a portfolio with 50% high-yield bonds will typically have more spread impact than a portfolio with no high-yield bonds.

Of the five fixed-income aspects we focus on, spread impact is generally the one we feel we have the best opportunity to strategically manage risk over time.

Winning The Game

Sometimes it is the most complicated strategies that win the game. Other times, a simple approach can get the job done. Whatever type of strategy is employed, we feel strongly that understanding your strategy is an essential part to winning the game.

It is one thing to make a conscious decision to allow player #20 to shoot 3-pointers. It is a much less desirable situation to have no idea how good of a shooter #20 is until after they beat you from the 3-point line. We encourage investors to do proper scouting, understand their strategies, and execute with discipline and skill.

Source: EFT.com

Posted by: The Trust Advisor

http://thetrustadvisor.com/news/5-focus-areas-for-a-fixed-income-plan

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