July 18

Making Sense of Fixed Income


Anyone who is keeping even a casual eye on financial headlines is aware that fixed income returns are a bit topsy-turvy these days. With bond prices reacting negatively to uncertain economic news, investments that are supposed to be our reliable safety net and income stream during troubled times are experiencing uncertain times themselves. Many investors are abandoning their existing plans (or had none to begin with), and are selling off their bond funds. To cite a June 28 column in The New York Times, “Taking a Cue From Bernanke a Little Too Far,” the month’s outflows neared $77 billion, handily exceeding the last high-water mark of nearly $42 billion bond-fund outflows in October 2008.

That’s too bad. None of us can forecast the future, but we see no strong evidence that the overarching laws of the investment universe have suddenly changed. As the New York Times columnist said: “The rush for the exits really means one thing: investors are betting that interest rates are about to begin their upward trajectory, something that’s been expected for several years now.” While this news may be important – maybe even good – for our economy, we would not advise joining those who are betting their life’s savings on outcomes that are yet to unfold.

Guiding Rule #1: Invest According to a Sensible, Customized Plan.

When we initiated our relationship with you, we began by exploring your personal circumstances, to determine the levels of investment risk you could or should accept in pursuit of your financial goals. Next, we crafted an Investment Policy Statement (IPS) to guide our way. Only then did we make specific, customized investment recommendations for your portfolio, including building – and maintaining – an appropriate balance between stocks and bonds.

As a result, your stock-bond allocations are closely tied to you and your needs. They’re also based on the available evidence on how markets are expected to deliver their long-term returns. In contrast, current headlines are based on predicting events over which we have no control. While there is no guarantee that your existing portfolio will deliver the outcomes for which it’s been designed, we recommend you stick with it, ignoring the temptation to react to near-term news. We believe that your carefully crafted portfolio continues to represent your best interests and your best odds for achieving your personal goals.

Guiding Rule #2: Bonds are safer; they’re not entirely safe.

You’ve probably already heard us repeatedly advise you to “stay the course” during troubled times. Still, you may be wondering whether, this time, it’s different. In our collective past memories, when market uncertainty has appeared, it’s usually been within your stock holdings. We’ve grown used to thinking that bonds will keep plodding along, reliably if unspectacularly.

This is close to, but not quite accurate. Compared to stocks, bonds have historically exhibited lower market risk (uncertainty) along with commensurate lower returns. But they have exhibited some market risk, along with some expected returns.

Consider the roles for which each asset is intended. We employ stocks to help you build new wealth over time. Bonds are meant to help dampen the bumpier ride that stocks are expected to deliver over time, while contributing more modestly to your portfolio’s overall expected returns. In the face of inflation, cash is expected to actually lose buying power over time, but it’s great to have on hand for near-term spending needs.

Expected Long-Term Returns Highest Purpose
Stocks (Equity) Higher Building wealth
Bonds (Fixed Income) Lower Preserving wealth
Cash Negative (after inflation) Spending wealth

Thus, in performance and predictability, fixed income is meant to be “cooler” than stocks, but “warmer” than cold, hard cash. Based on its in-between role, we actually expect fixed income to periodically deliver disappointing returns, sometimes even for extended periods. These periods are expected to be less severe and less frequent than you’ll see in your stock holdings … but as we’re seeing right now, they exist. They need to, for fixed income to fulfill its intended role.

In other words, based on the long-term evidence on market performance, we see no compelling reason to abandon your existing plans at this time, at least not due to market forces. Our position is substantiated by a July 2013 article by DFA Australia Ltd.’s Jim Parker. In it, he observed: “We are seeing a classic example of how markets efficiently price in new information. Prior to Bernanke’s remarks, markets might have been positioned to expect a different message than he delivered. They adjusted accordingly.”[1]

Guiding Rule #3: Act on What You Can Control

So, where does that leave you, the long-term investor who is diligently adhering to your carefully wrought strategy? Is there really nothing to be done? There are some possibilities we can help you explore at this time.

  • Are your fixed income holdings the right kind? Thus far, we’ve spoken of fixed income as a single pot. In reality, just as there are various kinds of stocks, there are various kinds of bonds, with different levels of risk and expected return. Because the goal with your fixed income holdings is to preserve wealth rather than stretch for additional yield, we typically construct your fixed income holdings using high-quality, short- to medium-term bonds.

    If you have fixed income holdings in accounts we are not currently managing that may not fit this prescribed balance, now would be an excellent time for us to analyze these assets and determine whether changes may be warranted. For example, if you have a 401(k) or other outside accounts, let’s look at what’s inside. You may also wish to refer friends and family with similar needs to us, so we can also help them assess their fixed income investments.
  • How are your own goals and risk tolerance holding up? While they may not be fun times, periods of market uncertainty can be good times to revisit the plans you made during calmer times. Think of the current market as a field test. If you feel your portfolio may not be performing as hoped for or you don’t feel prepared to continue tolerating current market risks, let’s get together and take a look at the numbers.

    You may be pleasantly surprised by the assessment. Alarmist headlines have a way of generating levels of fear and pessimism that may not be warranted. That said, if your IPS and portfolio are no longer meeting your personal goals or reflecting your true risk tolerance, we can help you plan for cost-effective adjustments along a sensible timeline.
  • Time for a rebalance? If it makes sense for you to remain invested according to your existing plans, market conditions may warrant a rebalancing, to ensure that your stock/bond balance remains at or near your target goals. When we created your portfolio, we did so according to percentages defined in your IPS. As the markets shift around over time, your investments tend to stray from their original, intended “weights” or allocations. Rebalancing is the act of shifting those allocations back where they belong. Because rebalancing often requires trades, we have guidelines for when and how to cost-effectively do it. We also can use new money added to your portfolio to perform efficient rebalancing whenever possible.

Guiding Rule #4: Be Brave.

More than four centuries ago, Galileo Galilei is attributed to have said: “All truths are easy to understand once they are discovered; the point is to discover them.” He also was accused of heresy and placed under house arrest for the remainder of his life after he observed that the earth revolves around the sun.

Galileo’s experiences offer an early illustration that there’s a big difference between understanding and accepting best available evidence in an uncertain world. In many respects, investing is a scientific endeavor. But there are times when it requires courage and perseverance to remain confident about that evidence, particularly when others are succumbing to irrational doubts. We’ve said it before, and we’ll say it again: Stay the course.

[1] Jim Parker, Outside the Flags, “Second-Guessing.” DFA Australia Limited, July 2013.


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About the author

Gardner is a CERTIFIED FINANCIAL PLANNER and principal of Sherrill Wealth Management in Bradenton, Florida. He has spent 20+ years in the wealth management field helping families negotiate the various obstacles and opportunities that retirement provides them.
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