Understanding Fixed Income Roles and Risks

In my previous post, Planning a Fixed Income Course Through Uncertain Times, I explored Guiding Rule #1 for fixed income investing – investing according to carefully considered, personalized plans. This helps provide you with the stamina to stick it through when either stock or bond markets grow particularly turbulent. As Winston Churchill advised during World War II, “If you’re going through hell, keep going.”

This brings us to my next point …

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

Even if you intuitively get the general advisability of staying the course during troubled times, you still 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. Perhaps 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 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, you should 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, I still see no compelling reason for you to abandon your existing plans at this time, at least not due to market forces. On that count, this time, it’s not different. 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]

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? In my next post, What’s a Fixed Income Investor To Do? I’ll help you explore some positive possibilities.


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

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  1. […] my previous blog post, Understanding Fixed Income Roles and Risks, I explored Guiding Rule #2 for fixed income investing: positioning your fixed income for the role […]

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