Fixed income is the second core asset class.
Here we can start to look at percentage allocations when investing.
Again, the investor profile will determine the appropriate amount to invest in fixed income.
Within the profile, the phase of one’s life cycle and the investor’s risk tolerance are keys.
Fixed Income Recap
Fixed income normally includes bonds, debentures, notes and preferred shares.
Fixed income is generally higher risk and higher return than cash equivalents. But it has a lower level of risk and expected return than common shares. Fixed income may be sought by relatively risk averse investors.
Of course, within the asset class, the expected risk-return profile may fluctuate substantially.
People who desire a constant stream of income liked fixed income. Though one can also buy zero coupon bonds.
What about the suitability of fixed income for those in the different phases of the life cycle?
Fixed Income for Accumulators
Not Really Suitable Investments
The logic goes that Accumulators tend to be young, with extremely long investment horizons. As a result, they can better absorb the fluctuations of higher risk and higher return investments than those in other phases of life. Because of this, Accumulators tend not to emphasize lower risk fixed income in their portfolios.
I agree with this logic.
Unless extremely risk averse, Accumulators should not invest heavily in fixed income assets.
But Do Not Exclude Completely
But that does not mean they should be totally excluded from one’s portfolio. Fixed income investments may provide diversification benefits with other asset classes.
For example, consider a few current inter-asset correlations. I will use data from Portfolio Visualizer as at March 15, 2019.
The current 10 year correlation between 20 Year U.S. Treasury Bonds (i.e., fixed income) and various traditional equities are: U.S. Large Cap Stocks −0.47; U.S. Mid Cap Stocks −0.46; U.S. Small Cap Stocks −0.45; International (excluding U.S) Stocks -0.43; Emerging Market Stocks -0.38.
If you recall our discussion of correlations, combining two assets with negative correlations is very beneficial in reducing portfolio risk. And any correlation below 1.0 (perfect positive correlation) improves overall portfolio efficiency. But the lower, all the way to -1.0 (perfect negative correlation), the better for diversification of portfolio risk.
When we look at alternative asset classes, we shall see that fixed income can also enhance diversification. Consider the latest 10 year correlation between 20 Year U.S. Treasury Bonds and: U.S. Real Estate −0.22; Commodities -0.22; Gold 0.17. Once again, fixed income can aid in portfolio diversification with alternative assets.
Do not forget that within the asset class itself, various subclasses may provide diversification benefits too. For example, the correlation between the 20 Year U.S. Treasury Bonds and U.S. Municipal Bonds is only 0.37. So there is still value in diversifying within the asset class.
Of course, you also need to factor in asset risk (standard deviation) and expected annual return in your portfolio calculations. Adding a high risk, low return asset to your portfolio simply because it has a low correlation may not be wise.
The Magic Number
Accumulators should include a percentage of investable assets in fixed income. For diversification, if for no other reason.
Also, fixed income may be a good place to park cash as financial objectives approach. You may tolerate high volatility in equities for retirement 30 years away. But perhaps you need a down payment on a new home in 6 months. Shifting assets to cash or lower risk bonds may be the wise move as objective due dates approach. When you seek certainty and safety over potential return and risk.
However, parking assets in cash or bonds for near term objectives should not reflect your general target asset allocation.
Another consideration for Accumulators may be zero coupon (aka strip or deep discount) bonds. Little or no interest is paid out. But you are able to buy an asset, with a known future value, with very little money. And very little money is common for Accumulators.
For example, a 30 year zero coupon bond yielding 3.0%. You can purchase a $100,000 bond for about $41,000. Not bad if you do not need the cash flow until retirement. The higher the interest rates and longer the term, the lower your outlay. A $100,000 zero coupon, 40 year bond at 5.5% would only cost about $12,000.
That longer time horizon is why zero coupon bonds may be better for Accumulators than older investors.
There are pros and cons to zero coupon bonds. Big con is no interest payments, yet you may still be liable for tax on the deemed interest income each year. If investing, do so in a tax-deferred or tax-free investment account. Also, you need to consider future inflation. At current 3.0% yields, given historic inflation rates, your real return over time with a zero coupon bond may be poor (or worse). But perhaps at 5-10% rates, these bonds become a nice addition to your portfolio.
Most Accumulators should not invest more than 50% of their investable assets in fixed income. I likely would not recommend 50% in fixed income even after backing out one’s cash equivalent component. The time horizon for most Accumulators is so long that investing in riskier assets, with higher long-term expected returns, makes more sense.
For the generic Accumulator, I might recommend somewhere between 5%-25% in fixed income. This assumes someone with a moderate risk tolerance and whose cash component, as a percentage of total wealth, is roughly 15-20%.
It also assumes that the fixed income itself is diversified. Which should be done when investing in any asset class.
Where you fall in this range will depend on your risk tolerance and amount invested in cash.
We shall break here for today. Next week, a look at fixed income allocations for Consolidators and Spenders.
