Episode 26: Fixed Income Allocation

What is the Fixed Income asset class? Why invest in fixed income, such as bonds and preferred shares? How does the phase of your life cycle, personal circumstances, and risk tolerance affect your target asset allocation to fixed income?

All that and more in Episode 26 on the Wilson Wealth Management YouTube channel.

“What is fixed income?”

A quick review of the fixed income asset class. Plus, why investors typically invest in this asset class.

For much more detail on fixed income, please refer to “Fixed Income Key Terms”, “Money Market Instruments”, “Bonds, Notes, and Debentures”, “Typical Bond Issuers”, “Corporate Bond Variations”, and “A Few More Bond Types”.

Fixed income issuers often attach special features, usually called “sweeteners”, to make an issue more attractive to investors. If you want to learn about a few common features, please read, “Key Bond Features: Part 1” and “Key Bond Features: Part 2”.

Preferred Equity is usually treated like fixed income for asset class allocations. To find out why, please read, “Preferred Shares” and “Preferred Share Features”.

“How should those in the Accumulation phase of life assess fixed income portfolio allocations?”

Accumulators are relatively young, just starting their careers. With little wealth to invest, what should they allocate to fixed income?

Given that Accumulators tend to have longer time horizons and can handle asset volatility, then relatively lower volatility fixed income, with its low-return, may not be best allocation. At least for the assets not targeted to shorter term objectives.

While fixed income is currently useful for its diversification benefits combined with equities, a heavy allocation here for Accumulators is usually not warranted. But, as we will see below, other factors may arise that make relatively more fixed income prudent.

To refresh on the different life cycle phases, please review “Life Cycle View of Wealth Accumulation”.

“What about Consolidators? How is fixed income for them?”

Consolidators are in the sweet spot of their earnings and careers. With a relatively long time horizon until retirement, there is still no real need to shift into low-risk, stable assets.

Again, fixed income is more a diversification tool than an investment to generate returns. That said, in times of falling interest rates, fixed income can offer some very healthy returns.

There may still be a role for shorter term objectives, where they do want that certainty and liquidity. As well, as Consolidators approach retirement age, then adding to the fixed asset allocation may make sense.

“What sort of fixed asset allocations for Spenders?”

Spenders are at, or near, retirement. They rely on pension income, supplemented by cash flow from investments. At this phase of life, there is more interest in stable, liquid investments. Like fixed income.

The problem for Spenders is that people continue to live longer. Investors used to allocated 80-90% in fixed income and cash equivalents upon retirement. But that assumed retirement at 65 and life ending at 72. Fine if there is only 7 years remaining.

People now often live into their 90s. If your time horizon is 30 years, trying to do so with a 90% fixed income portfolio may be difficult. You likely want to still invest in higher risk (higher return) equities as you need to grow your assets. As well as to keep ahead of inflation, which often ravages fixed income yields. For today’s 65 year old investors, 30-40% in fixed income might be warranted. Then slowly adjusted upwards as the years pass by.

“What about personal circumstances and its impact on allocations?”

Identical issues as with cash.

Everyone is in a different situation. That will impact the optimal fixed income asset allocation.

Perhaps you require a fixed amount monthly for living expenses. Or have health issues that need to be addressed. Your personal status will determine, to some extent, what you need in monthly net cash inflows and asset safety. In turn, that will dictate the asset allocation and specific investments to best meet that cash flow requirement. In interest or dividends. Or possibly in an annuity.

“And investor risk tolerance? Does that affect the target asset allocation?”

Your personal risk tolerance also guides your investment decisions.

Some young investors prefer no allocation to fixed income. They want all their capital invested in higher return assets. The benefits of diversification are less important to them than higher expected returns. With long time horizons to manage volatility, this may be reasonable. But likely less than an optimal portfolio should hold.

Conversely, other investors may prefer safety and stability in their portfolios, regardless of age and personal situation. Again, their risk tolerance may create a desire for more fixed income than is optimal.

In most cases, risk tolerance is more emotional. Based on factors such as personality, past experience, etc. Much less on taking a purely ration approach to risk management. To refresh on investor risk issues, please refer to “What is Your Risk Tolerance?” and “Investor Profiles”.

As with cash, there are some generalizations that are useful for investors to factor into their own target asset allocation. But there are also unique, personal aspects that will alter that general allocation.

That is why it is crucial for investors and/or their financial advisors, to develop comprehensive Investor Profiles before beginning the target asset allocation. The unique circumstances of the investor must be factored into the allocation equation. Otherwise, a poor investing plan will be created.

For additional information on fixed income asset allocations, please refer to “Asset Allocation: Fixed Income (Part 1)” and “Asset Allocation: Fixed Income (Part 2)”.