Should your income be fixed?

David King, CFA, Senior Portfolio Manager | December 16, 2013

  • Investors need to rethink the role of fixed income in building portfolios
  • How to provide an adequate rate of return with an acceptable level of risk
  • Benefits of a non-fixed, income-oriented strategy in today’s environment

Peanut butter and jelly. Bacon and eggs. Scotch and soda. In the investment industry, the words “fixed” and “income” seem as inseparable as our favorite food and beverage combinations. Something which has served millions of people well must generally have merit, and fixed-income investing certainly does. Still, even the most popular combinations are not for everyone, or for every point in time.

Combinations work when their elements are complementary. An investment where you expect complete return of your capital at a future point in time is conservative. So is an investment with regular, defined cash returns. No wonder high-quality government and corporate bonds are a huge asset class.

It feels uncomfortable to challenge the merits of popular and conservative investment vehicles, but today there is basis for doing so. The historical role of bonds, bank term deposits, savings accounts, etc. has been to provide an adequate rate of return with low risk. If these investments will do that today, this discussion is over; but will they?

The event we now call The Great Recession have wrung inflationary expectations out of the global economy. All major commodities, whether gold or oil, cotton or corn, are priced well below their peak levels of recent years. Recipients of government payments linked to inflation are receiving nominal or no increases. Nominal interest rates, which factor in inflation expectations, are very low.

Low nominal interest rates would be of little concern if real interest rates (defined as the total interest rate minus expected inflation) were high. However, Federal Reserve policy has been waging war on real interest rates for years, with success. Constant, large-scale buying of bonds, including a conscious effort to lower longer term interest rates, continues to depress interest earned per dollar invested. The most recently issued 10-year U.S. Treasury bond carries a coupon of 2.75%. There is no specific standard for “adequate” when it comes to bond returns, but to realize a real return up to 2% per annum on these 10-year bonds, inflation must remain at historically low levels for a very long period of time. With U.S. gross domestic product (GDP) growth now trending up to an average rate, job creation accelerating and commodity prices at moderate levels, betting on very low inflation for a very long time appears risky.

Redefining quality bonds, even temporarily, as highly predictable assets without an adequate return profile immediately casts traditional portfolio construction views into question. Quality bonds continue to provide statistical diversification, which could be reason enough to maintain some exposure, but the goal of most portfolios is not predictable, inadequate returns. Is this a case where diversification is really di-worse-ification? The question deserves serious consideration by all income-oriented and conservative investors.

Fortunately, the words “income” and “fixed” are not linked by decree. There are many non-fixed, income-oriented security structures which are suitable for investment, including:

- Common stocks with safe, stable or rising dividends

- Floating rate bonds

- Bank loans

- Preferred stocks and bonds with interest rate reset features

- Master Limited Partnerships

Without question, some of these asset classes are more volatile than investment-grade bonds or the like. However, this may be offset by the potential for either income or capital return to exceed expectations (which is not possible for traditional bonds or term deposits held to maturity.) Additionally, the Federal Reserve has historically had only limited and indirect influence on floating rate or equity-related financial markets. For example, today’s relationship between the S&P 500 dividend yield and 10-year Treasury bonds would indicate stocks are still cheap. Free market forces holding stock prices down — compared to where they would be if Fed-driven interest rates had a strong and direct linkage to dividend yields — is a likely explanation for this apparent cheapness.

Financial market conditions are anything but permanent. At some future time, interest rates may rise rapidly, rendering moot any concerns that bond yields are too low. Until such a time, investors may want to explore the benefits of non-fixed income strategies, which may help achieve higher income and total return levels than quality bonds. Investors can choose to accept the moderately higher risk of this approach, or manage risk by reducing other volatile, low-yielding assets in their portfolios. Either way, a non-fixed income strategy may have advantages over the proverbial bird in the hand, until such time as the “bird” becomes a little bigger.


David King

CFA, Senior Portfolio Manager
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