For a deeper understanding of how we approach fixed-income investments based on academic evidence, this analysis will help. Learn how we balance credit risk, interest rate risk, and reinvestment risk. To discuss further, please call us at 203-985-0448.
The Role of Fixed Income
OpenCircle’s fixed income philosophy starts with the premise that most portfolios contain elements of equities in addition to fixed income. Both asset classes have their specific roles to play: equity for capital appreciation and fixed income as a portfolio stabilizer and a diversifier of portfolio risk. It is important for both asset classes to maintain their clearly defined roles throughout the life of the portfolio. For fixed income, this means ensuring the fixed income portfolio is not stretched in search of additional yield by assuming imprudent risks. Purchasing low-credit-quality bonds or bonds in risky market sectors are strategies that fall into the risk-stretching category.
There are three primary risks within the fixed income markets: 1) credit risk, 2) interest rate risk and 3) reinvestment risk. We will discuss in detail these risks and how our approach to fixed income can combat them.
Credit risk is the risk that a fixed income security will not pay all principal and interest. Arguably, any security that is not a Treasury bond (or a bond issued by another highly rated government entity) has some measure of default risk. The primary way to assess the reward of bearing credit risk is to look at the credit premium, which is measured by comparing the returns between investment-grade corporate bonds and their Treasury counterparts. One difficultly with measuring the credit premium is that high-quality data only goes back to the late 1980s, unlike most other market data that can be traced to the 1920s. Despite this relatively short period of data, we can still draw some interesting conclusions.
From 1989–2015, the investment-grade credit premium averaged only 0.43 percent per year, with volatility around 6.6 percent and a Sharpe Ratio (a measure of risk-adjusted returns) of only 0.07.
This last figure compares rather unfavorably to the Sharpe Ratio of 0.40 for the equity risk premium (stocks – bonds) over that same time period, making the equity markets much more advantageous from a risk/return perspective. Lastly, the investment-grade credit premium has a positive correlation to the equity markets, meaning they both tend to underperform or outperform at the same time. This makes investment-grade corporate bonds less effective as a portfolio diversifier.
Investment-grade bonds are only half of the credit spectrum in the fixed income markets. To properly evaluate the full credit spectrum, the high-yield credit premium must also be measured. From 1989–2015, the high-yield credit premium averaged 2.9 percent per year. While this premium looks enticing on the surface, it comes at a price in the form of much greater volatility of 16.3 percent. Factoring in the increased volatility, the Sharpe Ratio for the high-yield credit premium drops to only 0.18, which is still well below the equity risk premium of 0.40. More alarming, the high-yield credit premium is the correlation to the equity markets, which is very high at 0.61.
Due to their low Sharpe Ratios and high correlations to equities, we avoid both investment-grade and high-yield corporate bonds.
Interest Rate Risk
This is the risk that a fixed income investment’s value will change due to a change in the level of interest rates. Longer-term bonds are more sensitive to interest rate risk than their shorter-term counterparts. Longer-term bonds do carry higher yields to compensate investors for accepting more interest rate risk. The question then becomes how far out should an investor go on the yield curve to get the proper balance between yield and interest rate risk?
The first thing we want to look at is the term premium, which examines whether interest rate risk has been rewarded. Traditionally, the term premium has been measured as the difference in returns between short-term Treasury bills and the five-year Treasury note. From 1927–2015, the term premium averaged 1.9 percent with a Sharpe Ratio of 0.37. The risk-adjusted return of 0.37 compares very favorably to the equity risk premium of 0.40 over that same time period, indicating that extending to the intermediate portion of the curve is an attractive option. Another important piece of data to note is that the term premium has zero correlation to the equity premium, making it an ideal diversifier.
Much like the credit premium, we also need to look at the full yield curve and examine term premium for the long-maturity portion of the curve. This is best examined by comparing the returns on long-term Treasury bonds and the five-year Treasury note. Over that same 1927–2015 period, the longer-term premium was only 0.7 percent, which is well below the 1.9 percent premium for the intermediate portion of the curve. The risk adjusted returns as measured by the Sharpe Ratio are also significantly less at 0.12 versus 0.37 for the intermediate-term premium. This data clearly shows that extending to longer-maturity securities has not been rewarded historically.
Based on this evidence, we invest in short- to intermediate-term bond portfolios in an attempt to capture the term premium. We avoid long-term bonds and their lower risk-adjusted returns.
This is the risk that future interest and principal payments, when received and reinvested, will earn less than the prevailing market interest rate. Traditionally, bonds with long maturities will have less reinvestment risk because they lock in the rate of interest earned on principal for a longer period of time.
Our Fixed Income Philosophy
The next logical question: How do we most effectively balance these risks associated with fixed income? The most effective way to combat these risks is through the use of a well-constructed bond ladder. A bond ladder is a portfolio of fixed income securities with equal weights that come due in varying maturities. For example, if a client had $1 million to invest in fixed income and wanted to create a 1–10-year bond ladder, he or she would purchase bonds in $100,000 increments in each year from 1–10 years.
A bond ladder is such an effective tool because it is able to strike a balance between both reinvestment and interest rate risk while also helping mitigate credit risk. Credit risk is the easiest of the three risks to hedge because it is the most straightforward. This risk can easily and effectively be reduced in a portfolio by limiting fixed income purchases to only high-quality bonds.
Reinvestment risk and interest rate risk are much harder to hedge as they compete with each other. For example, the most effective way to reduce interest rate risk is to buy only short maturities in the portfolio. Unfortunately, this strategy greatly increases reinvestment risk because principal and interest will need to be reinvested often. On the opposite end of the spectrum, purchasing longer-term bonds would be the most effective solution to fully hedge against reinvestment risk because that would lock in the yield on the portfolio for a greater period of time. The downside is these long-term maturities would increase the interest rate risk in the portfolio. A bond ladder balances these risks. The short-term maturities help protect the portfolio against interest rate risk while the intermediate-term maturities help reduce reinvestment risk. The ladder strikes a balance between these two risks by lowering the overall volatility of the portfolio while diversifying equity risk.
Although not a portfolio risk, per se, asset location is another important consideration when investing in the fixed income markets. Asset location is the process of determining what asset classes to place in tax-advantages accounts (Roth IRAs, IRAs and other retirement plan accounts) versus taxable accounts (joint accounts, individual accounts, etc.). The logic here is simple: If possible, strategies with high effective tax rates should be sheltered in tax-advantaged accounts. Fixed income fits this definition because the bulk of the return is generated from coupon interest, which is taxable at a client’s marginal tax bracket. Because of this, fixed income is sheltered in tax-advantaged accounts as much as possible.
Constructing Fixed Income Ladders
Now, let’s discuss how bond ladders are constructed. To deliver the best after-tax returns, we build customized fixed income ladders with targeted durations between three and five years using the most optimal mix of taxable, tax-exempt and inflation-protected securities. The duration and mix of securities is all predicated on the asset location and tax status of each individual client as no two portfolios are constructed the same.
A pure, academically based philosophy relying on peer-reviewed literature:
- Optimize risk-adjusted rates of returns.
- Do not incur expenses attempting to “beat the market” by forecasting interest rate movements or selecting mispriced securities.
- Minimize costs by reducing price markups and avoiding costly infrastructure expenses of an active portfolio management approach.
- Maximize after-tax returns by strategically locating tax-efficient assets in taxable accounts and tax-inefficient assets in tax-advantaged accounts and tax-loss harvesting year-round.
True customization based on a client’s individual circumstances:
- A thorough discovery process uncovers a client’s needs and objectives, including financial objectives, risk tolerances, current and future income needs, tax status, health status, gifting requirements, and philanthropic desires.
- Create a written fixed income investment plan tailored to each investor.
- A comprehensive approach considers assets across all investable accounts.
Diversified instrument implementation:
- Employ both taxable and tax-exempt securities to provide the best after-tax yield.
- Use TIPS to hedge against unexpected higher inflation.
- Use both individual securities as well as bond funds when appropriate.
- Screen portfolios daily for any changes in credit quality.
- Monitor portfolios weekly for upcoming maturities and redemptions.
- Monitor portfolios for 18 other material events that could affect credit quality.