Did you know the fixed-income market is three times bigger than the equity market?
Most investors focus on equity-related decisions but don’t know the best practices and strategies for fixed-income deployment. However, some investors need to add fixed-income securities to their portfolios as they approach retirement. How should these investors optimize the fixed-income part of their portfolios – or at least avoid common pitfalls?
Fixed-income index strategy or not?
Unlike ordinary equities, indexing strategies are not suitable for fixed-income securities. Most passive indexing strategies aim to build a portfolio representing the market you want to gain exposure. So, the more significant the weighting of a security is in a market, the more the index investor will seek to invest a proportion of his funds in it.
Fixed-income securities are essentially debt; investors should avoid investing in issuers showing the most debt. Remember, issuers will always want to borrow at a rate and maturity favourable to themselves. What is advantageous for issuers does not necessarily benefit investors.
In addition, bond supply and demand are influenced by institutional investors, such as insurance companies, pension funds, and charities, whose needs are considerably different from those of someone looking to invest in an RRSP or TFSA. For these reasons, the index strategy is often incompatible with the objectives of individual investors.
Objectives and Limitations of Fixed Income
As with the rest of the portfolio, the investor’s objectives and limitations must be considered. Fixed income can generate retirement income, diversify the portfolio, or finance an anticipated large cash outflow, such as purchasing a house.
Specific strategies, such as using preferred shares, can help reduce the tax burden on taxable investments. Some strategies also seek to eliminate the risk of not having a regular cash inflow.
Fixed Income and Immunization
Immunization is a strategy that eliminates the risk of running out of money in the future. This strategy involves buying a combination of fixed-income securities with a low credit risk, whose combination of maturities and interest payments is matched by potential cash outflows.
Imagine you need $25,000 per quarter for living expenses. In this case, you would build a portfolio guaranteeing an inflow of $25,000 every quarter, whether it’s through interest payments or security maturities.
While highly secure, this approach requires a large sum of money to set up, which is why it is popular with institutional investors and less with individuals.
Maturity Ladders
What if you diversify your portfolio by purchasing fixed-income investments that mature on different dates, for example, every year for ten years? Investing in a basket of fixed-income securities with maturities spread over time is a simple but effective strategy, as it reduces risks associated with interest rate fluctuations. Similar to the immunization strategy, a maturity ladder strategy can reduce the risk of running out of money in the future. It is less effective and precise than the immunization strategy but more straightforward and accessible.
Barbell Strategy
Another strategy, whose name is inspired by weightlifting, is the ‘barbell’ strategy, which seeks to reduce risk over time. The idea is to invest in securities that are about to mature and in others that will not mature for many years. That way, if rates rise, you can quickly reinvest the portion of early maturities into higher-yielding assets. If rates fall, you still benefit from the higher rates on your longer-term investments.
Income Strategy
You can also focus your strategy on generating income by investing in perpetual bonds, debentures or specific securities with long maturities. Since the goal is to create income rather than resell the securities at a higher price, we are unhampered by certain drawbacks, such as the lack of liquidity in the fixed-income market, to create an attractive income strategy.
Guaranteed Investment Certificates (or GICs) and Other Securities
Investors are under no obligation to invest solely in government bonds. An astute investor will seek to make the most of all fixed-income securities. Guaranteed investment certificates, or GICs, can be integral to this strategy. You can also look at credit risk. Specific strategies involving preferred shares and corporate and convertible bonds can add attractive returns when diversification is optimized.
Diversification
Unlike equities, where many factors influence the value of securities (and where the distribution of returns can be extensive depending on the strategy used), with fixed income, the prevailing interest rate and credit rating dictate valuations. Therefore, there is no potential disadvantage to over-diversifying a fixed-income portfolio.
The opportunities for fixed-income investing are plentiful. No single strategy suits everyone, but by understanding your objectives and being open to different approaches, you can create a portfolio that suits your needs.
