The Role of Fixed Income in a Diversified Portfolio

Randy Joseph

July 30, 2019

As humans, our vast collection of behavioral biases and emotions often causes us to make decisions that aren’t in our best interest. When left to our own devices, we often make investment decisions that work against us, not for us.

One of the many behavioral pitfalls investors tend to fall prey to is recency bias, which causes us to focus on recent events when making decisions rather than events that took place in the past. For example, recency bias may cause you to increase your allocation to equities after a period of strong stock market performance, even if your primary goal is to preserve wealth. Or, it may compel you to sell all your investments and hold cash after a sharp market correction despite having a long-term investment horizon and investment plan in place.

In both scenarios, your perception of risk changed solely because of recent market conditions. By focusing on recent events, you likely forgot the pain you experienced during the last market correction or the exhilaration experienced during a bull market recovery. Acting on recency bias causes investors to be greedy and fearful at exactly the wrong times and has generally led to poor long-term investment performance.

Recency Bias and Fixed Income

Naturally, recency bias can also affect your attitude towards bonds. After 10 years of strong performance from the U.S. stock market, it’s hard to remember a time when asset class diversification mattered. If you’ve thought about cashing in your fixed income investments and buying equities during the last decade, you’re not alone.

Still, there’s a reason recency bias is viewed as a pitfall. The inability to consider the broader context when making investment decisions often leads to unnecessary—and sometimes permanent—capital losses. As the market continues to rise and the last correction becomes a more distant memory, it may be beneficial to reiterate the important role fixed income plays in a portfolio.

Fixed Income Can Reduce Portfolio Volatility  

When equities are performing well, many investors become frustrated with their fixed income investments for not keeping pace. Yet bonds are not supposed to drive portfolio performance. They are generally meant to reduce the overall risk profile of a portfolio, meaning you shouldn’t see large swings in fixed income performance over time. An allocation to high quality fixed income may limit your upside, but it can also reduce your potential downside, making it easier to recover losses after a market downturn. Owning bonds in a significant downturn can help you stick to your long-term investment plan, even when the equity markets are moving against you.

In general, fixed income can reduce portfolio volatility because of three distinguishing characteristics:

  1. Low Correlation to Equities

Historically, stocks and high quality bonds have had low or negative correlations with one another, meaning they tend to perform well at different times. Fixed income investments tend to prove their relative worth when equity markets are declining, and particularly when the decline is driven by an economic contraction or recession. When economic growth slows, central banks often respond by lowering interest rates, which benefits bond prices.

  1. Focus on Capital Preservation

Generally, when you invest in a bond, you collect regular interest payments until the bond matures, at which point you also receive the face value of the bond. This feature makes bonds ideal for capital preservation, which can help offset the more volatile nature of equities. While there are circumstances that can cause you to lose money following a buy-and-hold bond strategy, these risks can usually be managed by investing in high quality bonds, and having a disciplined investment process and a diversified approach.

  1. Predictable Stream of Income

Most bonds pay coupons twice per year until the bond matures. Typically, these coupon payments are determined at issuance and remain fixed until maturity. While the prevailing interest rate environment can impact the underlying price of a bond and therefore its yield-to-maturity, the dollar earnings you receive throughout the life of the bond isn’t likely to change. Therefore, bonds deliver a predictable stream of income that can help moderate overall portfolio volatility.

While it’s easy to focus on recent market events when evaluating your investment strategy, often, the best way to combat any behavioral bias is to stick to your plan. Indeed, fixed income returns have lagged equity returns over the last several years. However, history tells us that eventually the tide will turn. When it does, we expect fixed income to play the role it’s meant to play by dampening overall portfolio volatility and minimizing capital losses.

Randy Joseph is a relationship manager for CIBC Private Wealth Management with more than 20 years of industry experience. He is responsible for business development and managing existing relationships for high net worth individuals and families. He joined Team Geneva Advisors in 2014.