- Fixed income is held for risk reduction, not return enhancement. It is the ballast that allows the ship of your portfolio to withstand the financial storms that periodically roil the markets.
- It is conventional wisdom that “correlations go to one” in times of stress, but this is incorrect. Correlations between risky investments go up, but the correlations between risky assets (stocks) and safer assets (investment-grade bonds and cash) go down in periods of market stress. Thus, the fixed income portion of a portfolio should include only the safest categories of bonds.
- A fixed income portfolio should be equally weighted between nominal bonds and inflation-protected bonds to hedge unexpected inflation, unless the investor has exposures elsewhere that should be hedged (e.g. a very large pension with no COLA, or a real-estate portfolio with long-term, fixed-rate financing and short-term leases).
- If foreign bonds are used in a portfolio they should be currency hedged.
- Since liquidity in the bond market is higher for large (institutional) transactions than for smaller (retail) transactions, (inexpensive) bond funds, rather than individual bonds, are typically better for retail investors.
- Due to interest being recognized immediately and as ordinary income, fixed income is ideally held in tax-sheltered accounts. If that is not possible, alternative exposures might be advantageous. In addition, some alternative exposures might be better than traditional fixed-income investments regardless. Here is a list of alternative types of fixed income grouped by when/why they should be considered:
- Better tax treatment but lower return (so benefits correlate with tax-bracket and interest-rates):
- Municipal bonds.
- Variable annuities (a plain-vanilla, inexpensive wrapper solely to defer income taxes).
- Permanent life insurance.*
- Better tax treatment without any reduction in return (so advantageous if fixed income would otherwise be held in a taxable account):
- Non-deductible contributions to IRAs or other retirement plans (defers interest that would otherwise be taxable annually).
- Potentially higher returns (tax treatment is not a primary factor):
- Debt reduction if the after-tax interest rate on the debt is higher than an equivalent-duration bond with no credit risk.*
- Social Security delayed-claiming (equivalent to purchasing TIPS).*
- Pension annuitization rather than taking the lump sum is equivalent to purchasing fixed income.*
- Human capital investment (additional education and training), particularly for younger individuals.*
- Better tax treatment but lower return (so benefits correlate with tax-bracket and interest-rates):
*Other factors, in addition to just taxes and rate of return, will affect the prudence of this option.