Understanding the important role which fixed-income securities play within investment portfolios is crucial for investors of all persuasions, regardless of whether income generation or capital growth is the primary objective.
The 60/40 Portfolio
The 60/40 portfolio has formed the bedrock of the modern investment portfolio for decades, and for good reason.
Within such a portfolio, 60% of the available investment capital is allocated to equities for capital growth, while the remaining 40% is invested into fixed-income assets which seek to stabilise the portfolio overall.
Greater portfolio stability can be achieved by including fixed-income securities within a portfolio because they generally move inversely to stock prices. This means that when weaker economic conditions arise and stock valuations decline, the valuation of some fixed-income assets can increase as capital flows into perceived safer assets.
It’s important to point out that the inverse correlation of equities and fixed-income isn’t guaranteed and has changed throughout history.
Additionally, not all fixed-income securities may exhibit an inverse correlation, especially if the market perceives them as risky, so it’s important to consider this when allocating to specific securities.
Stable Income Generation
In addition to portfolio stability, fixed-income investments also provide a stable and regular income stream which can help to smooth investment returns over time. This is especially valuable when the outlook of the stock market might seem dubious.
Certain fixed-income securities including those issued by governments, but also corporations with excellent credit quality are considered to be relatively safe investments, offering high levels of investment protection.
Although corporate fixed-income bonds and other securities are not considered to be ‘risk-free’, they can provide investors with enhanced portfolio protection when compared to equities.
Just like the stock market, there is an expansive universe of fixed-income assets to choose from. In fact, the global fixed-income market is larger than the global equity market with a combined market capitalization of $129.8 trillion in 2022 vs $101.2 trillion in 2022.
Given the plethora of choice, it’s important to be discerning when it comes to security selection as different fixed-income instruments all have idiosyncratic characteristics which influence the risk and return profile.
One of the main risks associated with fixed-income securities is interest rate risk. When interest rates rise, the price of fixed-income assets generally fall, and this can lead to potential capital losses if an investor in a certain bond chooses to sell the bond at that time. Conversely, prices usually rise when interest rates decline, which can result in a capital gain if the investor chooses to sell the bond before maturity.
However, if an investor holds a bond to maturity, the investor will receive the full-face value of the bond (regardless of what the interest rate is in the market at that time). Of course, in addition, fixed-income securities will continue to pay interest via coupon payments to investors based on the face value of the bond, regardless of the asset price, as long as the issuer of the fixed-income security remains solvent.
Another major risk to be aware of when investing in fixed-income assets is the credit quality of the issuer. Credit risk, also known as default risk, is the risk that a borrower or issuer of a fixed-income security may fail to meet their financial obligations, specifically the repayment of borrowed money or the payment of interest.
The Bottom Line
Incorporating fixed-income securities into an investment portfolio can enhance risk management, income generation, and overall portfolio performance.
The specific opportunities and benefits will vary depending on security selection and an investor’s financial goals, risk tolerance, and the prevailing market conditions.
Overall however, fixed-income securities are an important asset class which play a key role within a well-rounded and diversified investment strategy.
Disclaimer: Australian Bond Exchange Pty Ltd ACN 605 038 935 AFSL 484453 (ABE). This article is intended to provide general information of an educational nature only. It does not constitute the provision of personal advice and does not take into account your personal objectives, financial situation or needs. Before investing with ABE, you should consider the appropriateness of the investment to your particular financial and taxation situation and consider obtaining independent advice before making an investment. Examples in this article are for illustration purposes only and are not a recommendation to buy, sell or hold a particular investment. ABE makes no representation or guarantee as to the availability of a bond with the characteristics described in this article or that an investment made by you will generate the returns in the illustration. Past performance is not an indication of future performance. Investing with ABE is subject to our Client Services and Custody Agreement Terms and Conditions and Financial Services Guide.