January 15, 2013

The Risks of a Fixed-Income Portfolio

Credit: Stuart Miles
You know how most beaches have those ocean flag warning systems? Well even if you don’t, let me summarize: a green flag flying usually means calm conditions (go ahead and jump in), a yellow flag usually means moderate waves (be careful), a red flag usually means The Perfect Storm-type waves (don’t even think about it), and a purple flag signifies that there is marine life of some type nearby (you might want to see what it is, but you don’t want to be lunch). Well if I personally were a flag warning system for a fixed-income portfolio, I’d be yellow. Chances are you, or someone you know, currently has an investment strategy in place that is heavy on fixed income, and today I want to tell you to be careful, and that moderate waves are probably coming!

First of all, what do I mean when I say "a fixed-income portfolio?" I mean money that is being invested specifically in money market funds, Certificate of Deposits (CDs), and bonds. I’m not talking about your day-to-day checking account or your emergency fund savings account because those accounts should be viewed separately, and should be part of your financial plan and investment strategy regardless of the current market situation or forecast.

Fixed-income investments can be a sound strategy, and in my opinion, should be a portion of any well-diversified investment portfolio. Fixed-income investments are great because they are much less volatile than stocks, and theoretically, they offer a probable positive return (as long as the bank, company, or municipality in which you are invested doesn’t fail). On the other hand, fixed-income investments are not so hot historically because they do not keep up with inflation, and more importantly, a bond’s value typically goes down when interest rates increase. It’s inflation and interest rates that have my flag yellow.

From 1914-2012, the inflation rate (increase in prices) in the U.S. has averaged just a bit lower than 3.5%. What interest rates are you currently getting on your money market funds and CDs? For many of you, I bet the answer is less than 3.5%. Now the question I raise is this: even if your fixed-income investments are fairly stable and will likely offer a positive investment return, do you really want to invest a lot in something that will not grow as fast as prices have historically increased? Sure, inflation has been lower than average in recent years, and bond returns have been pretty good too, but over the long term, I’m not sure fixed-income investments will allow you to keep up with the Joneses. Fixed-income investments should still be a part of your prudently diversified portfolio, but if you have a lot of your assets invested in fixed-income investments, be careful; you could be on a path that will slowly erode your purchasing power.

As I alluded to earlier, a bond’s price and interest rates have an inverse relationship. Let’s say you previously bought a 7% bond for $1,000: you would expect to receive a coupon payment of $70 (7% of $1,000). Well what if interest rates go up 1%? Then, people buying a new $1,000 bond would expect to receive a coupon payment of $80 (8% of $1,000). Would someone still be willing to buy your previously purchased 7% bond for the $1,000 you originally paid when they can now get 8%? I don’t think so! In recent years, people holding lots of bonds have typically fared pretty well because the value of their bonds has been steadily increasing as interest rates have continued to decline to almost zero. The immediate problem for bondholders is that interest rates can’t mathematically go down much more. The bigger problem for bondholders is that interest rates will eventually go back up, and that means the value of bonds will have to go down. This concerns me because it really isn’t a matter of if interest rates go back up; it’s a matter of when. Bonds should still be a part of your prudently diversified portfolio, but if you have a lot of your assets invested in bonds, “waves” of interest rate increases are eventually coming; the bond investment return you have enjoyed in recent years will be hard-pressed to continue.

Fixed-income investments can be very solid investment positions. The problem is that fixed-income investments are like many other things in life - too many of them might not be good for you. My fixed-income flag is yellow, but I should tell you that not everyone shares my opinion. There are a lot of people much smarter than me out there whose fixed-income flags are proudly flying green. Of course, there are also a lot of people much smarter than me out there whose fixed-income flags are proudly flying red...

Great Tom, what should I do? Well, it all depends on your stage in life and your risk tolerance, but (1) make sure you have an adequate emergency fund, (2) make sure you have a prudent amount of diversified fixed-income investments to protect against market volatility and provide a stream of income, and (3) make sure you also have a prudent amount of diversified stock investments to protect your purchasing power against inflation and interest rate changes. Please talk to your financial advisor about your specific situation if you have any questions or concerns.

Well sorry to be a bit of a “Debbie Downer,” but I think it’s always important to tell you my true thoughts and concerns. In happier news, even with a yellow flag, the beach sounds pretty nice right about now!


1 comment:

  1. I'm thinking I need to talk to our advisor(s). That's on the top of my "to do" list! Thanks again for some great food for thought!