Fixed Income Investments

It’s rather funny how something that is mainstream for experts is usually considered on the fringe for ordinary folk. I guess that’s what makes them experts; they see something the majority does not.

Take fixed income investments, for example, such as U.S. Treasury notes, corporate bonds, and an ever growing array of bond ETFs. Professional portfolio managers love them, but you will rarely hear very much talk about them. They are just too boring.

Most investors like the excitement of equities, where you lay your money down on a stock, cross your fingers with a big smile, and hope for a big payoff. Sometimes you score big, other times you get wiped clean. In the meantime, that passive fixed income investor is slowly moving along. At a turtle’s pace, mind you; but moving forward nonetheless.

Perhaps George Soros, one of the most successful investors of all time, drew the distinction between the two groups best: “If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.”

So what do these boring professional money managers know that most investors don’t? What’s so great about those sleepy, lethargic, and sometimes catatonic fixed income vehicles?

What Are They Good For?

As Investopedia explains it, fixed income is “a type of investing…for which…periodic income is received at regular intervals at reasonably predictable levels.” For example, investing in a bond that pays 3% interest (predictable level) once a year (regular interval).

Such predictability and regularity of income takes much of the volatility out of the bond’s price. Volatility is driven by uncertainty. Since a bond reduces uncertainty, its volatility is reduced as well. That’s why they are so boring. Bonds are like those short little 5-yard passes on the football field. They are not designed to throw you a 75-yard “Hail Mary” touchdown pass; that’s what stocks are for.

Therein lie the contributions that fixed income investing can make to a portfolio – steady income and reduced volatility. For this reason, fixed income is typically recommended for retirees who need regular income at reduced risk.

But it can be very valuable to younger investors too, especially for money that has been set aside for a future purpose. Take a young couple saving up for a down payment on a house, or a young family saving for their children’s college education. They still want to earn something from that money until it is used, but they don’t want to risk losing it. That’s where fixed income comes in handy, adding interest or dividend income while preserving the principle investment.

Recent Drivers of Fixed Income

But even with their lower volatility relative to stocks, bonds do move up and down. The last five months since May, for instance, have seen bonds thrust into the spotlight at center stage, quite the change from their usual hiding place way in the background. And it’s all because of the U.S. Federal Reserve’s monetary policies.

From May until the beginning of September, the expectation was that the Fed would begin reducing its monthly bond purchases soon, eventually eliminating them by mid 2014. The anticipation of lower bond demand by the Fed drove bond prices down and interest yields up.

But in early September, everything reversed. Investors started returning to bonds in droves, driving bond prices back up on the expectation that a government shutdown will put the Federal Reserve’s tapering plans on hold for a while.

Further supportive of bonds is today’s nomination by President Obama of Federal Reserve Vice Chair Janet Yellen as Chairman Bernanke’s replacement at the end of January, an indication that the Fed will remain dovish and accommodative over the next four years.

Thus, we mustn’t dismiss the fixed income class from our portfolios completely, since the U.S. economy is still not out of the woods and the Federal Reserve is still not out of the picture. Here is what we might expect for bonds going forward…

• The government shutdown and worries of a possible debt default have most likely postponed Fed bond tapering until early 2014. We can thus expect a few more good months for bonds ahead.

• At some point, the Federal Reserve will reduce and eliminate its monthly bond purchases, possibly from mid-2014 to mid-2015. We can expect bonds to correct back down over that period.

• After its monthly bond buying program is terminated in 2015, the Fed will likely keep interest rates unchanged at near zero until employment and inflation reach their targets, probably by 2017. We can expect bonds to move back up from the end of bond buying in 2015 to the beginning of rate increases in 2017.

So by the look of the presumed timetable, fixed income instruments could still hold their own quite well for the next four years until interest rates start to rise in 2017.

Yet we still need to be selective. As the following graph shows, not all bond vehicles perform the same. (click to enlarge)

Source: BigCharts.com

Comparing the S&P 500 index (black) to three bond ETFs on a weekly basis over the past five years, you will clearly note the importance of stocks when equity markets rise. But when equities fall, that’s when you notice the value of bonds.

When the S&P index corrected substantially in the summer of 2010 and even more in the late summer of 2011, the SPDR Barclays High Yield Bond ETF (NYSE: JNK) (beige) corrected much less. If JNK’s 6% annual dividend yield were factored in, its plot line would be even higher.

By contrast, during those same equity corrections, the iShares 10+ Year Credit Bond ETF (NYSE: CLY) (purple) actually rose in value. Its annual dividend yield in the high 4% area sweetened its performance all the more.

Meanwhile, the shorter duration holdings of the iShares 1-3 Year Credit Bond ETF (NYSE: CSJ) (blue) have made it the most stable of all, with an inflation-hedging 1.1% annual dividend yield.

As we can see, a portfolio can’t thrive on equities alone, but needs to have fixed income vehicles blended in for added stability. Once you determine the blend that’s right for you, you might consider trading them against one another using “build-and-store.”

The “Build-And-Store” Method

Since equities are more volatile than bonds, they would be the class to buy on the dips and sell at the tops. Over the past ten years, the S&P 500 has enjoyed three fantastic bull runs, gaining 95% from 2003 to 2008, 100% from 2009 to mid-2011, and some 60% from late 2011 to present. If only equities didn’t have to give so much of their gains back during those periodic corrections.

That’s where fixed income comes in handy when properly traded in conjunction with equities. Simply use your equities to “build” your profit and use your bonds to “store” it. When the markets are toppy, you might consider selling some stock and buying some bond funds. When equities have corrected, you could use the money saved in your bonds – plus the dividend income collected in the meantime – to buy stocks on the dip, and then let the cycle run again.

So where are we now within that cycle? The graph above shows that equities have drawn a perfect double top and have been correcting ever since. There may still be some downward movement in stocks until the government shutdown and credit limit issues are resolved, which might make a switch out of equities and into bonds over the immediate term still a viable move.

Just keep in mind that once the current uncertainties are behind us, equities should mount a comeback that could run into the first half of 2014. Even so, if you manage your mixture of equities and bonds using one to build and the other to store, you could be growing a sizable nest egg in very quick order.

Joseph Cafariello

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