In today’s dynamic investment landscape, seeking a balance in your portfolio is crucial for long-term financial stability. Fixed-income bonds offer a reliable way to achieve this balance by providing steady income and acting as a hedge against market volatility. In this comprehensive guide, we will explore how to use fixed-income bonds to seek balance for your portfolio and how to integrate this investment strategy.
The Unusual Correlation Between Stocks and Bonds
Historically, a well-established narrative in the financial world dictates that when stocks zig, bonds zag. Nonetheless, this traditional relationship has witnessed some turbulence over the past few years.
Note: The correlation between stocks and bonds is a statistical measure that gauges the degree to which these two variables shift in relation to each other.
The past year, in particular, was a challenging environment for fixed income, with bonds falling alongside stocks for the first time in decades. This anomaly was catalysed by rapid rate increases by central banks against a backdrop of record-high inflation rates, which caused significant turmoil in the economy.
A Snapshot of the Equity Market Correction Periods
An examination of the correlation between stocks and bonds during equity correction periods since 2010 reveals just how unusual it was. Here’s a brief overview of these market correction periods:
- Flash crash (April 2010–July 2010)
- U.S. debt downgrade (April 2011–October 2011)
- China slowdown (May 2015–August 2015)
- Oil price shock (November 2015–February 2016)
- U.S. inflation/rate scare (January 2018–February 2018)
- Global selloff (September 2018–December 2018)
- COVID-19 pandemic (February 2020–March 2020)
- Historic inflation and rate hikes (January 2022–October 2022)
The Return of Fixed Income as a Portfolio Ballast
As the effects of the rate hikes fade and markets shift their focus to the growth backdrop, fixed income may reclaim its role as a portfolio ballast.
Economic weakening should generally be positive for fixed-income bonds, providing diversification from equities.
What Are Fixed-Income Bonds?
A fixed-income bond is a debt security that pays a fixed interest rate to the bondholder until its maturity date. In comparison to stocks, these bonds are a relatively low-risk investment option that governments, municipalities, and corporations issue to raise capital.
Despite bond return optimism at the beginning of 2023, the Fed’s actions have continued to cast a long shadow over the Bloomberg U.S. Aggregate Index, making it difficult for it to post gains.
Types of Fixed Income Bonds
Government bonds are issued by the government to finance public spending.
Corporate bonds are issued by corporations to raise capital for various purposes, such as expansion or debt refinancing.
Municipal bonds are issued by state or local governments to fund public projects such as infrastructure development.
Benefits of Fixed-Income Bonds
Steady Income: Fixed-income bonds provide a predictable stream of income through regular interest payments.
Capital Preservation: They offer more stability compared to equities, making them a valuable tool for preserving capital during market downturns.
Diversification: Adding fixed-income bonds to your portfolio can help mitigate risk and balance the overall asset allocation.
Integrating Fixed-Income Bonds into Your Portfolio
Assessing Your Risk Tolerance
Before integrating fixed-income bonds into your portfolio, it’s essential to assess your risk tolerance and investment goals. Consider factors such as your age, financial obligations, and long-term objectives to determine the appropriate allocation for fixed-income bonds in your portfolio.
Asset Allocation Strategy
Diversification: Allocate a portion of your portfolio to fixed-income bonds to diversify risk and reduce overall volatility.
Rebalancing: Regularly review and rebalance your portfolio to maintain the desired asset allocation, ensuring that fixed-income bonds continue to play a strategic role in your investment strategy.
Rebuilding a Fixed Income Allocation
Despite the unusually positive correlation between bond returns and stock losses in 2022, a more benign outlook for inflation may enhance diversification going forward.
Where to Focus in Fixed Income
Investors should consider their bond fund’s exposure to high-quality holdings and duration.
We recommend higher-quality credits, which can be more insulated from economic weakness than their lower-quality counterparts.
The Importance of Diversification
During periods of market volatility, diversification plays a crucial role in the construction of bond portfolios.
Looking Ahead: A More Constructive Outlook
After a prolonged slump, fixed-income bonds appear poised to regain their status as equity diversifiers in investor portfolios.
With inflation on a downward trend and the policy rate potentially reaching its peak, the risk-return prospects for bonds appear favourable.
Nobody can have certainty in today’s outlook, but over the next 12 months, high-quality fixed income has the potential to provide attractive opportunities from both a yield and total return standpoint, supporting its traditional role as a ballast within diversified portfolios.
Incorporating fixed-income bonds into your investment portfolio can significantly contribute to achieving balance and stability. By understanding the fundamentals, you can embrace a diversified approach that includes fixed-income bonds that can help navigate market uncertainties and build a resilient portfolio for the long term.