5 Focus Areas For A Fixed Income Plan

May 13, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF asset managers in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based ValMark Advisers, which markets the “TOPS” brand of asset allocation models.

Basketball coaching great John Wooden once co-wrote a book titled, “A Game Plan for Life.” The title of the book summarizes what any experienced coach would echo: A solid game plan gives you the best chance for success.

Portfolio management parallels coaching in many ways; namely, managing portfolios involves assembling a team, developing a strategy and carrying it out. Like coaching, the game often shifts, and decisions need to be made during the game. Great coaches, like great portfolio managers, need to both prepare and execute.

The current interest-rate environment, however, is like being a coach but not knowing which sport your team will play next season. Obviously, there are drills and preparation that would be optimal for a basketball season, but what if football will be the sport instead?

Given this situation, we would guess Coach Wooden's game plan would be to focus on overall athletic preparation, teamwork and building confidence through experience. Likewise, he would probably advise to be prepared to do some serious coaching during the game.

Our suggestion for the current fixed-income environment is not much different.

In the current fixed-income environment, we recommend a well-diversified portfolio of fixed-income instruments, focusing on the overall environment of opportunities and risks that may play out.

Likewise, we recommend that investors focus on what level of risk to take and where to take risk.

Identifying Portfolio Attributes

We typically look at our fixed-income portfolios in reference to the following areas that may impact results. Likewise, we make our decisions at the portfolio level on where we would like to focus our exposure.

  • Volatility
  • Inflation
  • Foreign Exchange
  • Spreads
  • Rates

After using multiple versions of fixed-income portfolio framework over the last 13 years, we have settled on the above structure as our most efficient way of outlining the fixed-income attributes of our portfolios.

By labeling these attributes, we feel we can better frame our portfolio decisions and have a healthier grasp on how different market environments will impact our portfolios.

Volatility

Some fixed-income investments are inherently more volatile over time than others. For example, high-yield debt is expected to be more volatile over time than short-term U.S. Treasurys.

When including high-yield debt into a fixed-income portfolio, it is important to understand it can have similar impact on overall portfolio volatility as adding stocks. While stocks and high-yield bonds have their own inherent attributes and correlation matrices, their absolute volatility can be similar over time.

Inflation

Fixed-income investments will have unique responses to changes in inflation levels. The best example in this area may be Treasury inflation-protected securities (TIPS) bonds.

While TIPS bonds have a built-in inflation adjustment, some other types of fixed-income investments may not perform well in a period of rising inflation, and may perform better in a period of inflation that falls short of expectations. Therefore, overweighting TIPS bonds may increase the portion of your return that is driven by levels of inflation in the markets.

It is important not to simply look at TIPS bonds as checking off the box to protect against inflation risk. Portfolio managers must recognize that TIPS bonds will increase the overall sensitivity of a portfolio to inflation levels (high or low), meaning a portfolio heavy in TIPS bonds could be impacted significantly by changes in inflation that may have little impact on other portfolios.

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