Asset allocation accounts for nearly 90% of volatility and returns, according to Vanguard.
While equities have generated the highest returns over time, fixed income plays a critical role for investors more interested in protecting their principal. Bonds help reduce the volatility of a portfolio and minimize the risk of loss over time.
Let’s take a look at how fixed income can protect your principal, risks that affect bonds and strategies that you can use to safeguard your principal.
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Significance of Fixed Income within a Portfolio
Fixed income plays an essential role in an investor’s portfolio. For example, many investors increase their fixed income allocations as they approach retirement to reduce volatility and generate income to support retirement. Other traders and investors used fixed income as a safe-haven asset class during periods of uncertainty or volatility.
There are a few reasons to consider fixed income:
- Liquidity Preference: Bondholders have liquidity preference over equity investors. In the event of a bankruptcy, bondholders tend to lose less money since they are repaid from asset sales before equity investors.
- Volatility: Bonds tend to be less volatile than equities. When investors add bonds to their portfolio, the overall portfolio tends to experience less volatility, which can help preserve capital during turbulent downturns.
- Diversification: Bonds tend to be negatively correlated with equities. When equities experience a decline, investors tend to shift their holdings into bonds, which can help offset the decline in equities and improve risk-adjusted returns.
- Recurring Income: Bonds typically make regular coupon payments over time, which generates income and helps reduce risk.
Of course, fixed income investments aren’t without risk. Bond prices and yields fluctuate due to a number of factors, including interest rates, credit risk, inflation risk and reinvestment risk. Investors must be cognizant of these risk factors when building fixed income into their portfolio in order to ensure that their principal is safe.
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Going a Step Further
The price of bonds and other fixed income investments is heavily influenced by interest rates. When interest rates rise, bond prices fall, and bond yields rise to remain competitive. These movements may not affect the repayment schedule of individual bonds, but they can have a significant impact on bond funds that many investors use for fixed income exposure.
Of course, a rise in interest rates doesn’t affect all bonds equally. Duration is a measure of the degree to which a bond is likely to change in value when interest rates rise or fall. Long-term bonds tend to have a higher duration than short-term bonds, since their prices are more heavily influenced by changes in interest rates.
The relationship between a bond’s price and yield isn’t always linear. Convexity is a measure of the interaction between a bond’s price and yield as it experiences changes in interest rates. High-yield bonds tend to have lower convexity because a 5% bond is more sensitive to interest rates than a 10% bond, while callable bonds could even have negative convexity.
Strategies to Protect Your Principal
Most investors use laddered bond portfolios to manage fixed income risk. By holding a mix of short-, intermediate- and long-term bonds, a portfolio can diversify credit risks and interest rate risk can be spread out over time to mitigate any volatility.
One easy way to build bond ladders with funds is using the iShares iBond ETF line-up, which includes various durations. For example, the iShares iBonds Dec. 2021 Term Treasury ETF (IBTA) has much less duration than the iShares iBond Dec. 2030 Term Treasury ETF (IBTK).
Investors that want more principal protection can adjust portfolio allocations in several ways either as a whole or within specific sectors, like it is shown below.
| Strategy | Key Benefits | Key Risks |
|---|---|---|
| Shorten duration | Reduces volatility | Lowers yield |
| Reduces principal risk | Inflation risk | |
| Diversifies equity risk | Short-term risk | |
| Sell to cash | Reduces principal risk | Inflation risk |
| Diversifies equity risk | No income | |
| Buy individual bonds | No principal risk | Higher costs |
| Flexibility over security selection | Less liquidity | |
| More research | ||
| Less diversification | ||
| Use floating-rate products | Reduces duration | Higher credit risk |
| Diversifies equity risk | Less diversification |
These are typical benefits and risks and may not be the case in individual situations.
In the meanwhile, core duration funds—or investment-grade corporate bonds, Treasuries, agency securities and municipal bonds—may still be worth considering despite today’s low interest rates, too. For example, the Schwab U.S. Aggregate Bond ETF (SCHZ) and the SPDR Portfolio Aggregate Bond ETF (SPAB) both provide intermediate core bond holdings.
There are several reasons to stick with core duration:
- Rates Could Fall Further: Interest rates could fall even lower due to a decline in the neutral policy rate (e.g., the rate that neither simulates or restrains growth), greater transparency among central banks, and a benign global inflation outlook.
- Lock in Long-term Rates: The yield curve may be relatively flat now (e.g., there’s little difference between short- and long-term bond yields), but long-term bonds can lock in the current yield over your entire investment horizon.
- Bonds Are Better than Cash: Investors worried about the near-term economic outlook may consider holding cash in lieu of bonds, but evidence suggests that fixed income outperforms cash even during recessionary times.
When deciding on a strategy, investors must consider their risk tolerance and investment time horizon. Those who are already well into retirement may want to consider shorter durations to limit risk, whereas those that simply want to play it safe may want to stick with core duration bond funds to hedge themselves against even lower rates in the future.
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The Bottom Line
Fixed income plays an important role in protecting principal, but there are also many risks to keep in mind. Using the aforementioned strategies, you can keep fixed income risks in check and ensure that you’re maximizing the protective qualities of your fixed income allocations.
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