Fixed Income & The Portfolio

What is Fixed Income?

Fixed income (FI) refers to debt securities issued by entities such as governments, corporations, and other organizations to a borrower. These securities are typically characterized by a set term, periodic interest payments (known as a coupon), and face value, which is the amount the investor will receive when the bond matures. 

Individually, fixed income securities vary widely in both term and coupon, with maturities ranging from one day to perpetuity and coupons of zero to whatever the counterparties negotiate. Fixed income securities include both publicly traded instruments such as commercial paper, notes, and bonds as well as non-publicly traded products such as loans and private placements. 

Traditional bonds, also known as straight or vanilla bonds, are fixed income securities that pay interest at predetermined intervals and return the full principal upon maturity. However, most bonds, including both government and corporate, are not vanilla, often engineered with various degrees of customization and sophistication. These non-vanilla bonds may include various features, including optionality, floating interest rates, contingent conversions (the possibility of converting the bond into equity), payment in kind versus payment in cash, covenants (conditions or rules the borrower must follow), and restrictions. 

Further, fixed income products can be classified based on their level of risk and security. They can be collateralized (backed by assets) or uncollateralized; the debt may be senior, junior or mezzanine in the issuer’s capital structure (This determines what order the debt is paid if the issuer experiences financial distress, with senior debt being paid first.), or the bond may be offered individually, or it may be securitized (grouping loans, debts, or bonds and creating a new security). The credit ratings of bonds range from investment grade, meaning the probability of default is very low, to junk, indicating a greater likelihood of default. There are also bonds that are unrated. The most universally consistent characteristic of a fixed income product is that it will have a face value, which represents its worth at maturity, assuming no credit event. 

The FI market is highly complex, less transparent, and deeper than the equity market. In 2023, the global fixed income was valued at USD140.7 trillion and the equity market was valued at USD115 trillion (Capital Markets, n.d.). Fixed income products range from riskless, generally regarded as a 3-month T-Bill, to highly speculative. Ultimately, the success of bonds to manage risk is contingent on the quality of the fixed income instrument. 

Fixed Income in Portfolios

Fixed income serves as a valuable resource that provides income, preserves capital, and may reduce overall portfolio correlation (CFA Institute, n.d.). Over the past 20 years, stocks and high-grade, short-duration bonds have frequently been negatively correlated, meaning when the stock market drops, bonds tend to hold steady or rise. This inverse relationship has created a ballast for investment portfolios during periods of poor equity performance. In the recessionary markets of 2000, 2008, and 2020, bonds did rise as equities fell. However, in 2022, stocks and fixed income became positively correlated (moved in the same direction), and, depending on the type of fixed income product, the performance of bonds was frequently as bad as equities. 

The 2022 bond and equity correlation phenomenon led several analysts to conclude that bonds were no longer risk reducing investments and therefore had limited utility in a modern portfolio. Yet, as is evidenced by the charts below, not all fixed income performed equally during the 2022 drawdown. While the S&P dropped 23.87%, the Bloomberg US Agg 1-5 Yr TR fell 7.78%, while Bloomberg 1-3 Yr US Treasury TR fell only 5.17%. 

Drawdown: 31 March 2021 to 30 November 2022

Further, studying the performance of specific FI during the period of high inflation and rising interest rates that occurred from 31 March 2021 to 30 Nov 2022, one will see that the quality, duration, and issuer of the FI product was a factor in determining performance (T. Rowe Price, n.d.). 

According to Morningstar, a 60/40 portfolio broad market bond and equity positions returned less than -15% in 2022. However, that same portfolio returned 18% in 2023, far outperforming most other forms of risk management and strategic investing (Arnott, n.d.). 

60/40 vs Alternative Risk Management & Strategic Investing Portfolios

Today, many analysts have been reframing the negativity surrounding fixed income post-2022, now frequently referring to the period as a type of turbulent aberration rather than a structural change in FI’s utility. Prior to 2022, the credit markets rallied during a 40-year period of both stable inflation and low interest rates. For most bond managers, fixed income trading was focused on three aspects: term, credit, and liquidity. In a normal market, meaning one with stable inflation and steady growth, systematic bond risk earned a premium that was derived from taking greater term risk (increasing maturity), buying lower credit instruments, and trading in less liquid markets. 

The fact is present markets are not the same as pre-2022, and bond traders are finding it harder to rely on traditional strategies. Bond traders are less reliably rewarded for taking term exposure. For example, the yield curve (the difference between short-term and long-term interest rates) has been almost continuously inverting, meaning 2-year US Treasury bonds are yielding more than10-year US Treasury bonds, a sign of uncertainty in the market. Even credit spreads (the difference between the interest rate on government bonds and corporate bonds) remain tight, with less reward for taking risk, as proxied by the 286-basis point option adjusted spread (OAS), the [NF1] reported by the St. Louis Fed (FRED 2024). However, it should be noted, tight OAS markets are historically considered bullish indicators. 

Behavioral Considerations

A less frequently discussed factor to consider when FI investing is the psychological and behavioral effect FI can have on an investor’s portfolio. Behavioral finance is the field of behavioral economics concerned with the study of why humans are not rational utility-maximizing investors (McClure, n.d.). In other words, behavioral finance seeks to understand why individuals make financial decisions unmoored from economic theory. 

Within the study of behavioral finance, there are identified cognitive biases that have been empirically proven to influence a person’s financial decision making. However, despite the widespread awareness of biases, investors continue to be subject to them. Even veteran investors and traders periodically make significant choices grounded in behavior rather than rationality. Fixed income in a portfolio may act as a hedge against irrational behavior. The ability of the FI to remain relatively strong and liquid during market drawdowns may temper an investor’s emotions, thereby allowing them to approach the situation in both a better capitalized and more strategic manner. 

Conclusion

Fixed income appears to remain an efficient and effective means to reduce portfolio volatility and drawdown and mitigate behavioral biases. However, bonds are sensitive to inflation, which continues to define contemporary markets. Moreover, inflation drives higher correlation between equity and fixed income markets, as represented by the table below from Morningstar (Albrecht 2024).

Thus, investors selecting FI as a means to manage risk may want to consider high-quality bonds with shorter durations, which can still perform well during inflationary periods. Outside of risk, FI remains a reliable means of liability matching and income creation. For investors that need predictable cash flows, fixed income is, in principle, a simple and historically dependable resource, and may be worth consideration when designing an investment portfolio. 

Sources:

Albrecht, Bella. 2024. “‘Diversification Is Back’—Why 60/40 Portfolios Are Working.” Morningstar, Inc. November 8, 2024. https://www.morningstar.com/markets/diversification-is-backwhy-6040-portfolios-are-working.

Arnott, Amy C. n.d. “Naysayers Were Wrong About the 60/40 Portfolio. Here’s Why. | Morningstar.” Accessed December 27, 2024. https://www.morningstar.com/portfolios/why-naysayers-were-wrong-6040-portfolio.

Capital Markets. n.d. “The Capital Markets Fact Book.” SIFMA. Accessed November 28, 2024. https://www.sifma.org/resources/research/fact-book/.

CFA Institute. n.d. “Overview of Fixed-Income Portfolio Management | CFA Institute.” Accessed November 28, 2024. https://www.cfainstitute.org/insights/professional-learning/refresher-readings/2024/overview-fixed-income-portfolio-management.

FRED. 2024. “ICE BofA US High Yield Index Option-Adjusted Spread.” December 26, 2024. https://fred.stlouisfed.org/series/BAMLH0A0HYM2/.

McClure, Ben. n.d. “An Introduction to Behavioral Finance.” Investopedia. Accessed January 2, 2025. https://www.investopedia.com/articles/02/112502.asp.

T. Rowe Price. n.d. “Understanding the Roles of Fixed Income | T. Rowe Price.” Accessed December 20, 2024. https://www.troweprice.com/financial-intermediary/us/en/insights/articles/2023/q2/understanding-the-roles-of-fixed-income.html.

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