The Sum and the Parts
CHIEF INVESTMENT STRATEGISTOlivian Pitis, CFA, CFP® and AIFA®
VICE PRESIDENT, RELATIONSHIP DIRECTOR & INVESTMENT SPECIALIST
The Effects of Fixed Income Composition in Various Asset Allocations
While many decisions go into structuring an equity allocation, from an asset allocation perspective the goal for any equity allocation is growth. Fixed-income securities, on the other hand, can serve many objectives, from inflation-protected securities that help provide a hedge against unexpected inflation runs to municipal securities that allow for tax benefits to taxable investors. This variety of characteristics often raises the question about the optimal fixed-income allocation for asset allocations with high and low equity exposure.
Within fixed income, we have observable characteristics that provide information about differences in expected returns. For example, fixed-income securities with lower credit worthiness present an expected return premium over higher-quality securities, which can be considered when attempting to capture higher expected returns in well-diversified portfolios. An interesting development in fixed income markets is the reduction of corporate issuers with the highest credit quality rating (Aaa/Aa) in the investment-grade universe.
This limitation in the universe of top-quality issuers presents a challenge for investors looking for low-risk portfolios, because constraining the universe to top-quality issuers can expose them to more idiosyncratic risk versus investing in full investment-grade portfolios. Full investment-grade portfolios include those top issuers, but at lower weights, reducing the issuer-specific risks through broad diversification.
Along the maturity spectrum, there are also observable premiums. At first glance, longer-term securities tend to have higher expected returns than shorter-term securities. While this is generally the case, the picture is more complex since information in the term structure of bonds can be used to identify the durations with higher expected returns. The term structure is not unique for all bonds. Different bonds in different sectors with different credit qualities have different term structures. A careful analysis of bonds, using relevant yield curves and considering their coupon (or lack of coupon) structure, allows for better estimation of expected returns.
In this article, we review how composition differences in a fixed-income portfolio impact the overall allocation, including a simple framework for how to think about each component’s contribution to volatility.
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Diversification does not assure a profit, nor does it protect against loss of principal. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
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