Imagine for a moment you just bought a shiny new Porsche 911 Carrera 4 GTS. Jump in and inspect every detail to ensure it meets your exacting specifications: Espresso natural leather interior, GTS embroidered on the adaptive sport seats and a Bose Surround Sound system tuned to the car’s specific interior acoustics.
Zip off the lot and fill it up with regular gas. If you know anything about the 911 you’ll know you’ve not only compromised the car’s performance you’ve also upped the odds your car will soon need some professional help. Now think of that sports coupe as your portfolio.
Investors sweat the details when it comes to their fully-loaded equity investments, getting diversification by industry, geography and risk. But some investors treat fixed income, like high-performance gasoline, as an afterthought. Sure, yields are low but you still need to count on this asset class to provide income and reduce your overall portfolio volatility, especially given low rates, heightened global uncertainty and the threat of inflation.
Time to focus on fixed income
The need to focus on fixed income has “been forgotten because we’ve been in this environment for a number of years,” says Gregory Kocik, managing director at TD Asset Management. Today’s market is complex and too many investors expect government and corporate bonds to move in tandem. The same goes for shorter- and longer-term government bonds.
So where do you begin if you want to build a smarter fixed-income portfolio? A laddered bond portfolio, which staggers the maturity of the bonds and reinvests the proceeds at regular intervals, is a good start, but you need to diversify beyond that. A recent report from J.P. Morgan provides a good synopsis of how a diversified fixed-income portfolio should be built. It breaks the fixed income portfolio down into three core components: The core (high-quality, lower-volatility investments like government bonds that provide some diversification to stocks); core complements (absolute return bonds designed to hedge against inflation); and extended sectors (high-yield bonds that can provide some extra income, albeit with added volatility).
The best way to diversify fixed income
How you weight each of those sections depends on your goals, risk tolerance and the interest rate environment. Diversifying your fixed-income portfolio can have a real impact. For example, over the past 20 years the best approach was to have a portfolio with 20% exposure to high yield and 80% to government bonds, says Kocik. “You are actually reducing risk and increasing returns,” he says.
In order to get the mix right, some money managers turn it over to fund managers, who have the ability to suss out pockets of untapped value. Others prefer the passive low-cost ETF route. Vanguard, which runs both active and passive strategies, believes that there are opportunities to add value relative to a benchmark. However, in the current low rate environment that added value likely tops out at three-quarters of a basis point annually. You can add value relative to a benchmark, but you have to do it in a low-cost way, says Gregory Davis, Vanguard’s global head of fixed income.
Where to start
Start with a laddered-bond ETF like the iShares DEX Short Term Bond Index Fund (TSX: XSB) as part of your core holdings, suggests Chris Rawles, a certified financial planner with RT Mosaic. “Yields aren’t great but you have to let other parts of the portfolio do their job,” he says. As a starting point he says the mix would be 50% core with the rest of the portfolio evenly split between high-yield and inflation protection, using four or five different products.
Just remember, if you want your portfolio at peak performance, don’t use regular gas.