What is the best fixed income tool for you? Breaking down the options

I use the word “diversification” a lot. I know it’s simple and even boring, but I believe in it. For more than four decades, I have watched clients build their wealth and achieve their goals with diversified portfolios.

But the meaning of the word is more nuanced than I sometimes let on, especially when it comes to fixed income.

When I started in the 1980s, two types of assets made up the secured portion of portfolios: government bonds and government bonds. Today, there are a plethora of products with different features and usage scenarios.

They all have a fixed obligation to pay interest and repay the principal, but they deviate from that. In balanced portfolios, some provide smooth returns, some protect against market collapses, and some provide no diversification at all.

Let’s look at the fixed income toolkit through a diversification lens.

Saving vehicles

There are many options in the short-term savings category: government bonds, GICs, money market funds and cash management products.

These are easy to understand. The return is clearly stated and the principal remains stable even in bear markets. In a portfolio, they help smooth out the bumps and provide enough liquidity for spending and rebalancing.

However, there are costs associated with holding savings products in investment accounts. The return will generally be lower than your required return and may not fully offset inflation.

Government bonds

Government bonds are loans with a longer term (five to thirty years). As with the savings vehicles above, there is no risk of default. You know you will get your money back.

But government bonds are a more valuable offset to stocks because they are sensitive to changes in interest rates. Remember, when market yields fall to stimulate a faltering economy or head off a crisis, the bonds you already own become more valuable. With turbulence everywhere, government bond prices are rising (the longer the term, the better a bond responds to interest rate changes).

Government bonds are the best choice in times of crisis, but there are tradeoffs. They offer a stable income, but again the potential return is lower than most portfolios hope to achieve. And returns can be volatile as interest rates change. There will be times when you wonder why you own them. That is, until they show up to save the day.

So far I’ve talked about one source of return: interest rate risk. There’s another useful tool in the kit: credit risk, or the risk that a borrower will default on a loan.

Investment grade bonds

Corporate bonds carry credit risk and holders are compensated with higher returns compared to comparable government bonds. The additional yield is called a spread. How much spread depends on the reliability of the borrower. Investment grade borrowers such as banks, insurers, telecoms and utilities are unlikely to default and therefore have a modest spread of 0.5 to 1.5 percentage points. For bonds issued by less reliable and/or cyclical borrowers, spreads range from three percentage points.

Spread products are a valuable part of any portfolio, but complicate the diversification picture. When the economy and markets are weak, investors worry about defaults and spreads rise, wiping out some of the benefits from falling interest rates.

High yield bonds

Riskier high yield bond funds have an excellent return record and can in some cases rival equities.

However, one of my rules of thumb is that if something has an equity return, it also has an equity risk, and is most likely highly correlated with the stock market. That is the case here.

High yield generally has a shorter duration, which means that it benefits less from interest rate declines. The biggest swing factor is the changing sentiment towards bankruptcies. The increasing negativity could shift spreads from the mid-single digits to the low to mid teens. Yes, five to ten percentage points.

High yield is a great return generator, but not great diversification. Technically it falls under fixed income, but it behaves more like stocks.

Private credit

Private debt funds, which hold loans that are not publicly traded, have been the fastest-growing asset class over the past decade. As the category matures, the differences between private debt and high-yield bonds are narrowing.

However, there is one big difference: private loans usually have a variable interest rate. The return goes up and down with the interest rate. In an environment of falling interest rates, holders are hit by falling interest rates. If spreads also rise, these funds, like high yield, are not reliable diversifiers.

I left convertibles, mortgages and preferred stocks for another day. In the meantime, I hope you’ll assess your fixed income investments with a keener eye. Be clear about their purpose and ask yourself if they are there to improve your returns or provide downside protection.