Default Risk Factor

A Focus on Fixed-Income: Four Tips to Managing Bonds

Default Risk Factor

Anyone who is keeping even a casual eye on financial headlines these days is aware that bond returns have been a moving target for a while now — at home and abroad. Indeed, the long-term impact of inflation and concerns about any volatility bouts in global fixed-income markets can drive an otherwise patient and disciplined investor to panic. 

A wealth of comprehensive research by leading academics and financial scientists warns against trying to outguess markets by timing moves in and out of stocks. At IFA, our investment committee has found a similar pattern in bonds. For our clients, this means we haven't been able to find a crystal ball clear enough to predict how quickly or forcefully fixed-income prices and yields — which typically move inversely — will rise over shorter timeframes.

We're not alone. In fact, the latest S&P SPIVA (S&P Indices Versus Active) Scorecard found most active bond fund managers have failed over an extended period to beat their respective benchmarks. As shown below, trying to time markets hasn't proven to be an effective long-term strategy for a majority of bond fund investors. 

Instead of expending valuable energy on perennial uncertainties, we've found a more practical approach to managing investment portfolios. Chiefly, we focus on maximizing the expected returns of a client's total holdings in stocks and bonds by taking advantage of the components that are most readily within our control.

Fortunately, we've been able to indentify a number of evidence-based strategies to guide our asset allocation process. (For a broader overview of how we select funds and manage portfolio risks, see our article: "Selecting Investments.") Below are four key principles our wealth advisors like to adopt when talking to investors about designing and implementing portfolios with bonds. 

#1: Invest According to a Sensible, Customized Plan

The fundamental principle driving our approach to fixed-income investing starts with us helping you to determine the most risk-appropriate allocation in your portfolio between stocks and bonds. As a result, we've created a Risk Capacity Survey, which can be taken online. 

Along these lines, IFA offers our clients a holistic financial plan on a complimentary basis. Such a personalized blueprint not only defines how much risk is really needed to achieve your financial goals, it also protects you against being prone to reacting to short-term bouts of market volatility. 

A key to developing a robust financial plan is creating an Investment Policy Statement. In a nutshell, a sound IPS outlines your plan's main objectives, investment goals and strategies. It also should include any restrictions and significant details that your advisor might need to know in order to implement and monitor your portfolio.  

In the absence of a plan, we've found over the years that investors tend to be less disciplined about staying attuned to factors they can control. Again, leading academics and market researchers caution us that trying to time markets in bonds is likely to prove as unsuccessful as in stocks. 

In fact, our experience working with a broad range of different clients over the years has brought us to an overriding conclusion: Combining a formal IPS with a comprehensive financial plan covering both stocks and bonds is a sound and practical way to increase the odds of achieving financial success over a lifetime. 

#2: Let the Evidence Be Your Guide

With a personalized plan and IPS in place, a good next step is to embrace the decades of empirical evidence that helps us understand the overarching roles for which each investment is best suited. Here is an overview of what our wealth advisors like to urge their clients to consider as core tenets of constructing a globally diversified and passively managed portfolio of index funds:

Stocks — Stocks are the most effective tool for those seeking to accumulate wealth over time. But along with higher expected returns, these types of assets also typically expose investors to a much bumpier ride (i.e., volatility). This requires investors to determine an appropriate level of portfolio volatility (i.e., market risk) to meet their longer-term financial goals.

Bonds — Bonds are a good tool for dampening that bumpier ride and serving as a safety net during periods of increased market volatility. These types of funds can also contribute modestly to a portfolio's overall expected returns. We don't, however, consider this to be the primary role of fixed-income in a risk-appropriate and well-diversified portfolio.

Cash — In the face of inflation, cash and cash equivalents are expected to actually lose buying power over the long haul. Cash, though, can be a great option to have on hand for near-term spending needs.

Below is a table summarizing the basic roles of these three fundamental types of assets in a globally diversified IFA Index Portfolio:

  Expected Long-Term Returns Highest Purpose
Stocks (Equity) Higher Building wealth & hedging against inflation
Bonds (Fixed Income) Lower Dampening volatility
Cash Negative (after inflation) Liquidity for short-term obligations

#3: 'Safety in Bonds' is a Relative Term

To further maintain your financial resolve in the face of complex and often conflicting news headlines about fixed-income, our asset-allocation process also takes into account another important factor of investing in such markets:

While bonds have historically exhibited lower volatility, such lower levels of market risk have typically translated into commensurate lower returns for IFA's clients.

It's also worth noting that owning a bond fund means you're investing in debt markets — basically, IOUs that are issued by companies and governments. As a result, bond funds do exhibit some volatility (as well as some market risk).

Since bonds represent a loan as opposed to an ownership stake, these funds are subject to two types of risks that don't apply to stocks:

  • Term premium Bonds with distant maturities (or due dates) are generally more volatile. So, these types of fixed-income instruments when held to maturity have typically returned more than bonds with shorter maturities. 
  • Credit premium — Bonds with lower credit ratings (such as "junk" bonds) are also riskier, and have greater expected returns than bonds with higher credit ratings (such as government bonds).

When reading bond market headlines about interest rates, yield curves, credit ratings and so on, these are the two risks and commensurate return expectations that are rising or falling along with the news. Understanding this basic element of fixed-income markets, you can be better armed to take any recent news — whether good or bad — with a grain of salt. After all, the levels of volatility and degrees of risk aren't likely to be as extreme as we'd expect to see over time investing in equity markets.

#4: Act on What You Can Control

So, where does all this leave you, the long-term investor who is diligently adhering to your carefully crafted strategy?

Here are some proactive steps you can take to appropriately position your fixed-income investing to withstand varied market conditions:

  • Are your fixed income holdings the right kind, structured according to your goals? Just as there are various kinds of stocks, there are various kinds of bonds, with different levels of risk and expected return. Since the main goal for fixed-income is to preserve wealth and dampen volatility in your overall portfolio, we typically recommend turning to high-quality, short- to medium-term bonds that appropriately manage the term and credit risks described above.
  • Are you keeping an eye on the costs? One of the most effective actions you can take across all your investments is to manage the costs involved. When investing in bond funds, this means keeping a sharp eye on the expense ratios and seeking relatively low-cost solutions. For individual bonds, it becomes especially important to be aware of opaque and potentially onerous "markup" and "markdown" costs. While these costs don't typically show up in the confirmation report from your custodian, these expenses are very real — and can detract significantly from your net returns.
  • Are your solutions the right ones for the job? Whether turning to individual bonds, bond funds or similarly structured solutions such as Certificates of Deposit (CDs), the fixed-income portion of your portfolio should serve to dampen volatility in line with your capacity to hold risk (i.e., risk capacity).

To achieve this delicate balance, it can make good sense to seek the assistance of an objective adviser to help you weigh your options, determine a sensible course for your needs and implement that course efficiently and cost-effectively. Your advisor also can help you revisit your plans whenever the markets or your own circumstances may cause you to question your resolve. Should you stay the course? Are updates warranted? It can help to have an experienced ally to advise and inform you before making your next moves.


This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.