We believe that every portfolio needs an anchor to provide stability. Historically, high grade fixed income has been one of the few, if not only, asset classes to offset value declines in risk assets such as equities and equity-like investments. The primary purpose of fixed income should be protection, not income. Experience shows us that when the quality of the fixed income portfolio is reduced, typically to increase yield, protection can be severely reduced. Fixed income strategies emphasizing high yield and lower quality with their equity like risk characteristics are better left to compete with risk assets in the allocation process. In addition, interest sensitivity should be targeted to an intermediate duration allowing for dynamic adjustments to enhance stability. For most clients long duration strategies are too volatile.
Secondly, fixed income should provide liquidity. When your risk assets are down you will want to use your fixed income portfolio to provide for needed cash flows and opportunistic allocation to undervalued investments, eliminating the need to sell risk assets at a loss.
We focus on the total return of the fixed income strategy. This includes the yield but also capital appreciation. In fact, capital appreciation can be more dominant than yield in a high quality fixed portfolio when risk assets are declining, thus helping to offset losses in the risk portfolio. This is an important point in light of a low interest rate environment.
In the past some in the industry have deemphasized the role of high quality fixed income and have tried a basket of believed-to-be-non-correlating assets to provide stability only to find disappointment. Often termed the “Yale Model experience”, this experience only further verifies the need for high quality fixed income.
This is why our search process is focused on intermediate fixed income strategies for fixed income allocation. Fixed income should emphasize the return of capital rather than the return on capital.
Timothy J. Vos, CIMA®, AIFA®
Vice Charman & Director of Research
Released: February 15th, 2012 04:18 PM