Why investors must think more carefully about fixed income

Being able to select a single fixed income fund. Before pressing the set-it-and-forget button seems like a distant dream for investors right now. Instead, they have been urged to be more thoughtful. When it comes to their allocation, especially if they’re looking to eke out an income.

Brian D’Costa, the founding partner of Algonquin Capital, told WP that, just like The Rolling Stones sang, while you can’t get what you want from fixed income right now, you might just be able to get what you need.

That’s because, after years of “being spoiled” with returns, that portion of your portfolio is now under pressure, particularly when it comes to income, with some in the industry even declaring an “income famine”.

D’Costa remembers a time,

pre-Global Financial Crisis when you could get 5% by just owning a government five-year bond. Now, though, we are in an era where advisors need to “step back and really ask clients what they want out of fixed income”.

Primarily, he added, people want three attributes – safety (preservation of cash), diversification from equities, and income. Satisfying all three via one bond is no longer an option, so investors have to think carefully about what really matters to them and what their weighting is. Why? Because all three of these attributes now come with a negative attached.

If you have your money in a market product or a GIC, there is still some element of comfort; you’re not going to lose money. However, after taxes and inflation, it’s likely you’ll lose purchasing power.

If you want to diversify against equities. You can get some but you have to take on risk by owning longer duration sovereign debt. Like 10-year or 30-year bonds. D’Costa explained: “If interest rates go down, you will have a positive outcome, even from these current yields. If interest rates were to go down 50 basis points right now, 10-year bonds would probably generate a 4-5% return.

“That’s fantastic, but by the same token, if interest rates go up, you take a steeper loss. You can still get some hedging, it’s just not as clear cut and there’s a negative that comes with it.”

And then there is income. Getting 5-6% is just not realistic so the only way you get income is to invest in corporate securities. Whether that be investment-grade bond funds, high yield bond funds, or private debt.

But all this is just lending the money to less credit-worthy borrowers, warned D’Costa, so it comes with a risk of mark-to-market losses in your portfolio.

He said: “When you go to private debt securities, which a large number of people go to because they don’t mark to market, that creates an illusion of safety. But the reality is you are lending money to people that banks don’t lend to. Just because you don’t have market noise doesn’t mean you have less risk, you do face [the risk] of some permanent loss of capital.”

He added that if income is what a client wants. They have to take on some risk, and then it’s up to the advisor to work with them to identify. What their appetite for risk is.

“The other thing that comes out of this [income famine] is that it forces investors to consider an alternative and to think, ‘maybe I need to educate myself, maybe a small sleeve of private debt is what I should add to my portfolio, or maybe I should look at some of the liquid alternative fixed-income funds out there that are delivering slightly higher yields than traditional bonds’.

“It comes down to risk appetite. What am I willing to live with? Fixed income can still be a part of a portfolio but no longer just a single fund.”