The role of fixed interest

When talking about investment portfolios with clients, many are reluctant to hold fixed interest (i.e. gilts and corporate bonds). They think that these are ‘boring’ and will add no value to the portfolio. This is not the case. It is our belief that all portfolios should hold an element of fixed interest, with most clients holding upwards of 25% in this asset class.

The table below illustrates simply the benefits of this type of diversification. It demonstrates that although the historic return is lower when the equity component of the portfolio is reduced, the volatility or risk is also dramatically reduced.

Risk and Return on Equity and Gilt Portfolios from Jan 1956 – Dec 2007

Data is based on UK Treasury Bills and the FSTE All-Share. The Portfolio Return is an annualised figure. All data kindly provided by Dimensional Fund Advisors. Past performance is not a guide to the future.

Standard deviation is a statistical measurement of risk. The table above shows that as the gilt proportion of the portfolios is increased, so the standard deviation falls – i.e. the risk is getting lower. What is particularly interesting is that when a 100% equity portfolio has as little as 25% exposure to gilts added, the return only suffers marginally, however, there is a dramatic reduction in risk. It is for this reason that most of our portfolios will hold at least 25% in fixed interest as mentioned earlier.

At Evolve, we believe the primary role of fixed income is to reduce the risk for clients. It also plays an important part in increasing the yield of portfolios, particularly in a period when dividend yields are at low levels. Given their role in risk reduction, we concentrate portfolios in investment grade securities rather than chasing a higher yield. However, an additional dimension to consider is the maturity of the bonds. Whilst most investors may be vaguely aware that long dated bonds are higher risk than short dated bonds, they tend not to realise that this risk is not compensated for by higher returns once maturity exceeds 5 years. The table below showing the returns of different maturity US bonds from 1964 – 2004 clearly illustrates this using standard deviation as a measure of risk.

For this reason, the largest part of the fixed interest element of a client’s portfolio with Evolve will be made up of short dated investment grade corporate and government bonds.  There will also be an element of longer dated bonds, but these will be in much smaller proportions.

In a similar way to the equity element of portfolios, we position the bond holdings in passive funds.  If fund managers could consistently predict the future direction of interest rate decisions, it may be possible to achieve higher returns, however, research from Blake, Elton and Gruber in 1993 titled “The Performance of Bond Mutual Funds” in the Journal of Business, showed that actively managed bond funds consistently underperformed their benchmark indexes.

The majority of our bond holdings are based on a variable maturity strategy.  This strategy buys bonds that have the least expected volatility (risk) given their expected return.  When the market (yield curve) is rewarding longer term instruments, the strategy will buy longer term bonds, and when the market favours shorter term debt, the strategy buys short term bonds.  This is not strictly speaking following a passive strategy as the portfolio does need to be traded to match the bond maturity to the yield curve.  However, what is significant is that no value decisions are made in managing the fund – the manager does what the yield curve dictates.