Evaluating Fixed Income Through the Lens of Your Goals
-
The year 2020 saw stark differences in returns between fixed income categories—some of the largest in history.
-
This unprecedented return dispersion is a reminder that fixed income asset classes can behave very differently, so allocations should be tailored to an investor’s goals.
-
A one-size-fits-all approach to fixed income may lead to suboptimal results.
The first half of 2020 saw nearly unprecedented return dispersion across certain segments of fixed income. Globally, government bonds strongly outperformed corporate bonds in the first quarter. In particular, the spread in first-quarter returns between US Treasuries and US corporates was more than 11 percentage points, the largest quarterly return difference between the two in a sample going back a half century. Of course, the second quarter saw a sharp bounce-back for US credit, with US corporates outperforming US Treasuries by more than 7.7 percentage points. Historically, this represented the second-largest quarter of outperformance for US credit.
These outcomes are a reminder that fixed income asset classes can behave very differently, and that the choice of fixed income should be tailored to one’s specific needs and goals. This also implies that the framework for evaluating fixed income should be dictated by one’s goals. For example, the characteristics of a fixed income strategy that appeals to investors eyeing capital preservation may differ substantially from those of a strategy seeking to manage future cash flow liabilities. One’s investment goals should drive the evaluation process in fixed income investing. Three case studies illustrate this principle.
Class Action
Quarterly returns for US fixed income asset classes in 1H 2020
In USD. Performance data shown represents past performance and is no guarantee of future results.
A Holistic View of Fixed Income
For investors seeking return stability from their fixed income, a key part of the evaluation is their overall asset allocation. Components elsewhere in an investor’s portfolio may be a major determinant in how adding fixed income impacts asset allocation volatility.
Let’s take, for example, the decision of where to settle when it comes to duration and credit quality—how much exposure to longer-dated or lower-rated bonds should an investor pursue? As the top panel of Exhibit 2 illustrates, a global aggregate bond index holding a wide range of maturities and credits has had higher return variability than a shorter-term, higher-quality government bond index. Looking only at this data, an investor prioritizing return stability may view the government bond allocation as more appealing.
However, this sleeve of fixed income is unlikely to be the only component in an investor’s portfolio. Many investors may also hold stocks, and when held in meaningful proportions, equity components can often be the main driver of portfolio volatility. As a corollary, the impact on overall volatility from duration or credit exposure within fixed income can be less meaningful for portfolios with equity-heavy allocations. The bottom panel of Exhibit 2 helps illustrate this for two 60/40 stock/bond allocations. Return volatility is very similar, whether the fixed income allocation consists of short-term government bonds or a more core approach that holds a broader portion of the bond market.
What (Else) Is in Your Wallet?
Quarterly returns for allocations with fixed income, June 1994–June 2020
Performance data shown represents past performance and is no guarantee of future results. In USD.
Let’s Get Real
Some investors may prioritize preservation of purchasing power, or the amount of goods and services their savings can afford in the future. In this case, fixed income may be better evaluated through the lens of uncertainty in real, rather than nominal, returns. As Exhibit 3 highlights, inflation can substantially impact a fixed income portfolio’s growth of wealth in real terms.
Inflation Matters
Growth of a dollar for short-term US Treasuries, January 1976–December 2020
Past performance is no guarantee of future results.
Inflation-hedging assets such as Treasury Inflation-Protected Securities (TIPS) can help mitigate the impact of unexpected changes in inflation. A TIPS bond’s face value and subsequent interest payments are adjusted in response to changes in the Consumer Price Index (CPI). The result is TIPS holders get paid actual inflation—based on the increase or decrease in the CPI.
TIPS eliminate the inflation-related component from real return volatility. This can be observed in the returns for TIPS of various maturities shown in Exhibit 4—all have had lower volatility in real vs. nominal returns. In other words, TIPS have had lower uncertainty in units of the goal (real wealth) for investors focused on future purchasing power.
Real Deal
Annual returns for US TIPS indices, 2002–2020
Performance data shown represents past performance and is no guarantee of future results. In USD.
Another observation we can glean from these data is that the difference between nominal and real return volatility is relatively smaller for indices composed of longer-maturity TIPS. While inflation protection removes the inflation component of real return uncertainty, the component related to changes in real interest rates remains. Sensitivity to real rates increases with duration, and this source of variance is present whether returns are assessed in real or nominal units.
Whether an investor’s goal is real or nominal in nature, longer-duration bonds increase volatility in wealth units, or the value of an account balance. But what if progress toward the goal is not well specified in wealth terms?
Income Is the Outcome
Let’s say an investor’s goal is to prepare for retirement income. Supporting consumption in retirement requires funding a string of cash flows, which represents a future liability for this investor. Risk management in this scenario can mean reducing the uncertainty around the amount of future income that can be drawn from the investor’s current savings. Consequently, the risk-mitigating asset for this goal can be a portfolio of assets whose value changes commensurately with the cost of funding future income.
Exhibit 5 illustrates the role this plays in the evaluation of fixed income. When viewed in wealth terms, representing the magnitude of fluctuation in one’s account balance, One-Month US Treasury Bill (T-bill) returns have been very stable. For investors prioritizing capital preservation, this is an appealing characteristic.
A different story emerges when evaluating T-bills through the lens of supporting future liabilities. Since the goal is to reduce the uncertainty of meeting these liabilities, a more sensible metric may be the volatility of returns in income units (the amount of income that can be drawn in the future), scaling the T-bill returns by changes in the price of an income stream sustainable for 25 years of retirement. Income unit returns are much more volatile for T-bills. Because the duration of T-bills is far shorter than that of the liability, T-bill returns cannot keep up with changes in the value of the liability. The result can be substantial uncertainty related to how much one’s current savings can support in terms of consumption during the retirement period if invested in T-bills. So, what one investor might consider a low-risk asset may pose considerable risk to another investor with different goals.
Earnings Estimates
Monthly returns for one-month US Treasury bill in wealth units vs. income units, January 2003–January 2021
Past performance is not a guarantee of future results. Actual returns may be lower.
If the Shoe Fits
The year 2020 provided all sorts of unsolicited reminders about the importance of various investment principles, from sticking to an investment approach to maintaining a disciplined focus on value. Global bond markets were no exception, as the extreme return deviations among different segments of fixed income reminded us that fixed income allocations should be matched to the investor’s particular goal. As with clothing, a one-size-fits-all approach to fixed income may lead to suboptimal results. To that end, it’s important for an investor’s goals to play a central role in how fixed income choices are evaluated. After all, one person’s fashion statement is another person’s faux pas.
Learn More
glossary
Nominal Return: The rate of return on an investment without adjusting for inflation.
Real Return: The rate of return on an investment after adjusting for inflation.
Disclosures
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
CANADA: These materials have been prepared by Dimensional Fund Advisors Canada ULC. They are provided for educational purposes only, should not be construed as investment advice or an offer of any security for sale and do not represent a recommendation of any particular security, strategy or investment product. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.
This material is not intended for Quebec residents.
AUSTRALIA: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Investors should also consider the Product Disclosure Statement (PDS) and the target market determination (TMD) that has been made for each financial product either issued or distributed by DFA Australia Limited prior to acquiring or continuing to hold any investment. Go to dimensional.com/funds to access a copy of the PDS or the relevant TMD. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.
NEW ZEALAND: This material is issued by DFA Australia Limited (incorporated in Australia, AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. This material does not give any recommendation or opinion to acquire any financial product or any financial advice product, and is not financial advice to you or any other person. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Investors should also consider the Product Disclosure Statement (PDS) and for the Dimensional Wholesale Trusts the target market determination (TMD) that has been made for each financial product or financial advice product either issued or distributed by DFA Australia Limited prior to acquiring or continuing to hold any investment. Go to dimensional.com/funds to access a copy of the PDS or the relevant TMD. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.
WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED OR DIMENSIONAL FUND ADVISORS LTD.
Neither Dimensional Ireland Limited (Dimensional Ireland) nor Dimensional Fund Advisors Ltd. (Dimensional UK), as applicable (each an “Issuing Entity,” as the context requires), give financial advice. You are responsible for deciding whether an investment is suitable for your personal circumstances, and we recommend that a financial adviser helps you with that decision.
NOTICE TO INVESTORS IN SWITZERLAND: This is an advertising document.
WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED
Issued by Dimensional Ireland Limited (Dimensional Ireland), with registered office 3 Dublin Landings, North Wall Quay, Dublin 1, Ireland. Dimensional Ireland is regulated by the Central Bank of Ireland (Registration No. C185067). Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional Ireland to be reliable, and Dimensional Ireland has reasonable grounds to believe that all factual information herein is true as at the date of this document.
Dimensional Ireland issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from Dimensional Ireland will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.
WHERE ISSUED BY DIMENSIONAL FUND ADVISORS LTD.
Issued by Dimensional Fund Advisors Ltd. (Dimensional UK), 20 Triton Street, Regent’s Place, London, NW1 3BF. Dimensional UK is authorised and regulated by the Financial Conduct Authority (FCA). Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional UK to be reliable, and Dimensional UK has reasonable grounds to believe that all factual information herein is true as at the date of this document.
Dimensional UK issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from Dimensional UK will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.
RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
JAPAN: Provided for institutional investors only. This document is deemed to be issued by Dimensional Japan Ltd., which is regulated by the Financial Services Agency of Japan and is registered as a Financial Instruments Firm conducting Investment Management Business and Investment Advisory and Agency Business. This material is solely for informational purposes only and shall not constitute an offer to sell or the solicitation to buy securities or enter into investment advisory contracts. The material in this article and any content contained herein may not be reproduced, copied, modified, transferred, disclosed, or used in any way not expressly permitted by Dimensional Japan Ltd. in writing. All expressions of opinion are subject to change without notice.
Dimensional Japan Ltd.
Director of Kanto Local Finance Bureau (FIBO) No. 2683
Membership: Japan Investment Advisers Association
FOR PROFESSIONAL INVESTORS IN HONG KONG.
This material is deemed to be issued by Dimensional Hong Kong Limited (CE No. BJE760) (“Dimensional Hong Kong”), which is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
This material should only be provided to “professional investors” (as defined in the Securities and Futures Ordinance [Chapter 571 of the Laws of Hong Kong] and its subsidiary legislation) and is not for use with the public. This material is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence, or otherwise) the publication or availability of this material are prohibited or which would subject Dimensional Hong Kong (including its affiliates) or any of Dimensional Hong Kong’s products or services to any registration, licensing, or other such legal requirements within such jurisdiction or country. When provided to prospective investors, this material forms part of, and must be provided together with, applicable fund offering materials. This material must not be provided to prospective investors on a standalone basis. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice.
Unauthorized copying, reproducing, duplicating, or transmitting of this material are prohibited. This material and the distribution of this material are not intended to constitute and do not constitute an offer or an invitation to offer to the Hong Kong public to acquire, dispose of, subscribe for, or underwrite any securities, structured products, or related financial products or instruments nor investment advice thereto. Any opinions and views expressed herein are subject to change. Neither Dimensional Hong Kong nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors. Financial advisors in Hong Kong shall not actively market the services of Dimensional Hong Kong or its affiliates to the Hong Kong public.
SINGAPORE
This material is deemed to be issued by Dimensional Fund Advisors Pte. Ltd., which is regulated by the Monetary Authority of Singapore and holds a capital markets services license for fund management.
This advertisement has not been reviewed by the Monetary Authority of Singapore. This information should not be considered investment advice or an offer of any security for sale. All information is given in good faith without any warranty and is not intended to provide professional, investment, or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation, or needs of individual recipients. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional Fund Advisors Pte. Ltd. does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. Neither Dimensional Fund Advisors Pte. Ltd. nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors.