Making Fixed Income More Flexible When Targeting Your Goals

Fixed income can serve many roles in a portfolio to help investors achieve their goals. For example, adding fixed income to an equity portfolio is one of the most effective tools to balance the expected volatility and return of the total portfolio.

But once an investor determines the appropriate amount of fixed income for their portfolio, what should comprise that fixed income allocation? The answer depends on an investor’s goal.

The composition of the fixed income allocation needs to be evaluated in light of the overall portfolio characteristics and be consistent with the investor’s goal, whether it’s capital appreciation or capital preservation.

Decades of academic research show there are two predominant sources of higher expected returns in fixed income: term and credit premiums.¹ On average, bonds with a longer duration provide greater exposure to the term premium, and those with lower credit quality provide more exposure to the credit premium. Thus, allocations to such bonds may be appropriate for investors seeking capital appreciation.

Indeed, annualized returns have been higher for intermediate government and credit bonds (longer duration, lower credit quality) than for short-term government bonds (shorter duration, higher credit quality) over the last three decades (see Exhibit 1). 

While realized returns were higher for intermediate government and credit bonds, so was volatility (3.25% vs. 1.26%).

An allocation to fixed income can help dampen overall portfolio volatility even if that allocation is not exclusively to short-duration, high-credit-quality bonds.

In portfolios with a heavy weight in equity, allocating to longer-duration and lower-credit-quality bonds can result in a similar reduction in overall portfolio volatility when compared to a more conservative fixed income allocation while maintaining the ability to pursue higher expected returns.

We illustrate this with an example in Exhibit 2, which compares the impact of allocating 20% or 80% of an all-equity portfolio to shorter-duration, higher-credit-quality bonds (more conservative) vs. longer-duration, lower-credit-quality bonds (more aggressive).

For the 20% equity/80% fixed income (20/80) allocations, introducing fixed income meaningfully dampens overall portfolio volatility compared to the 100% equity allocation. Yet, the overall impact depends on the makeup of the fixed income component. Introducing the more conservative fixed income allocation (column A) drives down overall portfolio volatility from 15.40% in the 100/0 allocation to 3.20% in the 20/80, a reduction of 12.21 percentage points.

The more aggressive 20/80 allocation (column B) results in a reduction of overall portfolio volatility relative to the 100/0 allocation of 11.08 percentage points, from 15.40% to 4.33%.

While the more aggressive 20/80 allocation produces a higher annualized return than the more conservative allocation (5.71% vs. 4.56%), it comes at the cost of an increase in standard deviation of over 35% (4.33% compared to 3.20%). This tradeoff of higher return for much higher relative volatility is likely not suitable for a conservative investor with a lower risk tolerance.

On the flip side, the relative impact on volatility is more muted when comparing the more aggressive and more conservative approaches within the equity-heavy 80/20 allocations. Compared to the 100/0 allocation, overall portfolio volatility falls by about 3 percentage points in both the more conservative (column C) and more aggressive (column D) 80/20 allocations. Indeed, the increase in standard deviation from the more conservative allocation to the more aggressive allocation is marginal (12.31% vs. 12.44%).

Within equity-heavy allocations, the volatility of the equity component dominates overall portfolio volatility. As a result, allocating to longer-duration and lower-credit-quality bonds does not lead to a material increase in volatility compared to an allocation composed of shorter-duration, higher-credit-quality bonds.

A more aggressive approach in the 80/20 allocation also comes with an almost 30 basis point increase in annualized return relative to the more conservative fixed income allocation (6.81% vs. 6.52%). This increase aligns with the wealth-growth goal of investors holding equity-heavy portfolios without giving up the volatility reduction that comes from an allocation to fixed income.

Exhibit 3 provides a closer look at the impact on return volatility of taking on more term and credit exposure by comparing quarterly returns from January 1990 to December 2022 for shorter-duration, higher-credit-quality bonds and longer-duration, lower-credit-quality bonds in a fixed-income-heavy 20/80 allocation (Panel A) and in an equity-heavy 80/20 allocation (Panel B). In Panel A, the difference in return volatility between holding shorter-duration, higher-credit-quality bonds (blue) and longer-duration, lower-credit-quality bonds (teal) is clearly visible, with the latter exhibiting larger changes in returns over time. In Panel B, however, the difference in return volatility largely vanishes when incorporating these fixed income investments into an 80/20 allocation.

For both 80/20 allocations, the volatility of the equity component is the driving factor in overall portfolio volatility.

To further explore how an investor’s experience in the two equity-heavy 80/20 portfolios shown in Exhibits 2 and 3 may have differed over time, Exhibit 4 presents the average, best, and worst compound rolling one-year, three-year, and five-year returns (Panel A) and maximum drawdown (Panel B) from 1990 through 2022. For brevity, we label the 80/20 allocation with shorter-duration, higher-credit-quality bonds the traditional approach, because a traditional approach may hold a conservative fixed income allocation regardless of an investor’s goal. We label the 80/20 allocation with longer-duration, lower-credit-quality bonds the holistic approach, because a holistic approach instead holds fixed income securities that align with investor goals. Across all time horizons, the average and best performances of the holistic 80/20 allocation are better than those of the traditional 80/20 allocation.

For example, the average rolling five-year return of the holistic allocation was 47.55%, exceeding the average of 45.02% for the traditional allocation. More interestingly, the worst return of the holistic allocation was also better (in other words, less negative) than that of the traditional allocation over both three-year and five-year periods.²

Another aspect of risk to consider is potential drawdown and length of time it may take to recover lost assets. In Panel B, the maximum drawdowns for the two asset allocations were virtually identical—a loss of about 45% over the 16-month period ending February 2009.

These results—a generally better upside and similar downsides for the holistic allocation relative to the traditional allocation—indicate that an investor seeking higher expected returns would have been better off in the holistic allocation in most instances.

Some investors may question the prudence of allocating to the full spectrum of investment-grade bonds in an equity-heavy portfolio because conventional wisdom says that the correlation between bonds and stocks of the same company is high. Recent research by Dimensional, however, shows that the cross-sectional average correlation was low between investment-grade bonds and stocks of the same company across eligible issuers from 2001 to 2020.

As a result, adding investment-grade corporates in a multi-asset framework is not equivalent to doubling down on equities. It can actually help target higher returns without significantly increasing portfolio volatility.³

A holistic approach to asset allocation that varies the composition of the fixed income allocation based on overall portfolio characteristics may help investors better achieve their goals than a traditional approach that treats the composition of fixed income in a portfolio as fixed regardless of an investor’s goal.

Dimensional’s holistic approach to asset allocation is based on decades of experience in building and providing multi-asset solutions to clients across a variety of areas, including funds of funds, target date income funds, and model portfolios.⁴

Our approach starts with defining an investment goal and identifying the key risks relevant to this goal. Then we build solutions that aim to help investors achieve their goals by systematically pursuing reliable sources of higher expected returns while managing risks and costs efficiently.