Fixed income has an important role to play in a well-diversified portfolio, even in today’s rising interest rate environment, according to a new report from Wells Fargo Investment Institute.
The report puts forward five characteristics of bonds it says investors should consider before they make changes to their bond holdings.
Investors should judge fixed income performance by considering total return, according to Wells Fargo.
It asserts that a well-diversified fixed income portfolio will continue to outpace cash alternatives. Moving from fixed income into cash alternatives may not be profitable in the long term.
Investors should keep in mind why fixed income is part of the asset allocation before they move into more aggressive securities, asking themselves whether such a move is within their risk tolerance.
Investors should think hard before reducing or eliminating an asset class because by doing so, they may assume more risk as their portfolio becomes more concentrated. They should also diversify among their fixed income positions, as relying too much on any one credit, sector or fixed income asset class can be detrimental, according to the firm.
The report points out that reallocating for potentially higher returns may mean an increase in volatility.
Bonds can mitigate volatility of returns when they are used properly as part of a diversified investment strategy. And a smoother ride means investors are likelier to stay invested in the markets, which Wells Fargo considers the best strategy.
But again, it is important to avoid holding a concentrated position in a single segment of the fixed income market because doing so can make portfolios more volatile.
Before choosing a bond investment that offers the highest yield, investors should think about the marginal benefit in moving out on the yield curve. The report notes that longer-term maturities are highly sensitive to interest rates, while staying too short on the yield curve provides little yield and return.
Wells Fargo recommends intermediate-term maturities that will generate some yield and avoid near-zero returns in shorter-term ones.
Investors should also keep in mind that if prices should spiral upward and cash flow remains the same, they may not be able to meet expenses.
Most fixed income investments uniquely enable investors to plan for specific cash needs. If they can anticipate when they will need cash for a big purchase, they can buy bonds with a maturity near the time they will need money. This can be an effective way to stay invested in the markets and still have some assurance that money will be available when needed, the report says.
The report cautions, however, that selling bonds before maturity — if a need to raise money suddenly arises — can be costly and result in big losses if the market moves against the seller.