Like so many advisors and investors, we struggle daily with the low interest environment and the search for returns in the fixed income portion of portfolios. The reason people own fixed income historically is to reduce the volatility of their investment portfolio while generating some income. This is a challenge in the current environment, where most advisors and investors assume that interest rates will rise and owning long term bonds will not be a good strategy.

Like many others, we at Capstone have decided to take on more credit risk (i.e. lending money to lower rated borrowers) but keep the duration of loans as short as possible. The idea is to enhance the income generated but try at the same time to avoid the risks of rising interest rates as much as possible. We are in an environment of low defaults on debt, so this idea has been working pretty well. These investments did much better in 2013 than long term US Treasuries or similar long term fixed income investments.

However, advisors and investors need to have their eyes open and recognize the risks that they are taking on in their portfolio. Riskier bonds correlate to equity markets far more than do US Treasuries. In 2008, while your stocks were dropping like a rock, US Treasuries were soaring in value. Remember, one of the primary reasons you own fixed income is to reduce volatility and US Treasuries did just that in 2008. Meanwhile, high yield bonds (i.e. those with low credit ratings) dropped 30% from September of 2008 into December of 2008! It seems to us that people are now flocking into higher yield bonds without any recognition of the danger that chasing yields can produce. You get the yield, you protect yourself from rising interest rates, but… give up some of the benefits of owning ”safe” investments. Your portfolio loses some of its diversification and that can come back to haunt you at any time. We fear that many investors and advisors are looking at these assets through rose tinted glasses (how they have performed from 2009 through the present). They have done well, including in 2013, at the same time that equities have performed well. What you are choosing to own does not have a history of being a safe investment in times of crisis. What you are giving up is significant and should be understood by you prior to making the decision to move down the credit quality scale in fixed income.

By Ted Schwartz, CFP©