• Brian Bass

Rethinking Your Fixed Income Portfolio

The tragic incident this week involving Tiger Woods got me thinking about how our vehicles function very much like our investment portfolios. If you didn’t hear, Woods was involved in a rollover accident in an SUV which led to emergency surgeries and has left his golf career in jeopardy. The question now is whether the safety systems of the vehicle saved his life, or was the SUV not designed well enough for the type of driving it was pushed to do.



Interest rates around the world are at or near all-time lows. Many real rates are negative. The consensus from the Federal Reserve is that they are more than willing to entertain the idea of running the economy hot to create inflation. None of this is sexy for fixed income investors, especially those who desperately need to create yield for their retirement income. I’ll discuss three ideas that I’m using to provide some protections around fixed income exposure.


With fixed income doing very little for us, we need to think outside the box to find a source of return that has a risk profile similar to bonds.

What Purpose Do Bonds Serve?


As a primer for this discussion, I think it makes sense to discuss the purpose of owning bonds in a portfolio. At a high level, fixed income serves two basic purposes. First, (most) bonds produce income. In the past, it was possible to create significant cash flow by owning very liquid, very safe bonds. Second, fixed income is historically less volatile than stocks. In fact, Treasury prices have tended to move in the opposite direction of stocks, providing capital protection when stocks sell off.


When we step back and evaluate those two characteristics against today’s market conditions, we see that only one of them is still relevant. While bonds still produce income, the cost to purchase that income takes the total return near or below zero in most cases. Through that lens, the only real case for owning bonds right now is to provide ballast for the portfolio. I argue that there are better ways.


Ballast During the Working Years


The ability to earn an income is our biggest asset during your working years. Almost all of our decisions revolve around managing cash flows to support our current lifestyle while also keeping an eye on retirement. During this time, investment portfolios typically don’t need to be designed to generate a large amount of income. With fixed income doing very little for us, we need to think outside the box to find a source of return that has a risk profile similar to bonds.


Life Insurance


One way to approach this problem is to examine permanent life insurance. A whole life insurance policy, for example, offers a guaranteed rate of return on its cash value. When you think about the mechanics, this source of return is exactly what fixed income is supposed to do. It’s completely uncorrelated to the equity markets and is guaranteed by the insurance company to be there when you need it. While the main purpose of these policies is life insurance, the cash value piece is a great benefit for an outside-the-box approach.


Fixed Indexed Annuity


Another option to consider is a fixed-indexed annuity. These insurance contracts offer a minimum rate of return on the principal value while also offering some level of upside potential by linking to an investment portfolio. The idea here is to protect principal by using the guarantees of the insurance company while collecting a modest return. While there are some nuances to consider, this type of annuity can be a great way to replicate the returns of fixed income without the risk to principal.


Ballast During Retirement


Balancing a portfolio during retirement requires a very different approach than the one used during the working years. When we begin withdrawing funds from a portfolio, we change the dynamics of how the assets perform. In a perfect world, bonds would create a significant portion of the income need and the equity piece of the portfolio would serve to supplement for the remainder. Now, unless the portfolio is extremely large, the income that we can source from bonds simply does not move the needle. How, then, do we allocate the fixed income piece to take the most pressure off the growth engine (stocks)?


Income Annuities


Another take on an insurance approach is the income annuity. By annuitizing a piece of the bond portfolio, we can create a stream of cash flows that is immune to most of the risks we assume in traditional fixed income investments. In the case of a single premium immediate annuity (SPIA), the insurance company would take a lump sum payment in return for the promise to pay a set amount of income for the remainder of your life. This payment consists of a piece of your principal, a return on your investment, and what’s known as a mortality credit. When compared to bonds in a vacuum, these annuities can offer a higher rate of return through a vehicle that is completely unaffected by market price fluctuations.


The Bottom Line


Product implementation is the key to creating an efficient portfolio that meets current needs and is flexible enough to transition into the retirement portfolio over time. Remember, stocks are the engine in the car and the fixed income is the safety system. Having efficient protections and understanding when and how they work can make a huge difference in your investment experience.


Although it is possible to have guaranteed income for life with a fixed annuity, there is no assurance that this income will keep up with inflation. There is a surrender charge imposed generally during the first 5 to 7 years or during the rate guarantee period. Guarantees are based on the claims paying ability of the issuer.