Effective fixed-income diversification matters

The challenge

Fixed-income investments can help dampen portfolio volatility, preserve capital, reduce risk and generate income. However, investors are struggling to achieve acceptable bond returns in today’s low-yield environment, making it crucial to reposition your portfolio to capture as much income as possible now, while also being prepared for the eventuality of rising rates.

Fixed-income diversification is key – what leads the market one year may not the next year

Diversification, often considered to be the cornerstone of investing, is just as important within a fixed-income portfolio as it is in an equity portfolio. One of the ways you can diversify is by duration, meaning the length of time before the bond reaches its maturity date. Longer-term bonds can provide higher yields but are more susceptible to the risk of rising interest rates, while shorter-term bonds provide low yields in a low-rate environment but aren’t as impacted when rates rise. When you diversify effectively, you won’t leave your fixed-income portfolio unnecessarily exposed to a single risk.

Multiple options to choose from

There are a number of options within the fixed-income asset class that can provide investors with potentially higher yields without sacrificing credit quality, offer diversification benefits and safeguard against the impact of rising interest rates.

Corporate bonds. Investing in investment-grade corporate bonds (meaning corporate bonds that are rated as having a low risk of default) can provide higher yields than government bonds. Furthermore, default rates through an economic cycle have generally been very low. Corporate bonds, therefore, provide higher returns (higher coupons) with minimal added risk. While investment-grade credit has advantages, it does not usually provide much protection against interest rate movements.

Convertible bonds. With their built-in option to convert to a company’s underlying stock, convertible bonds are a hybrid solution providing the defence of bonds with the upside potential of equities. In fact, no other fixedincome solution has as much upside potential.

Floating-rate loans. Floating-rate loans are attractive when interest rates are expected to rise because, as rates move higher, the bond’s coupon also increases.

High-yield bonds. High-yield bonds offer much higher coupons than investment-grade bonds and are less ratesensitive since their performance is driven more by the underlying company’s health than interest rate movements. Keep in mind, though, that high-yield also entails greater risk than investment grade.

Inflation-linked bonds. Known in Canada as real return bonds, these securities can outperform regular bonds if the rate of inflation increases. Again, this strategy has been challenging to get right consistently and can be quite volatile given the long duration (i.e., higher sensitivity to interest rate changes) of most bonds in this category.

Emerging market bonds. Emerging market bonds have appealing characteristics (e.g., higher yields, lower correlation to developed-market government bonds) similar to those of high-yield bonds. Today, the emerging market debt market has grown into a mainstream asset class, boasting higher credit quality with greater depth and liquidity than in the past. Currency movements are a consideration with emerging market bonds, as changes in foreign currency values relative to the Canadian dollar can add or take away from returns.