As kids, we dream about eating an ice-cream-only diet forever. But as we mature, we understand the importance of a balanced diet. Flavor matters, but we learn to focus on the benefits food can provide to help enhance our overall health.
This benefit-focused mindset is also helpful for investors: Is my portfolio using the right ingredients to support my financial health?
If we think of a portfolio as a balanced meal, stocks (aka equities) generally act as the protein helping to grow your portfolio. But what about fats, which can help regulate your body, and carbohydrates, which provide energy? That’s where bonds (aka fixed income) can fill many important roles.
What Sets Fixed-Income Types Apart
While all fixed-income investments share some basic traits, they’re an investment type with many different flavors from which to choose. With so much variety, specific characteristics and roles can vary widely.
As we see it, there are two broad ways fixed income can serve investors. These include the potential to either reduce portfolio volatility (think fats) or generate income (think carbohydrates).
Potential Volatility Reducers (aka Fats)
Though dietary fats have gotten a bad rap, they’re necessary to support cell growth, help protect your organs, regulate your body temperature, and even absorb some nutrients.
In investing, you may need a cushion from equity-driven volatility. That’s a role that can be filled by high-quality bonds such as US Treasuries, municipal bonds, mortgage-backed securities, and global-government bonds.
These types of fixed income tend to behave differently than equities, which is why they can potentially offset volatility and add diversification (which does not ensure a profit or protect against a loss in a declining market) to your portfolio. However, these types of fixed income have historically offered lower yields than equities.
Income Generators (aka Carbohydrates)
When your body needs energy, it looks to carbohydrates. In your portfolio, rather than energy, think about where you source your income. This is where corporate bonds, global high-yield bonds, and emerging-market debt can help.
These bonds carry more risk because they tend to behave more like equities than say, a US Treasury bond. To compensate for added risk, these types of fixed income have tended to provide higher yields and a higher source of income.
FIGURE 1 compares how different types of fixed income have historically behaved in relation to equities (correlation) and their return (yield). Fixed income that’s less correlated to equities can offer diversification and help reduce overall portfolio volatility (bottom left circle), while fixed income that’s more correlated to equities has generally offered higher returns and can be a source of income (upper right circle).
