The beauty of fixed income in a volatile equity market

This is a guest post by Aditya Veera. Aditya has studied and worked in finance, but this is the first article on investment he has written. Hopefully it is not the last. He holds an MSc from the London School of Economics and has an evangelical fervour for low-fee, passive investments! You can find his other posts at adityaveera.wordpress.com

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Dear readers, when Mr. Pattu asked me to write a guest post, I puzzled over the topic. I wanted it to be something that summarized a good investment strategy without boring readers who dislike technical discussions. While money management is a universal need, the subject itself is not universally appealing. Happily, that is not an impediment to successful investing. The steps involved in good investing are simple, even if we can endlessly debate why they work and whether they will continue to work. I will discuss fixed income and break down its use to simple steps and objectives. For those who like reading just the key points, I have inserted cues in bold to highlight their importance.

The first step is to recognize what the asset class is, and what objective it serves in a portfolio. Debt funds belong to the fixed income asset class, and the purpose is to obtain safe returns that don’t fluctuate as much as equity, and are as high as possible after tax compared to similar options. Safety does not mean zero risk; a financial cataclysm, a global war, hyperinflation or a dictatorial government that refuses to honor its commitments are all credible destroyers of the value of debt funds. But more routine and less drastic negative events, which we are likely to encounter every decade, such as slowdowns, fiscal and current account deficits, as long as they remain within reasonable bounds, cannot erode the value of fixed income significantly.

There is a second function of fixed income. Fixed income reduces the volatility of your overall portfolio, while maintaining similar returns. That is, your total wealth will achieve the same return with less risk if it has a (small) share allocated to fixed income, than if it is allocated 100% to equity, in the long-term. This happens because there are periods where equity will do badly, and the historical tendency is that fixed income does better in those periods. You may be skeptical, given the recent losses of fixed income, but please note that relative 1 month or 3 month declines are not necessarily absolute losses to invested capital. Moreover, it is not high return that is promised as much as better return than equity in crisis periods. Such patterns have recurred repeatedly in history. This is imperfect correlation; assets that don’t move together perfectly are good for our portfolio. When one is doing badly, the other does better, and vice versa, thus ‘smoothing’ returns and reducing risk. That is why we add gold, real estate, small business stakes and fixed income to our equity portfolio, despite knowing that almost all of these will underperform equity in the long-term. This is why diversification works.

Imperfect correlation, combined with volatility, presents an interesting opportunity. If asset A is higher when asset B is lower, and this happens repeatedly, we can follow a simple rule of selling A to buy B, and selling B to buy A. But how would we know when to sell A or B? The simplest and most universal answer is: by sticking to portfolio allocation. Even the most conservative investor will have some equity in their portfolio, say 20%. If fixed income constitutes 80% of the portfolio at the time of investment, there will come a time when equity makes losses, so that fixed income is 90% of total wealth. That is the time to sell fixed income and buy equity, until we hit the 80-20 allocation again. This process is called rebalancing, and it is the most passive, automated, unemotional and safe way to ‘time’ your entry and exit in any asset. For first time investors, for those who have not yet reached their target asset allocation, this is not a good guide of when to invest, but for those who have, you don’t need to do anything more than rebalance. It is because of rebalancing that fixed income is able to make a portfolio safer without drastically reducing its return, despite having a much lower return than equity over long periods. If there is only one concept in this post a beginner investor is willing to explore, let it be rebalancing.

Sometimes our portfolios can get a little skewed
Sometimes our portfolios can get a little skewed

Now that we agree on the role of fixed income in a long-term portfolio, we can further increase its efficacy by choosing types of fixed income that match our use of it. There are many types of fixed income. I will not get into details, as you do not need most of them unless your use of fixed income is different from what I have outlined. In debt funds, categories include liquid, ultra short-term, floating, short-term and medium/long-term. These are plain vanilla categories i.e. the fund manager has to invest as per the category. For example, liquid funds will invest in debt instruments which mature in 30-90 days or less. Ultra short-term funds will typically invest in maturities of 1 year or less, while short-term funds will restrict their bets to maturities less than 3 years. Medium and long-term funds are allowed to invest in maturities ranging from 5 years to 10 years. While most funds take an ‘active’ view, that is, they choose the maturities they believe will perform best in the economic scenario, they are not supposed to deviate wildly from the category they’re in. The exception to this is the category of ‘income funds’ where the fund manager is allowed to invest across all categories of fixed income. I advocate plain vanilla, low expense ratio alternatives with above average performance in their category over active, mixed category options.

Since our use of fixed income is as an asset that is not fully correlated with equity, we must ask: which categories of fixed income are least volatile, compared to equity, which is highly volatile? The answer would be debt instruments with shorter maturities. These are safer, and thus carry slightly lower interest rates (yields) with lower volatility. You can reliably count on them doing better than equity when the latter is crashing down. So this would be, in order of least interest-rate risk, liquid, floating, ultra short-term and short-term, constituting the ‘short’ end of the yield spectrum, with medium and long-term funds constituting the ‘long’ end of the yield spectrum. I make the case that any investor who wishes to use fixed income to rebalance to equities should stay at the short end. You don’t sacrifice much return – say 1.5% per annum, with far lower volatility. Every time equity dips, we will sell a little of our debt fund holdings and buy equity. You cannot do that with as much comfort if your debt fund holdings are volatile, as they would be if you tried to maximize yield by buying only long-term funds. A scenario where your debt funds have lost 5% while equity funds have lost 15% is not attractive, and doesn’t allow for as much money to flow to equity as a scenario where debt funds gain 5% while equity loses 15%.

So we will be faithfully rebalancing both asset classes (fixed income, equity and gold) and the categories within each asset class. To do this, we should go one step further than asset allocation and assign an allocation to each category. For fixed income, if you accept my view that one should be at the short end of the yield curve, you could allocate 10% of your fixed income portfolio to liquid funds, 40% to floating rate funds*, 12.5% to ultra short-term funds, 12.5% to short-term funds and 25% to medium and long-term funds. I like floating rate funds because one of the major causes of equity volatility is movement in interest rates, and floating rate funds do well when interest rates rise, thus creating the imperfect correlation we love to see. The final allocation is about 60-40 fixed to floating, and 75-25 short-term to long-term. The idea is to allow 25% of our fixed income portfolio to earn higher yield, while 75% is available for our rebalancing needs. There is a significant benefit to rebalancing towards category allocations: you will buy the long-end cheap and sell it high. So during a year when long-end funds hit 30% of your fixed income portfolio, you will sell to the point that they are at 25% again, and use the funds to buy the short-end categories. Buying low and selling high is possible even in fixed income because bond markets are susceptible to sentiment just as equity markets are, thus overshooting and overreacting to fundamental economic data.

Rebalancing can breathe new life into the laggards in your portfolio. Copyright: StandUPP flickr
Rebalancing can breathe new life into the laggards in your portfolio. Copyright: StandUPP flickr

Why only rebalance from 30% to 25%? Why not go even lower if you’re sure that the long-end is hitting a high? That is indeed what great tactical investors have done. Such is their confidence in being able to tell the market is overpricing or underpricing assets that they have spent long periods with more than 90% in a single, low-return asset, waiting for a moment of rock-bottom equity prices to invest heavily, thus making massive fortunes. But I am assuming that most of us lack this ability, not just in terms of reading markets but also in terms of emotional temperament. We need not exacerbate our daily tensions by spending 20 years in a no-load liquid fund waiting for the PE ratio of the best Indian companies to hit 5. Your asset allocations and category allocations have a logic that suits your investment objectives and goals. By sticking to those allocations, you are ensuring you never step out of the bounds of risk and return upside you set yourself, but nevertheless take advantage of the sentiment-based opportunities that come your way. You accept moderate, safe returns over the extraordinary returns that breaking your asset allocation could get you, because that could also result in extraordinary losses.

As Warren Buffet points out, Mr. Market is ready to buy and sell at wildly different prices every day. It cannot be that the true value of securities changes so drastically every day. When everybody is telling you not to buy long-term gilts, and stay with short or ultra-short, that is usually the time to buy gilts. When everybody says buying equity is a bad idea, and fixed income is the way to go, that is the time to sell across debt funds and buy across equity categories. Rebalancing periodically gives you the best chance of doing this without needing to perform tedious calculations or read the business news. Ultimately, when you rebalance a portfolio which has hit 90% equity, 10% fixed income, to 75% equity, 25% fixed income (or whatever your asset allocation), you are broadening the fixed income base of your wealth, while allowing equity upside to remain to the extent of rational asset allocation. The result is a huge inflow into a safe, stable base of retirement spending. You are locking in the high, bubble valuations of equity into permanent wealth, and that is saying a lot because most investors let those profit booking opportunities pass them by. In the long run, the primary source of the growth of your fixed income portfolio is not yield, but rebalancing from equity. The use of the phrase ‘long-run’ introduces a caveat: those closer to retirement should limit rebalancing from fixed income to equity with a floor fixed income value. If I were a retired 70 year old today, I would not want my fixed income to go below 50 lakhs, regardless of how much sentiment has battered equity markets.

Thankfully, portfolio rebalancing is a lot easier than what they’re doing! Copyright: Alaskan Dude Flickr
Thankfully, portfolio rebalancing is a lot easier than what they’re doing! Copyright: Alaskan Dude Flickr

Won’t taxes and brokerage eat into returns if I keep rebalancing? This is a valid concern, for keeping fees and taxes low is of tremendous importance to long-term returns. There are two ways to conquer the objections. The first is to rebalance annually, say every 1 year and 5 days. This will safely ensure that your gains are subject to long-term tax rates, which are currently zero for equity, and post-indexation for debt. Having said that, I believe the world is entering a prolonged phase of volatility, as is inevitable in the aftermath of great structural changes in the economy, and therefore, you might also want to consider ‘band-based rebalancing’. Suppose you feel a 10% pre-brokerage gain is worth rebalancing in terms of time and effort. Then if you are taxed at 30%, you require a 14% movement in equity prices to consider rebalancing. If equity asset allocation is 75%, you will not rebalance until equity goes below 64.5% of total wealth or above 85.5% of total wealth. This is a philosophy of ‘look more often, and rebalance less’ as these thresholds could be hit any moment, but the gains are much greater because you are saving yourself the effort of rebalancing for times of greatest impact. Advocates of this method suggest you rebalance to the closest end of the band; i.e. if equity has hit 50% of total wealth, you would rebalance from fixed income to equity until 64.5% of total wealth. Presumably they say this so that you ride the lows of the bear market and fully capture the downside when you buy. I suggest that it is not so important which method you follow as long as you do rebalance, and track asset and category allocation diligently. In my view, it is not the perfect application of a few investment principles but a steady, rough application of all the important principles that makes for good, safe returns.

This has been a long discussion. There is not much data here to substantiate the analyses, and that is because all the major ideas contained here can be found with ample data and evidence elsewhere, if you simply Google. Happy investing 🙂

*Financial advisors in the US advocate that investors should view floating rate funds with caution, as these are constructed from the debt held on bank books. In the US, this is the debt of slightly riskier corporations who find it too expensive to raise debt directly on bond markets, and thus possess ratings below BBB. I am yet to investigate whether this is the case in India. So you should do the due diligence on this aspect. If it were the case, simply allocate the floating income percentage between fixed categories at the short-end of the yield curve.

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This is a guest post by Aditya Veera. You can find his other posts at adityaveera.wordpress.com

What do you think? Do you agree with Aditya?

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24 thoughts on “The beauty of fixed income in a volatile equity market

  1. Aditya

    I couldn't understand what writer is trying to say. It will be helpful if a hypothetical example can be given for portfolio rebalancing. Thanks

    Reply
    1. abvblogger

      You pick percentages to stay allocated to - say 50% equity, 50% to debt. And after you invest your money, the values will fluctuate. So suppose you invest in 4 mutual funds with 25,000 in each, that amounts to 1 lakh. Similarly 1 lakh in 4 debt funds will amount to a total wealth of 2 lakhs.

      After a year, your equity mutual funds may have grown to a value of 1,50,000 and debt mutual funds to 1,10,000. Equity is now 1,50,000 / 2,60,000 = 57% of total wealth, while debt is 42%. You would now rebalance back to 50-50 by selling equity to buy debt until they are 50% - 50% again. In this case, you would sell 20,000 of equity MFs and buy 20,000 of debt MFs, to have a net of 1,30,000 in each.

      If you do this every year, that's annual rebalancing.

      Reply
  2. Aditya

    I couldn't understand what writer is trying to say. It will be helpful if a hypothetical example can be given for portfolio rebalancing. Thanks

    Reply
    1. abvblogger

      You pick percentages to stay allocated to - say 50% equity, 50% to debt. And after you invest your money, the values will fluctuate. So suppose you invest in 4 mutual funds with 25,000 in each, that amounts to 1 lakh. Similarly 1 lakh in 4 debt funds will amount to a total wealth of 2 lakhs.

      After a year, your equity mutual funds may have grown to a value of 1,50,000 and debt mutual funds to 1,10,000. Equity is now 1,50,000 / 2,60,000 = 57% of total wealth, while debt is 42%. You would now rebalance back to 50-50 by selling equity to buy debt until they are 50% - 50% again. In this case, you would sell 20,000 of equity MFs and buy 20,000 of debt MFs, to have a net of 1,30,000 in each.

      If you do this every year, that's annual rebalancing.

      Reply
  3. kaizenvoyagernmol

    This concept is being implemented in the US by some companies. http://www.marketriders.com/ is one of them. Using low cost index funds/ETFs, you can simulate a portfolio of global assets, with set weights.

    This asset allocation approach was pioneered by Dave Swensen, an Economist who managed Yale's endowment. He has written 2 books on this topic.
    http://www.goodreads.com/book/show/17372.Unconventional_Success
    Unconventional Success: A Fundamental Approach to Personal Investment
    http://www.goodreads.com/book/show/17371.Pioneering_Portfolio_Management
    Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment

    Also, Mebane Faber has done a lot of work on this - Global Tactical Asset Allocation, he has written a book on this too, called "the Ivy portfolio" http://www.goodreads.com/book/show/8791638-ivy-portfolio

    Some skepticism has been expressed by Mr Leo Kolivakis on this issue, who was the head of hedge funds at a Canadian Pension Fund here - http://pensionpulse.blogspot.in/2012/10/university-endowments-face-hard-landing.html
    http://pensionpulse.blogspot.in/2011/05/crushing-harvards-mighty-endowment-fund.html
    http://pensionpulse.blogspot.in/2008/12/harvards-horror-will-decimate-pension.html

    Reply
    1. abvblogger

      Thanks. I think the post was already very long, so I didn't express a cautionary note, which is that rebalancing will only improve returns in certain markets. In certain markets it may even fare slightly worse than not rebalancing. Ultimately, I believe you cannot lose because rebalancing is first and foremost an alignment with your return-risk profile which is rationally suitable to your goals. The extra return, buying low and selling high etc. is a pleasant by-product produced by sentiment. Even without sentiment, we would rebalance merely to stick to our risk-appetite.

      Another area of caution is not rebalancing per se but the asset and category allocations. There's the temptation to engage in data-mining to find, for example, that weighting country x in your portfolio by 10% while weighting country y by 5% would have produced stellar returns. That should be viewed with caution, but it's not the rebalancing that's the issue as much as the view that certain allocations generate alpha.

      Reply
    2. abvblogger

      By the way, the criticisms are of endowment funds and their choice of alternative investments / hedge funds / calls on the market, not of rebalancing. Am I wrong? Is there a specific critique of rebalancing in those links?

      Reply
  4. kaizenvoyagernmol

    This concept is being implemented in the US by some companies. http://www.marketriders.com/ is one of them. Using low cost index funds/ETFs, you can simulate a portfolio of global assets, with set weights.

    This asset allocation approach was pioneered by Dave Swensen, an Economist who managed Yale's endowment. He has written 2 books on this topic.
    http://www.goodreads.com/book/show/17372.Unconventional_Success
    Unconventional Success: A Fundamental Approach to Personal Investment
    http://www.goodreads.com/book/show/17371.Pioneering_Portfolio_Management
    Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment

    Also, Mebane Faber has done a lot of work on this - Global Tactical Asset Allocation, he has written a book on this too, called "the Ivy portfolio" http://www.goodreads.com/book/show/8791638-ivy-portfolio

    Some skepticism has been expressed by Mr Leo Kolivakis on this issue, who was the head of hedge funds at a Canadian Pension Fund here - http://pensionpulse.blogspot.in/2012/10/university-endowments-face-hard-landing.html
    http://pensionpulse.blogspot.in/2011/05/crushing-harvards-mighty-endowment-fund.html
    http://pensionpulse.blogspot.in/2008/12/harvards-horror-will-decimate-pension.html

    Reply
    1. abvblogger

      Thanks. I think the post was already very long, so I didn't express a cautionary note, which is that rebalancing will only improve returns in certain markets. In certain markets it may even fare slightly worse than not rebalancing. Ultimately, I believe you cannot lose because rebalancing is first and foremost an alignment with your return-risk profile which is rationally suitable to your goals. The extra return, buying low and selling high etc. is a pleasant by-product produced by sentiment. Even without sentiment, we would rebalance merely to stick to our risk-appetite.

      Another area of caution is not rebalancing per se but the asset and category allocations. There's the temptation to engage in data-mining to find, for example, that weighting country x in your portfolio by 10% while weighting country y by 5% would have produced stellar returns. That should be viewed with caution, but it's not the rebalancing that's the issue as much as the view that certain allocations generate alpha.

      Reply
    2. abvblogger

      By the way, the criticisms are of endowment funds and their choice of alternative investments / hedge funds / calls on the market, not of rebalancing. Am I wrong? Is there a specific critique of rebalancing in those links?

      Reply
  5. Hari

    In a scenario wherein interest rates are raised in an economy then we will find both long term funds and equity will suffer.In that case whether to re balance with in the category first and then across the categories? OR the other way round? Request you to clarify on this.

    Reply
  6. Hari

    In a scenario wherein interest rates are raised in an economy then we will find both long term funds and equity will suffer.In that case whether to re balance with in the category first and then across the categories? OR the other way round? Request you to clarify on this.

    Reply
  7. abvblogger

    Sorry for the late reply - I had assumed I would be emailed about posts on this article 🙂 In case it is of help, here is my reply: One should always rebalance first across assets (so fixed income, equity, gold as per allocation) and then rebalance within category. In practice, for example once you know you have to sell fixed income, you need to find out which category of fixed income to sell, so you'll have to then do the category allocation calculation anyway. So you can do the calculations for both and then buy-sell the right amounts of each category accordingly. You will find that If you try it out, it will work. Let me know if I should explain further.

    Reply
    1. pattu

      Sorry Aditya, I thought since you were subscribed to the comments, you should receive a notification. So I didn't contact. Thanks for your response.

      Reply
  8. abvblogger

    Sorry for the late reply - I had assumed I would be emailed about posts on this article 🙂 In case it is of help, here is my reply: One should always rebalance first across assets (so fixed income, equity, gold as per allocation) and then rebalance within category. In practice, for example once you know you have to sell fixed income, you need to find out which category of fixed income to sell, so you'll have to then do the category allocation calculation anyway. So you can do the calculations for both and then buy-sell the right amounts of each category accordingly. You will find that If you try it out, it will work. Let me know if I should explain further.

    Reply
    1. pattu

      Sorry Aditya, I thought since you were subscribed to the comments, you should receive a notification. So I didn't contact. Thanks for your response.

      Reply
  9. abvblogger

    @Hari, I'm glad 🙂 Rebalancing benefits from volatility and Indian equity has historically been very volatile. Hence it's worth the effort. I'd be the first to admit that keeping track of all this is a bit of an effort for people with busy schedules, so one must use Excel and make the calculations as automated as possible.

    Reply
  10. abvblogger

    @Hari, I'm glad 🙂 Rebalancing benefits from volatility and Indian equity has historically been very volatile. Hence it's worth the effort. I'd be the first to admit that keeping track of all this is a bit of an effort for people with busy schedules, so one must use Excel and make the calculations as automated as possible.

    Reply

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