Investing Basics, Step 4: Fixed income allocation and the great equalizer of taxes
The last step in our introductory series
Much like in your stock/equity portfolio, there is an optimal asset allocation for your fixed income/bond investments. This is, of course, highly dependent on your risk tolerance, timeframe, and all the usual suspects we have discussed in prior installments of Investing Basics: Step by Step.
Step 1: Determining your savings goal (including reader Q&A)
Step 2: Establishing the overall asset allocation of the portfolio (i.e., the ratio of equities to fixed income investments) based on the timeframe available, risk tolerance, tax bracket, and your views of the world around you (including reader Q&A)
Generally speaking, the bond market was a conservative place to invest with relatively stable returns. However, in recent years, investors have gotten a taste of the scary underbelly of fixed income, which is not always as “safe” as many people believe it to be. In fact, according to Morningstar, the “Bloomberg U.S. Aggregate Bond Index had two consecutive calendar years of negative returns for the first time ever in 2021-22. Before 2021, the index had only been negative four times in 46 years” and “2022 was the first calendar year ever to end with a negative five-year annualized return.”
Even in the best of times, bonds are not as likely to outpace inflation, so why invest in them at all? We are back to the historical perspective that drives so many decisions surrounding portfolio structure. This includes the need to use asset allocation and diversification to ensure that the different “buckets” in your portfolio complement each other, with one “bucket” performing better when other buckets may be doing worse. And, with the exception of a few “outlier” years of late, bonds have historically performed well and provided a more predictable return (albeit lower).1
What is a bond?
Bonds represent a loan made by an investor (either an individual or a mutual/electronically traded fund) to the issuer (typically a government agency or company). These loans may include regular interest payments (often called the “coupon”) and can also have value through selling the bond at a discount to the “face value” (or par value) of the bond (meaning the value might be in the delta between the purchase price and the face value of the bond to be paid at the end of the term).
What are the types of bonds?
Bonds can have different maturities and credit quality. Maturities are simply how long the “term” of the bond is, and credit quality measures the likelihood that the issuer will make all coupon payments and return the value of the bond at the end of the term. The lower the credit quality, the higher the risk that the bond will default (and no payout will occur).
But why might an investor choose a bond of lower credit quality? Because often those lower credit quality bonds pay a higher coupon (i.e., interest), much like borrowers with lower credit scores may have to pay a higher interest rate on loans. Thus, depending on your risk tolerance, there may be a place for these “junk bonds” in your portfolio, as long as you understand that there is a much higher default rate on these instruments.
Bond asset allocation
Now we will return to the asset allocation work you did in Step 2. After doing the exercises, you likely decided on a percentage of bonds/fixed income investments within your portfolio of between 20% and 40%. For a portfolio with a current value of $200,000, this would be between $40,000 and $80,000. But how do you spread that investment out in a manner that “replicates” the total market, which hopefully leads to performance that is consistent with the historical market as illustrated above (though with a little luck without 2021 and 2022)?
Just like with equities, a great place to start is a “total market” index. One of the most common and most frequently cited of these indexes is the Bloomberg Aggregate Bond Index (the “Agg”), formerly known as the Bloomberg Barclays Aggregate Bond Index, and prior to that, the Bloomberg Aggregate Bond Index, and prior to that, some other name.
Basically, it is the Prince of indexes.
Just like everything else in the asset allocation sphere, modeling after the total bond market is always moving and is not an easy target to hit.
Diversification by credit quality and duration
The primary means of asset allocation following the Agg is to invest the majority (75%) of the bond portfolio in intermediate duration, investment grade vehicles.
Intermediate durations are usually terms of 2 - 10 years (fitting for longer horizon investment strategies and due to the duration, being less susceptible to interest rate volatility. Typically, the interest on these debt securities is greater than that on short-term debt of similar quality but less than that on comparable quality long-term bonds. The interest rate risk on medium-term debt is higher than that of short-term debt instruments but lower than the interest rate risk on long-term bonds.
Investment grade means that the bond investments meet the credit quality standards of the various rating agencies and are believed to have a lower risk of default.
Thus, like Goldilocks and the Three Bears, intermediate duration with investment grade quality is often “just right” in an asset allocation strategy, and its middle of the road risk and performance are why it is the largest part of most indexes.
After 75% is allocated to intermediate duration, investment grade vehicles, the rest of the portfolio may look like a bell curve, with a small portion of the portfolio (usually 10% each) in short duration (less than 2 years) and long duration (more than 10 years), investment grade vehicles. That leaves up to 5% to invest in the more speculative, non-investment grade vehicles if your risk appetite allows it. These are the categories aptly named “junk bonds,” and more kindly called “high yield” bonds.
Diversification by sector
After duration and credit quality, you may want to take your asset allocation a step further by choosing investments that also meet your goals related to sector diversification following the index models below for both the taxable and nontaxable bond sectors.
Remember the general makeup of the Agg? It provides another way to consider fixed income allocation.
Again, not perfect, but within the taxable bond sector, a common diversification includes:
⅓ government agencies,
⅓ corporate bonds, and
⅓ mortgage backed securities.
To more closely follow the Agg, these percentages will be slightly higher than a third for government agency and mortgage backed securities, with corporate bonds holding closer to 20%.
For the nontaxable bond sector (typically municipal bonds):
At least half of the index is typically in revenue municipals,
with 34% in general obligation mutuals,
and the remaining 10% in other municipal type vehicles, such as bonds issued by universities, hospitals and nonprofits.
Where do you go?
For many of us, asset allocation is simply applied to our 401k or IRA because that is the only place we are really building savings by investing. For others, there may be additional accounts, like individual brokerage accounts, that are not “tax advantaged.”
In a perfect world, we would be able to design a portfolio all at once and apply our asset allocation across all of our various tax advantaged and non-tax advantaged accounts in a way that makes sense forever because nothing would be a moving target.
But that is not how life works.
And two things in life are certain, death and taxes.
I can’t help you with the dying part, but I can give you a few tips on taxes that will hopefully allow your portfolios to grow in a more tax efficient way, allowing more money to stay in your pocket or, better yet, be reinvested to achieve more growth in your portfolio.
The most important thing to remember is that asset allocation is a little bit of science and a whole lot of “art.” We do the best we can to mirror our desired design at a point in time (either in the ratio of equities to fixed income, or asset allocation within each) to position ourselves in alignment with the total market. But then, a bullish year for stocks, or a great year in fixed income investments arrives, and suddenly that asset allocation is off again like a leaky bike tire.
What normally doesn’t change are the tax implications of your investment choices. As such, there are a few things to keep in mind to help you place each investment in the account that fits it best for tax purposes.
Generally speaking, IRAs, 401ks and other tax advantaged accounts allow you to defer taxes on capital gains, dividends, bond interest or coupons, etc. Thus, when possible, put the investments that “kick out” a lot of taxable income in those tax advantaged accounts, where you only pay taxes at the time of withdrawal (hopefully when you are in a lower tax bracket).
Some examples:
Turnover rate: The mutual fund turnover ratio is expressed as the rate of change over the course of a year. So, for example, if a fund has a turnover ratio of 50%, that means half of its investments were sold in the previous 12 months. The higher the turnover rate, the more the investments inside the fund are sold, and thus, the higher the likelihood of capital gains. Thus, the best place for funds with high turnover (over 20%) is in a tax advantaged account (when possible). Conversely, try to select funds that have a turnover rate below 20-25% for your brokerage or taxable investment account, as you will be paying taxes on any capital gains created by the fund in the year that gain occurs (eating into your returns and reducing the funds you have for reinvestment).
Dividends and interest: Dividends and interest are another type of return that can be taxable in the year received, unless the dividends and interest are paid into a tax advantaged retirement account (or are tax exempt interest, like that paid on many municipal bonds). Generally, funds and other investments that generate a lot of dividends or interest are most effective in a tax advantaged account (when possible). That way, you get the advantage of the full rate of interest or dividend, instead of paying between 10% and 37% of your yield to Uncle Sam.
In short, the optimum place for low turnover, low dividend investments (like growth oriented mutual funds) is in your brokerage account. Conversely, high turnover investments, or those producing substantial capital gains, dividends or interest, should be placed in tax-advantaged (think retirement) accounts first to minimize the impact of taxes on your portfolio’s overall performance.
And with that, you’ve reached the final step of Investing Basics. You now have the “right stuff”2 to start investing for a better tomorrow.
If you are just getting started with Step 1, or want more on your “magic” retirement number, check out this article in Kiplinger’s: https://www.kiplinger.com/retirement/how-does-your-retirement-magic-number-compare-to-others.
And, if you just want to understand more about the markets, check out this interesting Axios piece about how the recent lift has nothing to do with fundamentals of earnings and value: The stock market’s up big this year — but not because of earnings growth.
Experts disagree on what to expect from bonds moving forward. Recent unexpected volatility and lack of performance are why some advisors are now recommending that investors include CDs, money markets, and high-yield savings accounts in their fixed income portfolio (at least as long as rates are competitive) because in these volatile bond markets, more traditional vehicles can be as competitive as bonds and offer the added comfort of being federally insured. Others think that the worst is behind us and bonds are set for a return to historic levels of performance.
And a special thank you to the New Kids on the Block for inspiring this series.