July 2009

It may be time to put the fixed back in fixed income.

As the recent convulsions in global financial markets made clear, reducing risk by diversifying among asset classes can be crucial to building and maintaining wealth. Investors with stable exposure to less glamorous assets like bonds typically sustained less damage to their portfolios than the fast-money crowd.

“We believe many investors may be able to benefit from making fixed income a significant and permanent part of their portfolios,” says Peter Jacobs, mutual fund product manager for Northern Trust. “Bonds have historically been less volatile than stocks, so they can potentially add a degree of stability and consistency to returns over the long haul.”

Stability and consistency are important because equalsized losses and gains don’t offset — a 50% decline requires a 100% rise just to break even. Bonds may help to limit losses because fixed-income investments don’t always move in the same direction or by the same amount as equities.

In fact, one of the main sectors of the fixed-income market — U.S. Treasury bonds — has historically risen in value when stocks have tumbled. The Barclays Capital U.S. Aggregate Bond Index, which provides exposure to the full breadth of the domestic investment-grade bond market, actually gained 5.24% in 2008 amid the worst downturn in equities since the 1930s.

“The most significant benefit of maintaining an allocation to fixed income is the potential to possess a degree of downside protection during periods of financial market or economic turmoil,” says Jim McDonald, Northern Trust’s chief investment strategist. “During the recent bear market in stocks, a diversified portfolio of high-quality bonds may have been best positioned to provide not only stability but actual price appreciation.”

Of course, some investors might be tempted to go “all stocks” again once the next rip-roaring bull market starts to pick up steam. And since the economy is showing hints of recovery, that rally may already be underway. But McDonald warns against forgetting the hard-won lessons from the recent financial crisis about how bonds can potentially cushion losses during equity market declines.

Multiple choice
Like stocks, bonds are not a homogenous group. And that’s good, since more choices mean more diversification — and less overall risk.

Within the two main fixed-income categories — governments and corporates — there are several subsets or sectors. Besides Treasuries, which are direct obligations of Uncle Sam, the federal government category also includes indirect obligations like agency- and mortgage-backed bonds. There are also Treasury Inflation Protected Securities, or TIPS, whose interest rate increases as inflation rises. “TIPS may be a good insurance policy in case inflation resurfaces down the road,” says McDonald.

On the state and local level, municipalities issue bonds whose interest is exempt from federal income tax. And with tax rates likely to rise to plug massive budget deficits, the tax-free income generated by municipal bonds could become even more important in coming years. This might explain why legendary investor Warren Buffett doubled his exposure to municipals over the nine months through March, calling their yields “unimaginable.”(1) McDonald thinks that municipal yields are less unimaginable now after a strong rally, but they still may be attractive enough to provide a potential benefit to middle- and upper-income taxpayers.

The corporate sector offers an equally broad array of opportunities. Investment-grade corporate bonds include issues rated AAA through BBB, while the high-yield or speculative sector covers bonds rated BB and below. Even within the same ratings category, however, there can be significant differences in yields and total returns depending upon the economic context.

“The beauty of the fixed-income asset class is that these diverse sectors often move independently from one another,” notes Jacobs. “Skilled bond managers can exploit those differences.” For example, if the economy turns out to be stronger than most investors expect, lower-rated bonds would typically outperform. Conversely, higher-quality bonds usually lead when economic conditions are deteriorating.

Independent research
Though corporate bonds offer more yield than Treasury securities, the potential extra income comes with extra risk. This is why McDonald believes it makes sense to get exposure to the corporate sector through a broadly diversified, professionally managed vehicle like a mutual fund.

Professional management is especially important in the corporate and municipal sectors, where security selection can make all the difference. “There are always some high-yield issues that you shouldn’t touch with a 10-foot pole and others that are very underpriced,” Jacobs says. “But this is not a selection process that individual investors should try to do on their own.”

McDonald thinks that the major credit ratings agencies did a poor job in flagging potential problems prior to the financial crisis. He warns that some municipalities face revenue and cost pressures that could make their bonds more risky as well. However, McDonald says that Northern Trust’s culture of intense and independent credit analysis may help investors reap the rewards of fixed-income investing while minimizing such risks.

“We don’t rely on the credit agencies,” he says. “We do our own credit homework, and I think our track record shows we do it well.”

Though default risk is much lower within the investment-grade category than in high yield, caution and expertise are still warranted. “This is not something that most investors should try to do on their own,” Jacobs says. “And besides, AAA and BBB are virtually different asset classes, even though they are each considered investment grade. You’ve got to know what you’re doing.”

Volume discount
Credit risk isn’t the only issue on a bond manager’s plate. Interest rate risk also has to be monitored closely. But fund managers can take steps in an effort to make the best of virtually any situation.

If yields are expected to rise, a portfolio’s duration might be shortened to help minimize the impact on its net asset value. Conversely, the likelihood of falling interest rates might warrant extending the duration, a move which could significantly boost the portfolio’s value.

Besides mitigating credit and interest rate risk, mutual funds offer other advantages to investors interested in owning fixed income but unable to get adequate diversification on their own. “Buying power,” says Jacobs. “We buy in very large volumes, so we get better executions on our trades than could a retail investor. Northern Trust has relationships with dozens of municipal bond dealers that we’ve cultivated over 20 and 30 years, so we can exploit the inefficiencies that are a normal part of such a vast asset class.”

Needed income
Besides providing the potential for price stability, any income generated from a bond portfolio may help to pay the bills. That’s particularly important now, when money is tight and credit is restricted. And while some investors depend on dividend-paying stocks for income, such payments aren’t always reliable.

Last year, more than 600 companies cut their dividends; another 367 reduced their payouts during the first quarter of 2009.(2) Barring a default, investment-grade bonds are obligated to pay what is promised to their bond holders.

Bond income also has historically been more generous than that provided by stock dividends. Except for a brief period near the end of last year, the yield on 10-year Treasury notes exceeded the dividend yield on the S&P 500 during the last decade.(3) In fact as of July 9, 2009, 10-year Treasuries yielded 0.85 percentage points more than stocks,(4) AAA-rated tax-exempts provided 1.6 percentage points of additional income (even before taxes), investment-grade corporate bonds yielded 3.2 percentage points more than stocks, and high-yield bonds had about a 9.5 percentage point advantage over stocks.

Even on a total return basis — a bond’s income plus or minus changes in its price — the case for making fixed income a fixed part of a portfolio is compelling. Despite the powerful bull market in stocks between 1982 and 2000, bonds still beat equities over the 41-year period through February 2009.(5)

And while that outperformance is probably an aberration and unlikely to be repeated, it nonetheless shows that slow and steady sometimes does win the race. “You just might not notice while it’s happening,” says Jacobs.

Setting an allocation
So how much should investors put into fixed income? There’s no single answer that works for everyone. It depends upon a variety of circumstances that vary widely from individual to individual. Your Northern Trust relationship manager can help you determine a bond allocation that meets your objectives.

However, there are two general approaches to the question of how much to put into fixed income. Strategic asset allocation involves settling upon and maintaining the mix of stocks, bonds and cash that’s right for your financial and life circumstances. Tactical asset allocation involves changing the mix based on current valuations or expected economic developments.

“It would be great to always be 100% invested in the best-performing asset class,” says Jacobs. “But markets don’t give advance notice when they’re set to move, and if something is obvious, it’s probably already built into the price.”

Jacobs says that few investors anticipated the magnitude of the financial crisis and thus hadn’t built a big allocation to Treasuries before the storm hit. Similarly, he thinks most investors were late to the raucous rally in high-yield bonds that began in the spring amid the first signs of economic green shoots.

Nearly a year after the global credit crisis struck, many investors are still holding too much cash — and earning returns that are in negative territory after inflation. But with economic conditions improving, now might be a good time to move some of that money out of cash instruments like money market funds and bank CDs and into potentially higher-yielding investments like bonds.

“Being either all in or all out of an asset class is not a prudent strategy,” Jacobs says. “No one can time these markets. You’ve just got to be there all the time.”

Given the comforting blend of stability, consistency and income that bonds are designed to provide, fixed income can be a very nice place to be.

(1) www.bloomberg.com. June 9, 2009.
(2) Standard & Poor’s Index Services
(3) Barclays Capital, Inc., FactSet, Inc./Standard and Poor’s
(4) As measured by the Russell 3000 Index
(5) Barron’s. March 30, 2009. Data from a research paper by Robert Arnott to be published in The Journal of Indexes.

Past performance is no guarantee of future results.

Diversification Risk: Diversification alone does not guarantee a profit nor protect against a loss.

Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.

Tax-Free/AMT Risk: Tax-exempt funds’ income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax.

High Yield Risk: Although a high yield fund’s yield may be higher than that of fixed income funds that purchase higher-rated securities, the potentially higher yield is a function of the greater risk that a high yield fund’s share price will decline.

Funds vs. CD Risk: While CDs are insured by the FDIC and offer a fixed rate of return, the investment return and principal value of a mutual fund will fluctuate and an investor’s shares may be worth more or less than the original cost when redeemed. There may be additional fees and expenses associated with investing in a mutual fund. These fees and expenses are described in the fund’s prospectus.