Advisor Blog

In a prior article, we discussed the role of fixed income in a portfolio and the performance of our fixed income allocation during periods of stress in equity markets.  The fixed income portion of our portfolios has continued to do exactly what it is designed to do - limit volatility at the portfolio level.

There are several factors that we take into account when selecting a fixed income strategy that work together to insure that it serves this purpose.  First, we keep the duration short - that limits the volatility due to interest rate changes.  Next, we keep the credit quality extremely high - almost all in the upper half of the investment grade range.  This limits volatility due to credit/default risk.  We diversify globally to limit risk from exposure to any particular economy.  In each economy, we only take on term risk when the yield curve is positive and there is enough additional return for assuming that risk.  No decisions are made based on forecasting of interest rate changes.  Statistically, short-term high credit quality fixed income has a very low or negative correlation with equities.  This means that they tend to move "out of sync" with each other - exactly what you'd want to see when equities are performing poorly.  Finally, we hedge out exposure to foreign currencies.

Why does it usually make sense to hedge foreign currency risk in global bond allocations?  Remember that the purpose of the bond allocation is reduction in portfolio volatility.  Exposure to foreign currency risk in the global bond holdings would add volatility.  It's relatively inexpensive to eliminate currency risk by purchasing rolling one-month forward currency contracts.  In addition, exposure to currency risk has no expected rate of return.  Currencies simply fluctuate when measured against the value of each other and there is no evidence that these fluctuations are predictable.  When a particular currency is under pressure, as the Euro has been lately, hedging away currency risk pays off.

We typically use a combination of DFA's global fixed income funds to achieve this, although we may use other funds in portfolio designs for some clients that have specific goals/needs.  DFA won the award for best fixed income funds from Investment News in 2008 during the previous period of extreme equity market stress.  The strategy has worked very well during the most recent volatile period in the equities markets, too.