Portfolio construction
Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
One of the main advantages of constructing a portfolio of individual bonds is that it can be customized to meet the precise needs, wants, and objectives of the investor. While this approach allows for a portfolio that is tailored to an investor’s personal preferences, it requires some upfront consideration and analysis to ensure that the portfolio is in line with an investor’s targets. While not all-inclusive and in no particular order, the following paragraphs outline important areas of consideration when constructing a customized fixed income portfolio.
Objective At a high level, answer the question, “What is this portion of the portfolio trying to accomplish?” Is it earmarked to pay a tax bill next year? If so, minimal credit risk and a single maturity date just before taxes are due are likely appropriate. Is it a cash alternative account with regular liquidity needs? A short-term ladder with frequent maturities might make sense. Is it meant to preserve wealth and provide stability in your portfolio for years to come? Are you retiring and need this investment to produce cash flow to fund your lifestyle? The range of personal objectives are endless but determining the investment objective is important as it will guide the overall allocation process.
Liquidity Needs What are your near-term and long-term liquidity needs, if any? Sometimes, there are none and the fixed income allocation is just meant to preserve your wealth and for future generations. This would allow maximum flexibility to invest all along the yield curve depending on where the most value is right now. Is it a qualified account and a required minimum distribution must be made annually? Are you a real estate investor and need access to these funds over the next few years to make new investments? Perhaps you are retiring in 5 years and plan on using some of these funds to purchase that boat you have always wanted. Identifying any upcoming liquidity needs helps to ensure that money is available when you need it. One of the great things about owning individual bonds is that you can line up the maturity dates of specific investments with liquidity needs so you aren’t subject to market risk when the time comes to access your money.
Tax Bracket Identifying both your federal tax bracket and state tax bracket is important for ensuring that the most tax-efficient product is selected. Being aware of potential tax bracket changes that might be on the horizon is also important. If you’re a high-earner retiring in a couple years, oftentimes your tax bracket can change considerably and it might make sense to factor in the longer-run tax situation. A potential move to a different state is also an important consideration for many investors.
Cash Flow Are there specific cash flow needs that this portion of your portfolio is intended to satisfy? There are a wide range of purposes and reasons to establish cash flow. A common circumstance revolves around retiree’s need to replace working years’ paychecks. Cash flow needs can influence coupon choice as higher coupons will provide higher periodic payouts. Maturity choice may also provide required use of principal to offset or supplement coupon cash flow to meet the target.
Risk Tolerance There are multiple types of risk that should be considered. Credit risk is the most obvious and the first thing that comes to mind when most investors think of risk. Answering the question of how much credit risk is acceptable can help drive both product choice as well as credit quality within a product type. In addition to credit risk, other types of risk such as interest rate risk (price volatility), reinvestment risk, and liquidity risk need to be factored in. When determining appropriate levels of each type of risk, tradeoffs will have to be made between various types of risk along and with other portfolio characteristics. Less credit risk generally means lower yields, so a balance between maximizing yield and reducing risk needs to be found. At the same time, reducing near-term reinvestment risk will increase interest rate risk. There is no perfect formula or combination, as each investor’s personal situation is different but understanding what risks are being taken from the onset help to ensure that the portfolio aligns with investor needs.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.
To learn more about the risks and rewards of investing in fixed income, access the Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.