Fixed Income and Your Portfolio

Fixed income can play a critical role in a well-constructed investment portfolio. While equities are typically the primary driver of long-term returns, fixed income serves a different purpose: risk management. 

Our philosophy is straightforward. Fixed income should act as a true hedge against equity market volatility while also providing a predictable level of income. It is not intended to be the engine of growth in a portfolio. That responsibility belongs to equities. This distinction matters because fixed income investments have an inherently asymmetrical payoff profile. 

Understanding the Asymmetry of Fixed Income 

Unlike stocks, which have theoretically unlimited upside, the return profile of a bond is capped. When you purchase a bond, your maximum expected return, if held to maturity, is its yield to maturity - the annualized return you will earn if all payments are made as promised. 

Consider a simple example. You buy a bond for $100. The bond pays interest equal to 4% of its face value each year. At maturity, you receive your $100 principal back. Yield to maturity combines those interest payments and the return of principal into a single annual “effective return” figure. 

If everything goes according to plan, that yield is what you earn. However, if things go wrong and the issuer defaults, the downside can be severe. In the extreme case of bankruptcy, the return could approach -100%, as you may receive little or nothing back on your investment. All bonds have some default risk, with U.S. Treasuries having the lowest risk.   

How We Evaluate Fixed Income Allocations 

When reviewing a client’s fixed income allocation, we focus on three core questions. 

1. Is the Level of Risk Appropriate? 

All fixed income holdings should be investment grade. These instruments tend to provide more reliable protection during periods of equity market stress. 

We deliberately avoid “stretching for yield”—that is, taking on excessive credit risk by purchasing high-yield or junk bonds simply to reach an arbitrary income target. Yield should always be evaluated in the context of risk, not in isolation. 

A key consideration is whether the market is adequately compensating investors for taking on additional credit risk. Currently, the spread between BBB-rated corporate bonds and the 10-year U.S. Treasury is less than 1%, near a ten-year low. Historically, investors have demanded a higher premium for assuming corporate credit risk. When spreads are this tight, it may not be an attractive time to increase corporate bond exposure. 

2. Is the Yield to Maturity Appropriate Given Current Rates? 

Yield to maturity must be evaluated relative to prevailing interest rates and inflation expectations. Higher yields are attractive only if they compensate investors for the risks being assumed. In today’s environment, modest incremental yield from lower-quality bonds may not justify the additional downside risk. 

3. Is There Unnecessary Duration Risk? 

Duration measures a bond’s sensitivity to changes in interest rates. When interest rates rise, bond prices fall—and the longer a bond’s time to maturity, the more sensitive it is to those changes. This is because a greater portion of the bond’s cash flow occurs further in the future. 

Investors can increase portfolio yield by extending duration, but doing so introduces meaningful interest rate risk. If rates rise, long-duration bonds can experience significant price declines. 

Understanding the yield curve and forming reasonable expectations about future rate movements is essential. As a general rule, the 10-year Treasury yield should be approximately 2% above expected inflation. For example, if inflation expectations over the next 5–10 years are around 2.5%, a “fair” 10-year Treasury yield would be roughly 4.5%. 

If the actual yield is meaningfully below that level, interest rates are more likely to rise than fall. In such an environment, extending duration is typically not prudent. Conversely, yields above that level may suggest rates are more likely to decline, making longer-duration bonds more attractive. 

The Bottom Line 

Fixed income can be a foundational component of a sound investment strategy. While it does not require constant trading or dramatic shifts, it does demand ongoing monitoring. Credit quality, yield, duration, and the broader interest rate environment all need to be evaluated to ensure the portfolio remains aligned with long-term goals. 

When constructed thoughtfully, fixed income can provide stability, income, and diversification, allowing the equity portion of a portfolio to do what it does best: drive long-term growth.