Investment Objectives
The Fixed Income strategy seeks to improve the total risk-adjusted performance of a portfolio by adding a new asset class, fixed income, to an equity portfolio.
To meet this objective, the team will focus on:
- Considering the risks within the bond market, first and foremost.
- Pursuing appropriate returns from the perspective of the risk taken.
The Fixed Income strategy will not seek the highest returns available in the bond market when those returns are attached to higher-than-acceptable risks. Instead, it will be managed to mitigate the risk inherent in an equity-centric portfolio, aim to ensure a portion of your portfolio is reliably available should it be needed, and endeavor to reduce the severity of net portfolio losses from peak to trough.
Portfolio Managers
Who should invest?
Generally, the Fixed Income strategy is appropriate for the fixed income portion of an asset allocation strategy. As with any investment, investors should have a long-term horizon in mind before committing money. If you need the money in less than a year, keeping funds in a cash account is more appropriate than taking on the risk inherent in investing in fixed income.
That said, investments in fixed income are not generally considered as volatile as investing in equities. Neither do they usually have the same upside rewards as equities, and therefore are appropriate as a greater percentage of the holdings in a portfolio the older one is, i.e. the less time that an investor has to recover from the downside of a bear market in equities.
The Fixed Income strategy may be held in either a taxable or tax-deferred account, such as an IRA.
Philosophy and Strategy
The Fixed Income investing philosophy hinges on two key beliefs:
- A top-down mindset is necessary to identify risks and assess return adequacy.
- A laddered maturity approach of diversified issues is an efficient way to embrace a safety-first mindset to bond investing.
There are many different types of fixed income instruments available: corporate investment grade, high yield corporates, federal government, municipals, and mortgage-backed securities to name the most common. Additionally, bonds can be issued with different maturities, some returning principal to investors within a few years, and some extending to 30 years or even longer.
Our bond portfolio will seek to invest in those instruments which provide an attractive return but do so without taking on higher levels of risk. Higher levels of risk are generally associated with both longer-term bonds and low-credit-quality bonds.
The portfolio will rely heavily, and at times exclusively, on corporate bonds (particularly investment grade corporate bonds), when we deem them to be a superior risk-reward equation compared to bonds issued by the federal government. We intend to use government bonds, municipals, mortgage-backed securities, mortgage-related securities and other asset-backed securities in a tactical manner when they offer rates that are sufficiently attractive for their level of risk. High-yield corporate bonds may also be used to gain modest exposure to higher-yielding maturities, though the portfolio is unlikely to hold a large percentage of high-yield bonds, especially those of longer duration.
The Fixed Income strategy will be widely diversified in the number of issues owned. A cost-effective and simple way for us to achieve this is to use widely diversified exchange-traded funds (ETFs) issued from well-capitalized providers.
The philosophy of this portfolio is not oriented around taxes, which might be a consideration in particular for higher net worth individuals and for some investors at or near retirement. (Municipal bonds can generally be used effectively by investors to get tax-advantaged income.) That said, we expect to manage the purchase and sale of ETFs to mirror general long-term Foolish investing norms, and for there to be limited capital gains incurred within the strategy.
Portfolio Management Process
Portfolio Construction
The overall portfolio is constructed based on top-down, rather than bottom-up selection, with the primary considerations being current interest rates, the shape of the yield curve, spreads between corporate and government bonds, and spreads between investment-grade and high-yield corporates.
Generally, the bulk of the portfolio will be constructed with a ladder of individual year targeted (“bullet”), low-cost, highly diversified ETFs, each of which holds positions in hundreds of individual bonds.
Corporate bonds will typically be held in a ladder of corporate bond ETFs, each of which is designed to correspond to the performance of investment-grade corporate bond indices. The indices themselves are designed to represent the performance of a held-to-maturity portfolio of investment-grade corporate bonds with effective maturities in one specific year (e.g. an index of bonds maturing in 2023).
High-yield bonds may also be held in a similar ladder, but exposure may be achieved through ETFs with broader mandates. In either case, and given our low-risk stance, the total exposure to high-yield bonds is likely to be modest.
Exposure to non-corporate debt will also likely be achieved through ETFs as this is an efficient way to gain the diversified exposure we seek in this portfolio.
The portfolio is not restricted to holding fixed income instruments through ETFs, but given the strategy of the portfolio, it is unlikely at the present time for other instruments to be used.
Position Sizing
No individual ETF is likely to comprise more than 15% of the portfolio. As each ETF is comprised of hundreds of individual bonds, no individual bond should be a meaningful position in the overall strategy. Exposure to any one publicly-traded company’s bonds is unlikely to be very high. Exposure to a particular sector, such as financials, is likely to be significant.*
Position Management
Individual ETFs are monitored dynamically to ensure that they are nearly fully invested, and that the ETF is managed in a manner consistent with the description of the ETF in its individual prospectus.
Every month, typically at the beginning of the month, each ETF will make a cash distribution of the coupon payments made by the individual bonds into the ETF. These monthly payments are fairly small as a percentage of the portfolio. The distributions will be invested into existing ETF positions or to open an ETF position on an extended rung of the ladder.
Significant changes, such as selling out completely of an ETF position within the existing ladder, or significantly restructuring the ladder will occur infrequently, though active portfolio management includes the responsibility to react to significant opportunities when interest rates move dramatically.
Investment Risks
The investment risks of the Fixed Income SMA strategy are essentially the same as for any other investment in bonds. They include, but are not limited to:
- Interest rate risk (the risk that interest rates move up, lowering the value of already-owned bonds with lower interest rate coupon payments)
- Reinvestment risk (the risk that coupons will have to be re-invested at lower rates)
- Inflation risk (the risk that high levels of inflation will decrease the worth of fixed payments, especially those of longer duration)
- Credit/default risk (the risk that a bond issuer might default on a coupon or principal payment)
- Rating downgrades (the risk that a ratings agency will lower the credit rating on a bond issuer)
- Liquidity risk (the risk that there will be insufficient supply or demand in the market at time of purchase or sale to achieve a fair price at the time a transaction is to be made)
- Mortgage-related securities and other asset-back securities, including mortgage-backed securities (the risk that interests in “pools” of mortgages or other assets such as consumer loans or receivables held in trust and often involve risks that are different from or possibly more acute than risks associated with other types of debt instruments)
In addition to these risks, the ETFs themselves are subject to counterparty risk (the possibility that the ETF provider will at some point become insolvent). We monitor counterparty health regularly and estimate this risk as highly unlikely.
We are, at present, weighting those risks towards the preservation of capital. When opportunities in the bond market are scarce, due to low interest rates and narrow credit spreads, we will not pursue more risky alternatives merely to achieve slightly higher yield.
Please see Appendix B to our Investment Advisory Agreement for a discussion of additional risk associated with this strategy. A link to the Investment Advisory Agreement is provided at the bottom of this page.
* To the extent we invest more heavily in particular sectors or industries of the economy, the performance of our strategies will be especially sensitive to developments that significantly affect those sectors or industries. While investing in a particular sector is not a principal investment strategy of any model portfolio, client portfolios may be significantly invested in a sector or industry as a result of our portfolio management decisions.
Each client portfolio is subject to an account minimum, which varies based on the strategies included in the portfolio. Motley Fool Wealth Management retains the right to revise or modify portfolios and strategies if it believes such modifications would be in the best interests of its clients, and we may modify allocations within a client's account subject to the constraints of each client's current risk score and objective. Clients should be aware that their individual account results may not exactly match the performance of the Model Portfolios.