Effective Fixed-Income Diversification Matters

3 min read

Brought to you by Sound Choices - AGF Education for Investors and Advisors

The challenge

Fixed-income investments can help dampen portfolio volatility, preserve capital, reduce risk and generate income. However, an active, diversified approach to fixed income – one that incorporates a range of fixed income securities, is increasingly necessary to mitigate risk and increase risk-adjusted returns.


Fixed-income diversification is key – what leads the market one year may not the next year

2018 2019 2020 2021 2022
Canadian Bonds
1.29%
Global Conv. Bonds
13.66%
Global Conv. Bonds
34.50%
Floating Rate Loans
5.20%
Floating Rate Loans
-0.60%
Global DM Bonds
1.12%
EM Bonds
13.11%
Global Bonds
9.20%
Global Conv. Bonds
2.45%
Canadian Bonds
-11.25%
Floating Rate Loans
0.44%
Global HY Bonds
12.56%
Canadian Bonds
8.42%
Global HY Bonds
0.99%
Global DM Bonds
-12.66%
U.S. Bonds
0.01%
U.S. Bonds
8.72%
U.S. Bonds
7.51%
U.S. Bonds
-1.54%
Global HY Bonds
-12.71%
Global Conv. Bonds
-1.15%
Floating Rate Loans
8.64%
Global HY Bonds
7.03%
EM Bonds
-1.65%
U.S. Bonds
-13.01%
Global Bonds
-1.20%
Canadian Bonds
6.90%
EM Bonds
6.52%
Global DM Bonds
-2.41%
EM Bonds
-15.26%
EM Bonds
-2.46%
Global Bonds
6.84%
Global DM Bonds
4.88%
Canadian Bonds
-2.60%
Global Conv. Bonds
-16.21%
Global HY Bonds
-4.06%
Global DM Bonds
4.75%
Floating Rate Loans
3.12%
Global Bonds
-4.71%
Global Bonds
-16.25%

Source: Morningstar Direct, December 31, 2022 in local currency terms. Past performance is not indicative of future results. One cannot invest directly in an index.
Canadian Bonds represented by Bloomberg Canada Aggregate TR Index
Emerging Markets (EM) Bonds = Bloomberg EM USD Aggregate TR Index
Floating Rate Loans = Morningstar LSTA US Leveraged Loan TR Index USD
Global Bonds = Bloomberg Global Aggregate TR USD Index
Global Convertible Bonds= ICE BofAML Global 300 Convt TR USD Index
Global Developed Market (DM) Bonds = S&P Global Developed Sovereign Bond TR Index
Global High Yield (HY) Bonds = Bloomberg Global High Yield TR USD Index
US Bonds = Bloomberg US Aggregate Bond TR Index


Diversification, often considered to be the cornerstone of investing, is just as important within a fixed-income portfolio as it is in an equity portfolio. When you diversify effectively, you won’t leave your fixed-income portfolio unnecessarily exposed to a single risk.

Multiple options to choose from

There are a number of options within the fixed-income asset class that can provide investors with potentially higher yields without sacrificing credit quality, offer diversification benefits and safeguard against the impact of changing interest rates.

Corporate bonds. Investing in investment-grade corporate bonds (meaning corporate bonds that are rated as having a low risk of default) can provide higher yields than government bonds. Furthermore, default rates through an economic cycle have generally been very low. Corporate bonds, therefore, provide higher returns (higher coupons) with minimal added risk. While investment-grade credit has advantages, it does not usually provide much protection against interest rate movements.

Convertible bonds. With their built-in option to convert to a company’s underlying stock, convertible bonds are a hybrid solution providing the defence of bonds with the upside potential of equities. In fact, no other fixedincome solution has as much upside potential.

Floating-rate loans. Floating-rate loans are attractive when interest rates are expected to rise because, as rates move higher, the bond’s coupon also increases.

High-yield bonds. High-yield bonds offer much higher coupons than investment-grade bonds and are less ratesensitive since their performance is driven more by the underlying company’s health than interest rate movements. Keep in mind, though, that high-yield also entails greater risk than investment grade.

Inflation-linked bonds. Known in Canada as real return bonds, these securities can outperform regular bonds if the rate of inflation increases. Again, this strategy has been challenging to get right consistently and can be quite volatile given the long duration (i.e., higher sensitivity to interest rate changes) of most bonds in this category.

Emerging market bonds. Emerging market bonds have appealing characteristics (e.g., higher yields, lower correlation to developed-market government bonds) similar to those of high-yield bonds. The emerging market debt market has grown into a mainstream asset class, boasting higher credit quality with greater depth and liquidity than in the past. Currency movements are a consideration with emerging market bonds, as changes in foreign currency values relative to the Canadian dollar can add or take away from returns.


To learn how you can diversify your fixed-income portfolio, talk to your financial advisor or visit The Turning Tides of Fixed Income.


 

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This material is for informational and educational purposes only. It is not a recommendation of any specific investment product, strategy, or decision, and is not intended to suggest taking or refraining from any course of action. It is not intended to address the needs, circumstances, and objectives of any specific investor. This information is not meant as tax or legal advice. Investors should consult a financial advisor and/or tax professional before making investment, financial and/or tax-related decisions.

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May 4, 2023