THE ROLE OF FIXED INCOME IN GOALS DRIVEN WEALTH MANAGEMENT

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1 THE ROLE OF FIXED INCOME IN GOALS DRIVEN WEALTH MANAGEMENT In Goals Driven Wealth Management, we look at your portfolio as being composed of risk control assets (quality fixed income and cash) and risk assets (global equities and high yield bonds). Risk control assets purpose in the portfolio is to fund nearerterm, high-value goals, such as meeting your annual spending or core lifestyle needs over the next few years. Risk assets are used for funding longer-term goals where you can be more confident in earning the higher equity return premium over time. Since they have lower risk than equities, fixed income investments are used to fund near-term high-value goals but they are not risk free. COMPENSATING FOR THE RISKS TO FIXED INCOME While fixed income investments face lower risks than equities do, they are not risk free. Because fixed income s role in the portfolio is to fund nearer-term, highvalue goals, we must consider the risks that might undermine the funding of those goals and work to mitigate them. Exhibit 1 outlines the five primary risks to fixed income, and how we address them. EXHIBIT 1: MITIGATING FIXED INCOME RISKS Primary Risks Inflation Default Rising real interest rates Liquidity Taxation Investment Solution Used to Mitigate Risk Inflation-protected Treasuries High credit quality Low duration investment-grade bonds Liquid securities Tax-efficient bonds Northern Trust 1

2 Because principal s main purpose is to fund your near-term goals, the integrity of principal is more important than earning attractive yields. Therefore, our overall objective is to create a fixed income allocation with a relatively stable principal value that can withstand different distressed environments and offer a positive return after taxes and inflation. Because no single fixed-income security can accomplish all of these objectives, we use a mix of cash, lower duration investmentgrade bonds and inflation-protected bonds. Inflation presents perhaps the most direct risk to goal funding through a lifetime. The table in Exhibit 2 shows real bond returns through the inflationary period of the 1970s. Between 1973 and 1982, inflation eroded purchasing power nearly 9% each year. Long-term government bonds returned 5.76%, but lost 2.68% after inflation. Over the full 10-year time frame, long-term government bonds lost 24 cents on the dollar, despite having no credit risk. Our overall objective is to create a fixed income allocation with a relatively stable principal value that can withstand different distressed environments and offer a positive return after taxes and inflation. Let s say your goal is to have available $250,000 per year to maintain your lifestyle. This represents real purchasing power, so the amount you need will increase each year by approximately the rate of inflation. Now let s say you originally funded a goal with long-maturity fixed income. If inflation subsequently increased, you might no longer be able to reach your goal of $250,000 purchasing power each year. Why? The real value of the fixed income investment would fall, while the cost of funding your desired lifestyle would rise with inflation. As a result, you might be forced to reduce your lifestyle spending. EXHIBIT 2: COMPARISON OF SELECT RISK CONTROL ASSETS, Annualized Return Annualized Real Return Real Growth of $1 Standard Deviation Maximum Drawdown Inflation 8.67% Long-Term Government Bonds 5.76% 2.68% $ % 50.80% Intermediate-Term Government Bonds 8.00% 0.62% $ % 32.16% Low-Duration Portfolio 8.30% 0.34% $ % 21.58% Treasury Bills 8.46% 0.19% $ % 13.33% Source: Ibbotson LOW-DURATION BONDS MITIGATE INTEREST-RATE RISK Interest-rate risk captures both inflation risk and the risk associated with changes in real interest rates, which is the rate of interest relative to the rate of inflation. Shorter-maturity bonds have reduced exposure to changes in the real rate of interest and inflation. To mitigate inflation and rate risk in our Goals Driven Wealth Management portfolios, we use lower duration bonds. Looking again at Exhibit 2, we can see that a portfolio of low-duration bonds and Treasury bills did perform better during the inflationary 1970s than the long-maturity portfolio. Northern Trust 2

3 Exhibit 3 illustrates that over many interest-rate cycles, the compensation for longer-maturing bonds with higher yields has not been very compelling. The annualized compound returns of Treasuries with longer maturities were only slightly higher than the returns of intermediate and short-term Treasuries, whereas the volatility of long-term Treasuries was materially higher. When comparing fiveyear and 20-year Treasuries, we see that 20-year Treasuries earned just 45 basis points more annually, but with almost double the price volatility. Because credit risk increases in deflationary environments, we add high-quality municipal bonds to the portfolio. This also helps mitigate tax exposure. Although this additional volatility would be somewhat muted within a broadly diversified portfolio, it is directly relevant in a portfolio being used to fund a goal at a specific date. For this reason, we include shorter-duration bonds in the riskcontrol portfolios designed to fund your core lifestyle. EXHIBIT 3: ANNUALIZED RETURNS & VOLATILITY OF TREASURIES, Quarterly Returns (1964 to 2016) Annualized Compound Returns Annualized Standard Deviation 10.12% 12% 10% 6.59% 8% 5.33% 7.11% 6% 4.67% 5.10% 4% 0.90% 2% One-Month Bills 1.78% One-Year Bills Five-Year Notes Twenty-Year U.S. Govt. Bonds 0% Sources: Ibbotson, CRSP and Merrill Lynch ADDRESSING CREDIT RISK WITH MUNICIPAL BONDS Because credit risk increases in deflationary environments, deflation and default often accompany each other. To minimize material credit risk, we add high-quality municipal bonds to the portfolio. This also helps mitigate tax exposure. As shown in Exhibit 4, on page 4, tax-exempt issuers have historically shown very little credit risk. Looking back at the Great Depression, for example, we find that the annual default rate for municipal bonds was 1.8%, which translated to a cumulative default of 15% between 1929 and However, after taking into account recovery rates, the realized annual loss was just 0.1%. We see a similar story of risk when comparing investment-grade municipal bonds to corporate bonds. According to Moody s, from 1970 to 2011, 10-year average cumulative default rates for investment-grade municipal bonds were close to 0%, while the 10-year average cumulative default rate among investment-grade global corporate bonds was 2.6%. Although this difference in magnitude may not persist going forward, it does show the high underlying credit quality across a diversified pool of investment-grade municipal issuers. Northern Trust 3

4 EXHIBIT 4: ANNUAL DEFAULT AND LOSS RATES OF MUNICIPAL DEBT Chart 1: Annual Default and Loss Rates 7.3% % defaulted % loss Source: PIMCO 0.9% 3.6% : 7.3% default rate, 0.9% loss rate : 3.6% default rate, 2.1% loss rate : 1.4% default rate, 0.3% loss rate : 1.8% default rate, (15% cumulative default), 0.1% loss rate 2.1% 1.4% % 1.8% % 8% 7% 6% 5% 4% 3% 2% 1% 0% % of Average Bonds Outstanding CAN HIGH YIELD BONDS PLAY A ROLE IN GOALS-DRIVEN PORTFOLIOS? Although Goals Driven Wealth Management tries to mitigate credit risk for risk control assets, high yield bonds still can play a role in your portfolio. High yield bonds behave much more like risk assets than like other fixed income assets. For this reason, we would include them as part of a diversified risk asset allocation intended to fund long-term goals. But taxes also are a factor when considering high yield bonds: The income they generate is fully taxable at the higher ordinary income tax rates. This tax treatment mutes the relative appeal of high yield versus both municipal bonds, which have lower yields but are tax exempt, and public equities, which benefit from tax-deferred compounding of gains and the more appealing long-term capital gain and dividend tax rates. To mitigate these tax disadvantages, high yield bonds are best located in tax-deferred accounts, if you have them. PROVIDING STABILITY TO FUND YOUR NEAR-TERM GOALS We use fixed income in Goals Driven Wealth Management to fund your nearer-term, high-value goals. To do that confidently, we work to mitigate the key risks to fixed income inflation, credit risk, interest-rate risk, liquidity and taxation by including a variety of risk control assets in the allocation. This broader approach increases the likelihood that your overall fixed income allocation will maintain a relatively stable principal value in many types of environments, while still offering a positive return after expenses, taxes and inflation. Northern Trust 4

5 2017 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois U.S.A. Incorporated with limited liability in the U.S. Products and services provided by subsidiaries of Northern Trust Corporation may vary in different markets and are offered in accordance with local regulation. For legal and regulatory information about individual market offices, visit northerntrust.com/disclosures. IMPORTANT INFORMATION: This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Corporation and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor s particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved. northerntrust.com Q54429 (6/17) Northern Trust 5