Don't give up on fixed income

Over the past several years, fixed income has given investors plenty of reasons to be frustrated. After a long period of historically low interest rates, rates rose rapidly beginning in 2022 as the Federal Reserve increased rates to combat inflation. Rising rates caused bond prices to fall, and investors who had become accustomed to the stability of bonds experienced something they may not have seen in decades: meaningful losses in their fixed-income portfolios.

For investors who watched their stock portfolios recover while their bond portfolios struggled, it is understandable to ask a simple question: Why should I continue owning bonds?

The answer is that the role of fixed income in a portfolio is about much more than generating the highest possible return. For many investors, particularly those approaching or living in retirement, bonds serve an important purpose as a risk management tool.

Bonds are not designed to compete with stocks

One mistake investors can make after a difficult period for bonds is comparing their returns directly with those of stocks. Over long periods, investors generally expect stocks to provide greater returns because they are taking on greater risk. The purpose of adding fixed income to a portfolio is not necessarily to outperform stocks. It is to create a portfolio that behaves differently from stocks and is designed to provide greater stability.

Consider an investor with a portfolio consisting entirely of stocks. When the stock market falls 20 percent, the entire portfolio is exposed to that decline. An investor who instead owns a combination of stocks and high-quality bonds may experience a substantially smaller decline. That difference can become particularly important for someone who is withdrawing money from their portfolio.

The goal of fixed income is therefore not simply to maximize return. It is to help manage the amount of risk an investor takes to achieve their financial objectives.

The role of bonds becomes even more important in retirement

For someone who is still decades away from retirement, a significant market decline may be uncomfortable but may not materially change their financial plan. They have time to continue working, contribute to retirement accounts and wait for markets to recover.

The situation is different for someone who is already taking distributions from a portfolio. Selling stocks after a significant market decline to fund living expenses can permanently reduce the number of shares available to participate in a future recovery. This is one reason we generally do not believe a retirement portfolio should be constructed simply to generate enough dividend and interest income to cover every dollar of spending. Instead, we focus on total return while maintaining an appropriate amount of high-quality fixed income to help provide stability and liquidity.

For clients taking regular distributions, we often maintain approximately five to seven years of anticipated withdrawals in high-quality, low- to intermediate-duration fixed income. When a distribution is needed, we can use that portion of the portfolio rather than being forced to sell equities during a significant market downturn. As markets move, the portfolio can then be rebalanced to replenish the fixed-income allocation.

Today's yields are different from a few years ago

There is another reason investors should reconsider whether they have given up on bonds too quickly. The interest rate environment has changed significantly from the ultra-low rate environment that existed for much of the 2010s and early 2020s.

When interest rates were near historic lows, investors had little income available from high-quality bonds. Today, fixed income can provide a much more meaningful level of current income while still serving its traditional role as a stabilizing component of a diversified portfolio.

This does not mean bonds are risk free. Longer-duration bonds can still experience meaningful price fluctuations when interest rates change, and investors face credit and inflation risks depending on the securities they own. However, investors do not necessarily need to reach for lower-quality or highly speculative bonds to generate attractive income.

Fixed income can provide an opportunity during market stress

One of the most valuable characteristics of high-quality bonds is their potential to provide liquidity when investors need it most. During periods when stocks are under pressure, having a meaningful allocation to high-quality fixed income can give investors options.

Rather than selling stocks simply because cash is needed, an investor may be able to draw from the fixed-income portion of the portfolio. Once markets stabilize, the portfolio can be rebalanced. In this way, fixed income becomes more than an investment. It becomes part of the portfolio's overall risk management system.

This approach can also make it easier for investors to stay disciplined. Knowing that several years of spending needs are already positioned outside of equities can make it easier to remain invested when the stock market becomes uncomfortable.

The right amount depends on the investor

There is no universally correct allocation to fixed income. A 35-year-old investor with a long time horizon and stable employment may have a very different appropriate allocation than a 75-year-old retiree who depends on their portfolio for income.

The right allocation should consider an investor's risk tolerance, time horizon, cash flow needs, tax situation, other sources of income and overall financial circumstances. The important point is that fixed income should be evaluated based on the role it plays in the overall portfolio rather than simply based on whether it has outperformed stocks recently.

Final thoughts

The past several years have reminded investors that bonds are not immune from losses. Rising interest rates created a particularly difficult environment for fixed income, and many investors understandably became frustrated with the asset class.

But abandoning fixed income because of a difficult period may cause investors to lose sight of why they owned it in the first place. A diversified portfolio is not designed for every investment to perform well at the same time. It is designed so that different parts of the portfolio can serve different purposes throughout different market environments.

For many investors, particularly those approaching or living in retirement, high-quality fixed income remains an important tool for managing risk, providing liquidity, generating income and helping prevent the forced sale of equities during market downturns.

The question should not simply be, "Did my bonds outperform my stocks?" The better question is, "Did my overall portfolio provide the growth, income and risk management I needed to accomplish my financial goals?"

That is ultimately what diversification is designed to accomplish.

Reid Schwartz is a columnist for The Item and Co-Founder of Creech Schwartz Wealth Management &Partners in Sumter, SC, where he works as a financial advisor helping individuals, families, businesses, and nonprofits plan for long-term financial success.

*Tax and accountancy services are not available through or provided by Creech Schwartz Wealth Management or &Partners, LLC.

This article is for educational purposes only and not to be interpreted as tax or legal advice. Any tax planning strategies discussed by Creech Schwartz Wealth Management will be in conjunction with your tax/legal professional.

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