Promote fixed-income active management

How does the typical investor handle fixed-income investments? At Schwab's recent Impact 2007 conference in Las Vegas, I had the chance to ask investment advisors and investors about fixed income target rates of return, types of instruments, and investing tools.

Target Returns -- Not surprisingly, investment advisors target a 4.5 to 5 percent fixed income return; while some investors had no specific target, they estimated actual returns below 4 percent annually. When equity allocations exceed 80 percent of a portfolio, fixed income returns in such a range do not constitute a significant drag on overall portfolio returns. This will change as we age; reducing portfolio risk and increasing portfolio income will become important. Equity allocations will likely be reduced by a higher allocation to fixed income. This will tend to place a significant burden on equities to maintain portfolio returns, unless higher returning fixed income alternatives can be found.

Types of Instruments -- AAA-rated investments are popular due to a perceived lack of credit risk. This truism was been tested in 2007 as many AAA-rated securities in the mortgage space were anything but AAA. Municipal bond investors have not been immune to credit concerns. About 60 percent of the $2.6 trillion municipal bond market is insured by AAA-rated bond insurers; at this writing, given that many of these same insurers have significant exposure to the mortgage space, investors are concerned about the value of such insurance.

Alternative "managed fixed income strategies" can serve as an option to holding "AAA"-rated securities alone. According to Hedge Fund Research, the average annual return for its Fixed Income Index was about 8.6 percent and its High Yield Fixed Income Index was about 12 percent. Why limit fixed income returns to between 4.5 and 5 percent? Allocating a portion of one's fixed income exposure to alternatives can likely increase returns and decrease portfolio risks.

Investing tools -- While a company's equity is traded under a single ticker and on major exchanges, issuers of debt do not typically have one "tranche" or maturity of debt outstanding; rather, debt will have different coupon interest rates, maturities, and call and security provisions. Debt is often traded over the counter rather than on established exchanges. These characteristics require an understanding of bond math to correctly analyze a specific fixed income security. While "buy and hold" strategies are often used, fixed income investments are still susceptible to market volatility, credit risk and interest rate risk, notwithstanding the expectation that securities will be held to maturity.

To reduce these risks, a ladder strategy may be implemented, where short duration, high quality bonds are purchased over time. The laddering occurs as funds from coupon interest and/ or maturity dates are reinvested in new bonds. While this can be an effective tool, it does not replace the need to rely on expert advice and experience in regard to the direct investment in fixed income securities. When asked about managing fixed income, a number of folks answered "we tend to use a ladder strategy and pray." While we can endorse prayer for any number of obvious reasons, prayer investing would not have made our list.

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