Fixed Income Portfolio Construction – A Guide for Advisers
In a previous article, How to Use Fixed Income in a Balanced Portfolio, we discussed how bond exposure can support a diversified investment portfolio. This guide takes the next step by exploring how advisers can select the most appropriate bonds or bond funds based on an investor’s risk tolerance and financial goals – whether they prioritise growth, income, capital stability, or a combination of these objectives.
Establishing risk tolerance
The first stage of portfolio construction is determining how much bond exposure an investor requires to achieve their objectives.
- Cautious investors, such as retirees or those approaching retirement, may benefit from a larger allocation to bonds. Fixed income can provide defensive stability, a steady income stream, and capital preservation.
- More risk-tolerant investors, including younger individuals with longer time horizons, may prefer a smaller fixed income allocation. Even so, bonds can still play a role in diversifying equity-heavy portfolios by smoothing returns, offering regular income and adding downside protection.
Risk tolerance should be a starting point for setting portfolio objectives
Assessing an investor’s liquidity needs based on their financial goals
Once risk tolerance is established, the next step is to assess the investor’s liquidity needs - how much of their portfolio must remain readily accessible and how much can be invested with a longer time horizon. Liquidity requirements are closely tied to an investor’s broader financial goals and help determine the most suitable types of fixed income exposure.
A helpful way to think about liquidity is to view it in tiers, each reflecting different time horizons and levels of cash-flow urgency:
Tier 1: Immediate needs
This is typically the smallest and most liquid portion of an investor’s assets, reserved for day‑to‑day expenses, emergencies, or short‑term obligations. Capital stability and ready access are the priorities. This tier is usually met through traditional cash or cash‑equivalent holdings.
Tier 2: Near‑term needs
This tier is larger than Tier 1 and supports expenses that are not immediate but are expected in the near future. Investors here may be comfortable taking on a small amount of additional risk in exchange for slightly higher return potential. This tier may include short‑dated and other highly liquid fixed income instruments.
Tier 3: Longer‑term needs
Typically the largest tier, this portion reflects capital that investors can commit over a longer horizon. The objectives may include growing purchasing power, generate reliable income, or protecting against inflation over time. Dedicated return‑seeking fixed‑income strategies, such as core or income-focused bond funds, may be appropriate.
Both Tier 2 and Tier 3 naturally involve modestly higher levels of risk compared with traditional cash investments, so aligning these tiers with an investor’s time horizon and liquidity requirements is essential.
A tiered approach to liquidity
Source: PIMCO. For illustrative purposes only.
*Enhanced return investments include ultra- and short-term strategies and will be more volatile than traditional cash investments and their value will fluctuate. The investments may also invest a portion of their total assets in junk bonds.
While actively managed core and short-term strategies can offer additional return potential, investors need to carefully weight the pros and cons. Short-term strategies are not insured, are not a deposit or obligation of the bank, and are not guaranteed. They are subject to investment risks, including possible loss of principal. Money market funds are not insured or guaranteed and although money market funds seek to preserve the value of your investments, it is possible to lose money by investing in a fund.
A liquidity‑tiering approach is not static. An investor’s required balance between Tier 1, Tier 2, and Tier 3 will naturally evolve as life stages change, financial goals shift, or market conditions alter the opportunity set.
The most important step is determining the true amount of capital that must remain in Tier 1. Much of the potential return enhancement available to investors comes from the incremental “step out” into Tier 2 and Tier 3 assets, where longer time horizons allow for higher‑return opportunities and a broader selection of potential investments.
Expressing economic viewpoints
A well‑constructed bond portfolio can also reflect an investor’s—or adviser’s—view on the economy or specific issuers.
- Duration management: Duration can be used to align a portfolio with expectations for interest rate changes. If rates are expected to fall, longer-duration bonds may be appropriate; if rates are likely to rise, shorter-duration exposures may be preferable.
- Quality management: Economic conditions can influence whether a portfolio emphasises higher- or lower-quality bonds. In a strong economy, investors may be more comfortable allocating to riskier high yield corporate bonds, as default risk tends to decline. Conversely, during weaker economic periods, a tilt toward high quality government and corporate bonds might be more suitable.
- Sector management: Within corporate bond markets, advisers can express views on specific sectors through portfolio positioning. For example, if technology is expected to outperform, a portfolio can incorporate targeted allocations while still balancing risk through exposure to traditionally defensive sectors, such as utilities.
Passive bond strategies
Until now, we have assumed an active approach to portfolio construction. However, some portfolios may rely on passive strategies or a blend of both active and passive management.
Passive funds may appeal for several reasons: they often feature lower fees and transaction costs, and they typically provide transparency, as daily index listings reveal current fund exposures. However, advisers should note:
- Replicating bond indices can be challenging due to the size, turnover, and complexity of the fixed income universe, where many bonds are illiquid, have limited float, or are held to maturity.
- Index design in fixed income can be suboptimal, as many indices weight issuers by the amount of debt outstanding, rather than fundamentals. This can lead to the highest‑debt issuers receiving the largest weights.
Manager selection
After determining portfolio structure, some advisers may choose to invest through a bond fund manager. Selecting the right provider can be challenging, so it’s helpful to approach this process in stages. Key points to assess include:
Portfolio goals: Does the manager offer the funds that meet your client’s objectives? The initial list of potential managers can often be narrowed quickly by excluding those whose offerings do not align with the required strategies.
Performance experience: When evaluating core managers in similar categories, a key consideration is how they have performed during periods of stress. Core bonds should not only offer return potential but also provide diversification in client portfolios.
Fees: Management fees vary and can affect long-term returns. Compare costs with historical performance to assess whether fees are justified.
Risk management: The chosen manager should reflect the investor’s risk profile. Investment performance should be consistent rather than experience sharp highs and lows.
Overall, a fundamental question to ask is: How efficiently has the manager performed relative to the benchmark? Strong manager selection reflects not only excess return potential but also disciplined risk‑adjusted performance.
