Updated February 2021

FIXED INCOME INVESTING

Abstract:  Active fixed income managers underperform passive and index funds investing in fixed income just as they do with equities.  Research from DFA, Dimensional Fund Advisors, indicates that DFA's fixed income portfolios outperform actively traded fixed income portfolios between 75% and 95% of the time depending upon the fixed income asset class.  Active fixed income investing suffers from survivorship bias like active equity funds.  Funds which fail to survive are removed from the data base boosting apparent returns for the remaining funds.  Economists and experts cannot predict future interest rates or bond prices at a rate greater than chance guessing.  Long bonds are significantly more volatile in price and can decline far more in price than short or intermediate bonds and EAM does not recommend long bonds.  This article also examines the advantages and disadvantages of bond funds versus maturity laddered individual bonds and when to use tax free bonds as opposed to taxable bonds.

Fixed income investments are typically employed to generate income during retirement and dampen volatility in equity portfolios.  Passive and index management strategies are even more important in fixed income investing than in equity investing because probable long-term inflation adjusted returns are so much lower in fixed income than from equities and trading and management expenses significantly reduce returns.  Just what are the facts on fixed income investing?

ACTIVE FIXED INCOME MANAGEMENT UNDERPERFORMS PASSIVE AND INDEX FIXED INCOME MANAGEMENT.  As is the case with equities active fixed income managers who try to beat fixed income indexes add expenses and decrease investor returns.  A 1994 study found that only 16% out of 800 fixed income funds beat their relevant index benchmark over the preceding 10 years.  Average performance in another study of 361 active fixed income funds was about -1% annually under their index benchmarks.  DFA (March 2010) calculated the percentage of active fixed income funds that failed to beat their respective fixed income indexes for the period of July 2004 through June 2009.  Across eight different fixed income markets active managers underperformed 78% of indexes in intermediate government bonds up to 100% of indexes in California municipal bonds.  Underperformance by active managers is even greater in fixed income markets than in equity markets.  For 2005 through 2014 DFA found index benchmarks outperformed 95.4% of actively managed long government funds, 76.0% of mortgage backed funds, 70.5% of nationwide AMT-free municipal bonds, and 85.0% of AMT-free California municipal bonds.  Active funds also suffer from attrition through survivorship bias with 17% of fixed income funds having been merged or liquidated between 2010 and 2014.  This increased the performance of the funds that survived.

EXPERTS CAN'T BEAT CHANCE WHEN PREDICTING FUTURE INTEREST RATES AND ECONOMIC SHIFTS.  Active fixed income managers often try to beat fixed income index benchmarks by predicting the upcoming direction of the economy and interest rates.  Unfortunately, there's abundant evidence that economists and market analysts can't consistently predict the future of the economy or interest rates with any more accuracy than chance guessing.

One study of 36 biannual economic forecasts in the Wall Street Journal found that three-month Treasury bill rates moved in the opposite direction of the expert economists consensus forecasts 53% of the time.  Consensus predictions on the direction of the benchmark 30-year Treasury bond were wrong 67% of the time.  Chance guessing is only incorrect 50% of the time so predictions of the nation's most eminent economists were worse than chance guessing.  Active managers and economists avoid discussing this issue and are rarely questioned on frequent large past failures by the financial press, if ever.  Admitting that they don't add value would be bad for business.  The former Federal Reserve Chairman, Ben Bernanke, had been almost consistently wrong in his economic predictions.  In 2008 Dr. Bernanke asserted that the deterioration in the sub-prime mortgage market was contained, that the US wouldn't fall into a recession, and that the Fed could fix any problem with its $800B war chest.  Events played out exactly opposite in a few months but Dr. Bernanke never commented on his errors.

ACTIVE FIXED INCOME MANAGEMENT IS EXPENSIVE.  Fixed income investors who choose active managers give up a sizable percentage of the interest from their investments, about 15% to 35%, depending on current interest rates and management expenses.  Most actively traded fixed income funds today have expense ratios running between 0.5% and 1.0%.  An investor in short term 2-3 year maturity high quality intermediate term tax-free bonds in 2021 will receive around will receive around 0.3% to 0.4% annually and an investor with intermediate tax free 0.8% annually.  Both yields are currently about 1.5% below the inflation rate meaning investors are paying money to loan money, almost unique in market history and certainly not a reason to buy muni bonds in 2021.  Passive and index fixed income funds typically run 0.05% to 0.25% annually in management fees.

RISK AND RETURN IN FIXED INCOME ARE HIGHLY CORRELATED.  Even more than equities, risk and return are highly correlated in the fixed income marketplace.  This is so since virtually all fixed income buyers can agree that a 4% yield is better than a 3% yield so all other things being equal fixed investors will buy the 4% yield and drive up the price of the bonds and drive down the yield to 3%.  It isn't a tough decision to choose a higher yield.  There are no "undiscovered" high return, low risk fixed income investments though Wall Street constantly promotes new product.  All previously issued fixed income investments fluctuate in value as interests rates change.  High quality short-term bonds fluctuate far less in price than low quality long maturity bonds or non-maturing income investments like preferred stock.  Low and medium quality income investments, like high yield bonds and second mortgage pools, carry a risk that principal and income may decline or fail to be repaid entirely.  Thus, high yield means lower quality.  There is simply no evidence that adding lower quality or longer maturity fixed income investments to a fixed portfolio will produce better long-term returns for a given level of risk.  The best risk/return ratios are generally found in short maturity or intermediate maturity investment grade bonds rated A or better.  Since 2009 a large increase has occurred in the lowest investment grade bonds, BBB, and about 45% of all investment grade bonds in 2019 were rated BBB.  During a recession these could easily fall to a "junk bond" classification.

High quality fixed income investments include Treasury issues, investment grade corporate bonds, C.D.'s and other U.S. agency guaranteed issues like GNMA's, and investment grade tax-free municipal bonds.  Medium quality fixed income investments include preferred stocks, syndicated bank loan portfolios, asset backed securities, and global government bonds.  Low quality income investments include high yield or 'junk" corporate and municipal bonds, private uninsured trust deeds on real estate, and a variety of "structured product" derivatives like CMO's and CLO's.

Fama and French of DFA have applied their five-factor returns model to the returns of various "hybrid" stock/bond instruments including convertible bonds, high yield bonds, utilities, and REIT's.  Their model analyzes stock and bond returns with three stock factors, an overall market factor, firm size, and book-to-market equity, and two bond factors, maturity and default factors.  They then tested modeled hybrid returns against various combinations of stocks and bonds.  The returns of hybrid instruments were well-explained by the model in statistical terms.  This suggests that investors who wish to capture the expected returns from hybrid instruments can do so simply by combining high quality fixed income instruments with equities.

BOND RATING AGENCIES LIKE S&P OR MOODY'S ARE ENMESHED IN A CONFLICT OF INTEREST WITH INVESTORS.  Rating services are usually paid by bond issuers who have a strong interest in high ratings.  Prior to the 1970's this wasn't so.  Rating agencies were major factors in creating the credit crisis that began in 2007 and often rated highly risky structured derivative products as AAA prior to the 2007 through 2009 period.  DFA looks at commercial ratings but also adds in their own proprietary bond rating screens for all bonds in all its fixed portfolios.

NO FIXED INCOME INVESTMENT CAN BE CONSIDERED ABSOLUTELY SAFE.  No fixed income investment or any investment for that matter should ever be considered absolutely guaranteed and absolutely safe.  Please see "Investment Risks" elsewhere on our website.  Research by Dr. Reinhart and Dr. Rogoff in "This Time is Different", reviewed on our website, clearly shows that even sovereign (country specific) Treasury debt defaults are common throughout economic history.  One reason is that little if any legal recourse is available to foreign debt holders of another country's debt.  In 2011 even US Treasury issues were downrated.  Corporate bonds have varying default rates in varying economic conditions and default rates are also a function of bond quality.  Interestingly, in 2010 only four US corporations received AAA bond ratings.  Typical 10-year default rates for investment grade bonds range from around 3% annually for BBB corporates to well under 0.5% for AAA's.  Municipal bonds have lower default rates than corporate bonds but occasionally have defaulted or had long delays in interest payments.

LONG MATURITY BONDS ARE MORE VOLATILE IN PRICE AND RISKIER THAN SHORT BONDS.  Prices on long-maturity or non-maturing fixed income investments fluctuate much more than prices in short or intermediate maturity fixed income.  Short bonds are generally defined as anything less than 3 years to maturity and intermediate bonds are generally defined as bonds maturing in 4 to 7 years.  When interest rates rise previously issued bonds decline in price with intermediate bonds declining more than short bonds.  As a rough rule of thumb a 1% increase in interest rates will cause previously issued one year bonds to decline 1% in value, 5 year bonds to decline 5% and so forth.

Research has shown that investors receive little additional advantage from investing in long or non-maturing income investments along with more risk and volatility.  For example, Dimson, et al., "Triumph of the Optimists" (2002), looked at short maturity bills versus longer maturity bonds for 1900 through 2001 for fifteen countries.  Longer bonds outperformed short-term bills by about 0.5% to1% annually.  Yet, there is risk.  DFA data show that an investor entering the long US Treasury market in 1941 wouldn't have broken even until 1991.  Even the three-month Treasury bill beats inflation long-term by about 0.5% per year, optimum risk/return ratios are in the 3 year range and, the highest average yields are found in the 7 to 8 year maturity range.

Maturity laddered bond portfolios offer some protection against interest rate fluctuations if the money from the bonds will be needed at some specific time in the future.  For example, a maturity laddered portfolio might hold approximately equal weights of municipal bonds maturing from 2017 through 2021.  This would be termed a five year bond ladder.  When the 2021 bonds mature 2026 bonds would be purchased and when the 2026 bonds mature five years later bonds maturing in 2031 would be purchased and so forth.  That way investors always have money maturing and will always received the average five year bond yield.  Whether rates rise or fall new money is always available and current interest rates, high or low, are always being sampled.  Since 1982, a year when interest rates were at record all time highs, this strategy generally hasn't worked as well as just buying long-term bonds.  However, no one could have known in advance that America was about to experience a 30-year decline in interest rates from the mid-teens down to under 3% for 30 year bonds and the biggest bond bull market in our history from 1982 through 2015.  It is also interesting to note that from 1981 through 2011 the 30 year US Treasury slightly outperformed the S&P 500.  As of 2021 interest rates are effectively at zero or below after inflation and global bond yields are also very low with an estimated $15 trillion or so of global bonds at negative interest rates.  Interest rates fall and rise in 10 to 35 year cycles and it is virtually certain that at some point interest rates will begin to rise back to average levels from today's very low levels and then rise to much higher levels in an endless cycle of rises and falls.  The supply of and price of money determines the prices of all other assets, much money creation and very low interest rates stimulate the price of assets and that's what the US has experienced from 2009 through 2021.

DETERMINE WHETHER TAXABLE OR TAX-FREE BONDS OFFER THE BEST AFTER TAX YIELD.  Taxes should always be considered when constructing a fixed-income portfolio in a taxable account.  If additional income from investments will be taxed in the two or three highest marginal tax brackets it is usually in the investor's advantage to own tax-free municipal bonds for some if not all of fixed income in taxable accounts.  Yield spreads between taxable and tax-free bonds vary for a variety of reasons but US investors will generally begin to see a slight after tax advantage to tax-free bonds if their adjusted gross income is $225,000 or more.  Municipal bonds offer no after tax yield advantage for income taxed in lower brackets or in tax-deferred accounts.

DETERMINE WHETHER BOND FUNDS OR INDIVIDUAL MATURITY LADDERED BONDS WORK BEST FOR YOUR NEEDS.  Opinions on this matter vary.  In most cases bond funds from DFA or Vanguard are easier to use than maturity laddered bond portfolios and produce comparable or better returns than portfolios constructed from individual bonds since bond fund managers can obtain bonds at lower mark-ups than retail investors.  As noted above individual bond portfolios offer one clear advantage over bond funds.  They assure that no matter whether interest rates rise or fall the bonds in the portfolio will be worth par or $1000 per bond when they mature and the interest rate received is set at purchase.  If an investor needs a specific chunk of money at some specific time in the future then they should buy probably buy bonds maturing at that date.  DFA recommends this as does EAM.  Otherwise, passive and indexed bond funds are likely to offer a better result.  In periods of rising interest rates the income from funds will rise faster than in a individual bond portfolio since bonds within the fund are always maturing and being replaced with tomorrow's higher yielding bonds.  Bond funds typically hold 200 or more bond issues while an individual bond portfolio is likely to hold far fewer positions, offer less frequent opportunities for reinvesting proceeds from maturing bonds, and rise less rapidly in yield then a bond fund in a rising interest rate environment.  The downside is that rising interest rates cause a decline in bond fund share prices.  In the 2008 financial crisis short bond funds declined about 3% to 5% in value for six months or so and intermediate bond funds declined about 8% to11% for a bit longer.  When interest rates top out and the bonds within a bond fund all mature then the bond fund share price minus whatever the bond expense ratio cost over the years will gradually go back to par, the purchase price for the bonds.  Bond funds also offer share price appreciation in a declining interest rate environment and mitigate declines compared to portfolios of individual bonds since individual bond portfolios hold relatively few bonds compared to funds and will decline more from the failure of even one bond.

DFA and Vanguard bond funds we generally recommend carry expense ratios from 4 basis points (0.04%) up to about 25 (0.25%) basis points.  For a short bond portfolio this might mean that the total management expense for the bond fund would run 50 to 75 basis points for three years.  For an intermediate bond fund out maturing in 6 years they might total 100 to 150 basis points.  However, each time an individual bond issue is purchased by a retail investor there is a spread between wholesale and retail.  These are difficult to determine, not divulged by bond desks, and run up portfolio expenses in a portfolio of individual bonds.  DFA has looked at the typical spreads investors pay for purchasing bonds in various amounts.  DFA pays about 0.05% when purchasing bonds in $2.5 million or greater amounts per issue and notes that a typical retail investor pays 0.75% or more for purchasing bonds in $100,000 amounts, 1.12% when purchasing bonds in $50,000 amounts and a stiff 1.74% when purchasing bonds in $10,000 amounts.  The WSJ (10-25-15) cites an academic study by a former chief economist at the SEC in which he estimates that individual investors are paying bond dealers and other middlemen an average of $7.72 per $1,000 or par purchase on corporate bonds.  This is equivalent to 0.77%.

Assuming an investor has constructed a laddered portfolio of bonds running from 2 years through 7 years with a 5 year average maturity these spreads will be paid every time bonds mature and are replaced.  This produces a continuous drag on returns.  If we assume our investor is buying bonds in $100,000 amounts once per year in a five year bond ladder then their "expense ratio" on the $100,000 of bonds might be 75 basis points annually x 5 years or 375 basis points.  Based purely on spreads funds offer a much better value for investors.  And, if an investor needs cash before an individual bond matures and wants to sell it they will again pay a spread and they may confront a liquidity problem as was the case for some bonds in 2008 and 2009 .  Some investors pay a private individual bond fund manager 0.35% or so to manage individual bonds on top of any spreads the manager is paying to acquire bonds from bond issuers or brokers.  Often, they allege they can outperform the bond market.  Research shows that's highly unlikely.

A typical bond fund holds far more bond issues then private investors are likely to hold.  Bond funds increase diversification and decrease the effects of a bond default on total returns.  If one bond in a portfolio with ten bonds fails it will have a significant effect on the return of the portfolio.  If that occurs in a portfolio with 200 bonds it will make little difference.  Bond funds can add to returns in other ways.  DFA "actively" manages its passive bond portfolios and claims to add 0.15% to 0.40% above benchmarks by controlling where they invest on the yield curve (the term premium) based on its slope and relative shifts in bond prices due to continuous shifts in the perceived credit quality of classes of bonds (the credit premium).  They also monitor all bonds in all portfolios every day for any regulatory or other problems that may be developing for the issuer.  The main disadvantage of bond funds is that in a rising interest rate environment the share price or N.A.V. will decline until a little after market interest rates stop climbing and if an investor needs money from their bonds at a specific time in the future they may receive less back in a bond fund then if they hold individual bonds.  Our recommendation is to use individual bonds when money is required in some specific amount at some specific time in the future and otherwise use bond funds when a fixed income investment is likely to be held for a long period of time and particularly when it is held for current income.  Funds are also easier to purchase and maintain than portfolios of individual bonds.

FIXED INCOME INVESTMENTS ARE UNLIKELY TO OFFER ASSET GROWTH.  Fixed income investments provide interest income and increase stability in equity portfolios.  They should not be expected to grow in value though they will fluctuate in value as interest rates fluctuate.  They should not be used for speculative trading since the economy and interest rates are unpredictable and even professional bond traders underperform their respective indexes most of the time in all fixed income categories.

BOND MARKET PRICING IS OPAQUE.  Investors may occasionally come upon claims made by bond managers that they'll get special deals on bonds or benefit from tax-loss bond swaps and other bond trading or selling strategies.  The efficiency of bond markets, the failure of actively managed bond portfolios to outperform bond indexes, and the lack of any hard data to show that indexes can be improved upon all suggest that such claims are without merit.  On several occasions our firm has compared same day prices for identical bonds actually bought and sold by a variety of bond dealers and brokers.  We found little consistent difference in prices across various bond desks.  Troublingly, bond buyers have little or no ability to determine how much wholesale bond dealers are marking up their bonds.  On several occasions the SEC has called for more transparency in bond pricing but little has been done.

GLOBAL FIXED INCOME ENHANCES DIVERSIFICATION.  Most US investors today are familiar with and have exposure to some non-US dollar denominated equities in international developed or emerging markets.  Far less common is exposure to non-US dollar foreign fixed markets even though about 60% of all global investment grade debt is not issued by the US.  Most US investors do no hold any foreign fixed income.  DFA and a few other firms offer exposure to foreign debt markets as an additional diversifier across currencies and bond markets.  Since currency markets trade 24/7 and foreign bonds are effected by changes in relative currency prices if they are not hedged foreign bonds are a bit more volatile than domestic bonds.

CONCLUSION:  Investors interested in fixed income investments should employ passive and index strategies and not trade fixed income holdings.  Investors should avoid actively managed fixed-income mutual funds and actively managed fixed income bond accounts since management expenses very significantly reduce returns below those of bond indexes.  Depending upon an investor's time frame and purpose for the money either maturity laddered bonds or bond funds will be the better yielding choice.