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An Allocation to Investment-Grade Fixed-Income Securities in the Current Market Environment

If recent conversations with clients are any indication, a primary worry out there is how to plan for, or guard against, the "inevitability" of higher interest rates, a.k.a. falling bond prices. Most of these discussions arise from genuine concerns about the future performance of fixed-income investments given this backdrop.  Some arise from a touch of performance-chasing, i.e. "Stocks have done so well in the last few years, so why not allocate more of our portfolio to them at the expense of our bond allocation, which has been languishing?".

In either case, my response is that very little in the world of investing is inevitable.  When market participants unanimously judge that a future occurrence is inevitable, it becomes reality very quickly.  In other words, if higher interest rates in the near future were a sure thing, we'd already have those higher rates, for who would buy bonds now if they were guaranteed to quickly lose value?  (Your answer to that question right now might be "Central banks around the developed world", but they're not the only market players currently buying fixed-income products.)

I would also point out that financial markets have a way of confounding the consensus opinion.  More than thirteen years ago, I was quoted in a Financial Planning magazine article on how advisors were positioning client portfolios in light of the "inevitability" of higher rates. Needless to say, most benchmark interest rates both here and abroad are lower now than they were then.

This isn't to say I'm a bond bull.  I continue to feel that stocks (especially with a value and international tilt) and commodities will be better-performing asset classes over the intermediate- to long-term.  But between now and then, there will be times when you will be happy to have an allocation to high-quality bond funds as part of your diversified portfolio.

Most of us wouldn't do without car insurance if we had the choice, even though we know that on average it will be a losing proposition.  Think of high-quality fixed-income as portfolio insurance against those times when fear and uncertainty reign.  And even better, it's insurance that pays you a coupon.