The Risk in Fixed Income Investments

Conventional investment theory says that investors as a whole are risk averse, they want to avoid risk. Naturally the uninformed investor will gravitate towards the perceived safety of principal and lack of "risk" provided by savings accounts and GICs, term deposits and investment grade Bonds.

The definition of risk according to businessdictionary.com is the "[p]robability or threat of damage, injury, liability, loss, or other negative occurrence, caused by external or internal vulnerabilities, and which may be neutralized through pre-mediated action." Given this definition let's look at historical returns on bonds versus equities using US data. Gross historical annual returns on stocks (equities) over the past 70 years have been in the 10 to 12 percent range, while in the same period bonds have returned an average of 5 percent annually. Although the future is uncertain, if we extrapolate this historical data to expected future returns, stocks will out-perform bonds over the long term.

Over the long term (15-20 years+), on an after-tax real return basis (net of inflation and taxes), the only real growth an investor would see is in the portion of their portfolio allocated to equities. For example we will say that an investor holds exclusively fixed-income investments in a non-registered, taxable portfolio. Given our expected asset class return assumptions above, the Fixed Income portfolio earns 5% nominal annual return over a period of 20 years. With an inflation expectation of 3% per annum, and a consistent marginal tax rate of 45%, over that time the investor has actually realized a negative real return (~ -1%). Alternatively, if the investor held a 50-50 split of Equities and Fixed Income, the real return would have been positive (approximately 1.6%).

This demonstrates the very real potential risk that fixed income investments may not protect your wealth. The superior historical returns of equities on a real return basis will better protect your portfolio from cost of living increases and the wealth-erosion effect of inflation. Short-term and cyclical fluctuations in equity prices are what scare most investors away from allocating more of their portfolio to equities and stocks. The trade-off is in short-term fluctuation and/or loss versus long-term return that compensates for inflation and taxes. Investors must be educated on this point, because it will influence their willingness and ability to bear a given amount of risk. (More on risk tolerance in later posts)

But think about it. Business owners (shareholders) participate in the success and profits of the business. Returns may be in multiples of the original capital invested. There is unlimited upside potential. This is in contrast to those who lend to a business (bondholders). Bondholders are only entitled to a series of fixed periodic "coupon" payments, receiving their invested principal at the bond's maturity date. Thinking of it in this way it seems rather intuitive that equities would be superior in terms of wealth creation and preservation.

For more on this topic read the popular book “Stocks for the Long Run” by Jeremy Siegel.

Happy Investing!
Michael