These may be rough days for fixed income investors, but portfolios still require balance

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Fixed income isn’t a bad word. It has been hijacked by poor returns and shinier toys. Misunderstood. Rendered unattractive. Even made unwelcome.

I know – I live it daily. I and others focused on fixed income see the eye rolls and the blank stares, yet here we are.

At its core, fixed income exists to provide income and preserve capital: straightforward, if not precisely defined. But that inexact definition got exploited by the long equity bull market, rising rates battering bond prices and misleading marketing. Products posing as fixed income snuck dividends, converts, high yield and even equities into your fixed income allocation. The safe bucket became a yield scavenger hunt – or diluted by equity exposure creep.

But fixed income investing is not gone, and here’s why. The simple fact that you know what 60-40 means – including the debate about its exact application – says a lot. Frameworks don’t survive decades of market cycles by accident.

What if that maligned 40 per cent fixed income allocation in your portfolio earned absolutely nothing during the next inevitable equity sell-off? Nothing. Zero. Dead weight.

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If that sell-off – whenever it may be – caused the 60 per cent equity bucket to fall by 15 per cent, your portfolio would not be down 15 per cent. It would only be down 9 per cent, because that unsexy, easy-to-dismiss allocation just reduced the damage by 40 per cent.

Go one step further. What if that fixed income allocation earned 6 per cent annually, including through the downturn? The 15 per cent equity decline becomes only a 6.5 per cent portfolio decline. That is an entirely different recovery problem – and an entirely different personal investing journey.

Here is the math investors often miss: A 15 per cent portfolio decline requires a subsequent gain of roughly 18 per cent just to get back to even. A 6.5 per cent decline only requires 7 per cent. Earning back 7 per cent is a very different ask than earning back 18 per cent. Bull markets make upside feel magical, while the real magic of compounding is propelled by surviving the bad years.

So why did investors stop caring?

It’s understandable. The last 15 years didn’t just reward investors, it trained them: Buy the dip. Take more risk. Concentrate positioning. Passive equity performed; reaching for yield paid off. Even replacing fixed income with dividend stocks, covered call funds, REITs and equities posing as income – all of it worked.

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Meanwhile, the iShares core Canadian bond ETF XGB-T has produced an average of 1 per cent per year over 10 years and portfolio risk management became a textbook thing, collecting dust. Why carry the clunky umbrella? Who stretches before pickleball anyway?

The deeper damage is what that conditioning produced. Long bull markets don’t simply increase wealth, they distort portfolio theory and reshape what investors deem necessary. As billionaire quant investor Cliff Asness reminded us, “diversification means always having to say you’re sorry.” Fixed income knows the feeling.

Stabilizing assets started feeling like dead weight and, critically, investors stopped distinguishing between income and protection. A dividend fund that pays 5 per cent and drops 25 per cent in a sell-off is not a fixed income asset. It just dressed up and got invited to the party.

Some readers are thoroughly annoyed at this point – dismissive of anything but the optimistic observations and of the “people who missed the rally.” You know, the way bitcoin zealots speak to dinosaurs.

But this has nothing to do with calling a top. The observation would be the same if markets felt like crap. Since 1942, the average significant market decline has taken roughly one third off equity values. No predictions, just the average. At today’s starting valuations, the market is simply less forgiving if that kind of disappointment arrives.

As Oaktree Capital Management co-chairman Howard Marks put it: You can’t predict. But you can prepare. And today’s high stock prices make that preparation more relevant, not less. The Shiller CAPE ratio, which measures the value of stocks against their average real earnings over the past 10 years, currently sits around 40 while its long-run median is 16, suggesting the S&P 500 is historically overvalued. That doesn’t tell us when the next drawdown arrives. But it does suggest the margin for disappointment is thinner than investors might expect.

Many widely followed long-term market forecasts now project 5 to 7 per cent annual returns for the S&P 500 over the coming decade, largely because of these elevated starting valuations.

Easy to ignore, much like fixed income and perhaps this entire article, but not a crash forecast. Just the arithmetic challenge of starting expensive, which happens to make fixed income’s mix of risk management and return potential look compelling again.

Today’s effective fixed income solutions are built differently than the age-old bond funds. Less about betting blindly on rate direction, more about income generation, selective credit quality and genuine liquidity when you need it. Same function. Different construction. Some still don’t have the memo.

For those who held fixed income through the bull market while everyone else mocked it, the laugh was premature – especially for investors who stopped defining fixed income as a passive pile of rate risk.

Done properly, fixed income dampens volatility, reduces forced selling and makes staying invested through ugly periods materially easier. It’s not there to make you defensive; it’s what lets you stay aggressive in equities longer, with more conviction, and fewer of the panic decisions that destroy long-term returns.

Fixed income is not the enemy of equity ownership. It’s what allows investors to own equities more intelligently.

It will still only come up at cocktail parties as a nonchalant “nothing wrong with 6 per cent," and that’s okay. Fixed income accepted its role a long time ago – as a prudent pillar of portfolio management.

Kevin Foley is managing director, institutional accounts, at YTM Capital, a Canadian asset manager specializing in credit and mortgage funds. He spent two decades trading and managing fixed income at a major Canadian bank and serves on several Canadian foundation boards and investment committees. Kevin.Foley@YTMCapital.com