I spoke recently with a financial advisor about how challenging it is in this market environment to structure a portfolio to meet his client’s target return. He was fearful of the equity market citing lofty valuations, a prolonged bull market and the influence the Twittersphere now had on geopolitics and capital markets. Despite the admitted difficulties in finding potential equity investments, he was relatively confident in his fixed-income solution. It centred on a few portfolios that provided over 5% yields and didn’t take on any risk. His comments echoed what I’d heard from many others before − their uncanny ability to find a fixed-income solution that earned substantial returns with no risk.

Most investors probably understand that equity returns aren’t guaranteed and often don’t go straight up. It’s interesting to me that what can be commonly understood about equities can instead be thrown out the window when it comes to fixed income. Your grandma was right. There’s no such thing as a free lunch and in today’s world it’s impossible to earn over 5% without any risk exposure.

Some hear the word “risk” and want to run. It conjures up thoughts of mindlessly betting on dice rolls or spins of a roulette wheel. While gambling is risky behaviour, I don’t think it has much in common with investing. Gamblers focus on how much money they can win and are seduced by the chance to make a quick buck. The capital market equivalent is buying the next great micro-cap stock that your neighbour pitched at the weekend BBQ. Putting capital at risk and hoping to make money isn’t investing.

In my opinion, true investors never focus solely on the upside. They understand that to earn a return you must take risks. What separates investing and speculating is the ability to properly analyze and manage those risks. Purchasing a fixed-income portfolio earning 5% in today’s market environment may be a great investment but it’s certainly not risk free.

Any way the wind blows

Treasury bonds are often viewed as the benchmark for risk-free investing. The U.S. 10-year treasury bond has recently struggled to yield over 3%i. Anything yielding 60% more than the so-called risk-free rate has to be taking some form of risk. I have yet to meet an investor who also thinks of themselves as a wizard, but many today believe they have a magic fixed-income formula.

I want to be as explicit as possible: investors can and will lose money in bonds. Understanding this crucial element should be the starting point for anyone responsible for building a fixed-income portfolio. This isn’t meant as a scare tactic; it’s simply reality and accepting this will make investors better off.

It’s easy to understand why the average investor believes they can’t lose money in bonds. The past 30 years have seen interest rates decline and provide a tailwind for an entire generation of investors. This environment can’t continue forever and the past two years provided a small example of what can happen when rates rise. Tailwinds can quickly become headwinds as was the case for anyone who bought U.S. 10-year government bonds almost two years ago yielding 1.50%ii. Originally purchased at $100, they’re now worth just over $90. Looks like bonds can go down after all.

Some will say that if an investor holds that bond to maturity they’ll get their $100 back without losing anything. While that’s technically true, it requires an investor who can stomach that type of volatility and ignore the bond’s real return. If interest rates are rising, then inflation is likely also increasing and eating away at the purchasing power of that $100 investment. I’m willing to bet that whoever bought that bond has a personal inflation rate exceeding 1.50%.

Government bonds are the most sensitive to interest rates. To avoid accusations of cherry picking an example, let’s look at a US Investment Grade Bond Index that's representative of high quality corporate bonds. Many investors assume their high credit rating means they're low risk. An investor who purchased this index suffered a loss of over 3% so far this yeariii. While not a disaster I’m guessing that it wasn’t part of most conservative fixed-income investors’ plans. Let’s hope they don’t have to annualize that number for the second half of the year.

Approach with care

If you’re reading this commentary you likely know that EdgePoint’s fixed-income holdings within the balanced Portfolios yield over 4% today. How are we doing this and what risks are we taking?

I believe the main way to ensure you’re investing and not speculating is by adhering to a defined investment approach. Ours centres on analyzing businesses and developing proprietary insights about them. We’ve built skill in uncovering opportunities in corporate bonds based on our analysis of a business’s competitive position, growth prospects and asset values. We don’t have a crystal ball and therefore take risk when we practice our approach. We manage this risk by ensuring our investments are backed by thorough due diligence and diversifying our investments so we’re not overexposed to one idea.

When viewed through the lens of a prudent investment approach, taking risks isn’t a bad thing and is actually necessary for earning returns above the risk-free rate. Our approach leads us to only take risks when we believe we have a different view than the market and therefore being overpaid to take that risk.

In my opinion, fully understanding the approach and risks of any portfolio you’re invested in is the only way to be a successful long-term investor. Almost nothing is more uncomfortable than watching the value of your investment drop when you have no ability to analyze if it now represents better value. Is it on sale or has something changed? You can answer this question only if you have confidence in an investment approach and understand your investments.

Is your 10-year government bond still attractive after it falls 10% due to rising interest rates? Do you have conviction to buy more at this new price?

I’m much more comfortable analyzing a business’s fundamentals. If the price of a high-yield bond we own falls, our investment approach leads us to revisit our thesis and determine if the decrease is based on a change in fundamentals or a reaction to more short-term factors. We’re comfortable questioning if its competitive position or earning power changed and making a decision on whether the bonds represent an attractive opportunity at the new price. Trying to take advantage of the volatility that comes from price changes is core to our approach.

We’ve focused on corporate bonds as they align well with our approach and they expose us to a risk we believe we’re skilled in analyzing. We’ve kept our duration short as we don’t think we can predict the direction of interest rates or government policy.

Investors generally see fixed-income as a less risky option compared to equities. Declining interest rates over the last few decades and healthy returns give the appearance of safety, but the last two years were reminders that “less risk” doesn’t mean “no risk”. If the recent headwinds that the fixed-income markets experienced continue they could cause investors to react emotionally rather than rationally. It’s common for some to sell when they experience a decline in their investments and ask questions later. We welcome these opportunities.

Our low duration not only protects our current holdings from changes in interest rates and credit spreads but it enables us to re-invest our maturing principal payments into a more favourable market. We’re confident that our investment approach should enable us to continue to take prudent risks to generate returns for our investors. The path to these returns may be bumpier than in the past but our Portfolio and investment approach are structured to take advantage of this type of environment.