Debunking the Myth
Stock selection is no easy task, but there is nothing simple about researching bond issuers and understanding the industry and economic backdrop in which they operate. In reality, the value and number of US debt securities far exceeds those of US publicly traded stocks. To illustrate this, we only need to compare the 505 constituents in the S&P 500 index – a well-used proxy for the US equity market – versus the 9,300 constituents of the Bloomberg Barclays Aggregate Index – generally cited as a proxy for the US core fixed income market.1
In addition to the large number of fixed income securities to choose from, there are numerous variables, from the obvious to obscure, that should be considered prior to making any investment, including:
Interest rate risk, which requires both an informed view of broad economic trends and a bond’s specific duration, plus the sector’s sensitivity to interest rates.
Credit risk, which requires an in-depth cash flow analysis and a study of the issuer’s business operations, tangible assets, and financial leverage.
Economic outlook, which may affect the price performance of bonds in sectors that have historically underperformed during different stages in the economic cycle.
Managing a portfolio’s sensitivity to interest rates,which involves managing duration (or interest rate sensitivity), a portfolios position along the yield curve, and investing in sectors or instruments less sensitive to potential yield changes.
Individual issue characteristics, such as whether a bond is selling at a discount or premium, its duration, call risk, if the bond has sinking fund provisions2 and related call price, and whether bond covenants, which may require issuers to take, or refrain from, certain actions to protect investors, exist.
Event risk, which could affect the issuer’s financial condition or outlook as the result of a merger, acquisition, leveraged buyout, or corporate restructuring.
1Number of constituents as at September 30, 2019, according to fact sheets for each index.
2A sinking fund is a fund containing money set aside or saved to pay off a debt or bond. A company that issues debt will need to pay that debt off in the future, and the sinking fund is designed to help soften the hardship of a large outlay of revenue.