Outperforming your average bond fund on a risk-adjusted basis is not a particularly difficult task for the savvy retail investor. Investing in bond funds is a flawed exercise--particularly in a low interest rate environment. High management fees on bond funds offset much of their active management and diversification benefits. Fixed-income fund managers tend to strive for performance that tracks a respective index rather than portfolio optimization. For example, the overall market capitalization of the U.S. fixed-income market is the basis for the most popular fixed-income index--the Lehman U.S. Aggregate.

How can it be so easy to beat Wall Street's best at their game? Let's take a look at how diversifying across the different classes is the basis of successful fixed-income investing, and how the individual investor can use this premise to gain an advantage over fund managers.

Types of Asset Classes
Fixed income can be broken down into five asset classes: government-issued securities, corporate-issued securities, inflation-protected securities (IPS), mortgage-backed securities (MBS), and asset-backed securities (ABS). An enormous amount of innovation continues within the world of fixed income. For the retail investor, IPS, MBS, and ABS are all relatively new additions. The U.S. leads the world in the range and depth of fixed-income offerings--particularly with MBS and ABS. Other countries are developing their MBS and ABS markets.

The key issue is that each one of these asset classes has different interest rate and credit risks; therefore, these asset classes do not share the same correlation. As a result, combining these different asset classes into a fixed-income portfolio will increase its risk/return profile.

All too often investors only consider credit risk or interest rate risk when evaluating a fixed-income offering. In fact, there are other types of risk to consider. For example, interest rate volatility greatly affects MBS pricing. Investing in different asset classes helps offset these other risks.

Asset classes like IPS, MBS, and ABS tend to give you yield pickup without degradation in credit quality--many of these issues come with an AAA credit rating.

Government bonds, corporate bonds, IPSs, and MBSs tend to be readily available to retail investors. An ABS is not as liquid and tends to be more of an institutional asset class.

Behavior of Asset Classes

Many investors are familiar with government and corporate bonds and their correlation during economic cycles. Some investors do not invest in government bonds because of their low yields, choosing corporate bonds instead. But the economic and political environments determine the correlation between government and corporate bonds. Pressure in either of these environments is positive for government bonds. "Flight to quality" is a phrase you will hear frequently in the financial press. Let us look at some of the other asset classes.

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Inflation-Protected Securities
Sovereign governments are the largest issuer of these bonds, and they guarantee a real rate of return when held to maturity. In contrast, normal bonds guarantee only a total return. Real rates of return should be the focus for investors rather than total returns. Real rate and inflation expectations are the drivers for this asset class. (For more information on IPS, see the article Inflation Protected Securities – the Missing Link.)

Mortgage-Backed Securities
In the U.S., institutions such as Fannie Mae and Freddie Mac buy residential mortgages from banks and pool them into MBS for resale to the investment community. The structure and tranches of these pools usually leave little or no credit risk for the investor.

The risk lies in interest rate risk. Maturity is a moving target with these securities. Depending on what happens to interest rates after issuing the MBS, the maturity of the bond could shorten or lengthen dramatically. This is because the U.S. allows homeowners the ability to refinance their mortgages: a decline in interest rates encourages many homeowners to refinance their mortgages; a rise in interest rates causes homeowners to hold on to their mortgages longer. This will extend the originally estimated maturity dates of MBSs. When purchasing an MBS, investors usually calculate some degree of prepayment into their pricing.

This ability to refinance mortgages in the U.S. creates an embedded option in MBSs, which give them a much higher yield than other asset classes of equivalent credit risk. This option, however, means MBS prices are highly influenced by interest rate volatility (volatility is a major determinant in all option pricing).

Asset-Backed Securities
The concept of an ABS is similar to that of an MBS, but ABSs deal with other types of consumer debt, the largest of which are credit cards and auto loans. An ABS, however, can be created from almost anything that has material and predictable future cash flows. For example, in the 1990s, royalties from David Bowie's song collection were used to create an ABS.

The big difference between an ABS and a MBS is that an ABS tends to have little or no prepayment risk. The structure of most ABSs is at AAA, the highest credit rating. Because this asset class is relatively new, it has not been well tested through all kinds of market cycles. This makes ABSs defaults and prepayment assumptions susceptible to change during a severe economic recession.

Retail investors have difficulty understanding the ABS, and the liquidity of this asset class tends to be the lowest of the other five.

Conclusion
When building a fixed-income portfolio, investors should look at diversification the same way as in equity investing--diversification within the asset class is just as important. Equity investors tend to diversify across different sectors (finance, energy, etc.) of the market. Creating a portfolio with material representation from all fixed-income asset classes is one of the pillars of good fixed-income investing.

Mutual fund managers, however, generally don't adhere to this rule of thumb because they fear they will deviate too far from their respective benchmarks. Savvy retail investors can bypass this weakness and therefore gain an advantage in constructing their own portfolios. It's a matter of combining at least five high-quality bonds with representation from all fixed-income asset classes into a laddered, buy-and-hold portfolio. (For more information on bond ladders, see the article The Basics of the Bond Ladder.) Obtaining yield pickup with no loss of credit quality gives an investor the ability to focus on a limited number of bonds.

Once again, with a little bit of work, the savvy retail investor can beat Wall Street at its own game.

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