In this chapter, we address the roles of fixed-income investments in a portfolio and offer recommendations on credit quality and maturity. We also discuss inflation-protected securities and investing in municipal bonds.
The main roles of fixed-income assets in a portfolio are reducing portfolio risk to the level appropriate for the investor's unique circumstances and providing a reliable source of cash flow. Therefore, fixed-income assets should generally be limited to AAA/AA investment grades. When we refer to ratings, we are referring to what can be called a "natural" rating: those not enhanced by either an insurer adding their guaranty or by collateral acting as a credit enhancement (as is the case with most asset-backed securities). Historically, credit risk has not been well rewarded.
Bank certificates of deposit (CDs) can also offer competitive rates relative to other high-quality, short-term–fixed-income assets. To eliminate credit risk, CDs under a single account name at a single bank should not exceed the Federal Deposit Insurance Corp. (FDIC) limits. For additional information, please see the FDIC's "Guide to Deposit Insurance Coverage."
Hybrid securities such as high-yield bonds, convertible bonds, preferred stocks, and emerging-market bonds should be avoided. They all have equity-like risks managed more efficiently with direct investments in equities.
Short-term bonds have the benefit of less volatility ...