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Fixed income plays an important role in any portfolio that's retirement oriented. Aside from providing an income stream, it has the potential of providing diversification to help ensure capital preservation.

Of course, fixed income, or debt comes in a variety of flavors, which means there is a wide variation both in terms of yield, as well as the potential for a low or negative correlation to equities.

Among the options available to investors are:

  • US Fixed Income
  • High-Yield Fixed Income
  • Non-US Fixed Income
  • Emerging Markets Fixed Income
  • Convertibles

Within each of these categories are numerous sub-categories, but for the purposes of this article. I think the list suffices.

It should be apparent to the reader that each of these classes will vary sharply in terms of yield, based on risk (real or perceived) and duration. Additionally, the classes vary considerably in terms of correlation to equities.

For example, high yield (aka "junk") debt will more closely track equities, since a healthy economy which would favor stocks will also mean there's less likelihood of default on lower rated bonds.

Likewise, convertibles will also track equities fairly closely, since a part of their value stems from the ability to convert it to common stock.

Any investor who held positions in either or both classes during the last downturn, thinking they were "protected", got a rude awakening.

Given the difficulty in achieving diversification within fixed income for the average retail investor, the easiest way to employ debt in one's portfolio is via ETFs or CEFs.

My personal preference is to use CEFs, realizing that I'm making a "bet" on the manager's skills, as well as on the asset class. As a rule, I prefer to invest in funds that have at least a 10 year track record, or barring that I'll check management's track record at another similar fund.

Additionally, I only buy the fund at a discount to NAV to gain an additional margin of safety. An excellent resource for evaluating both ETFs and CEFs is etfconnect.com. It provides a wealth of information on both share price and NAV history, top holdings, distributions, management fees, etc.

I've found it possible to achieve multiple goals within my portfolio through the use of CEFs. As an example, the core holding in my fixed income segment is GIM, a global sovereign debt fund. One of my "macro" themes is a long term bearish outlook for the USD, and my position in GIM gives me my exposure to fixed income, as well as taking advantage of dollar weakness in the longer term

Full disclosure: Long GIM, AVK, HTR

Source: Thoughts on Portfolio Construction and Diversification (Part 2)