Fixed income securities play an important role in diversified investment portfolios. Below, we explore what they are, how they behave, and the part they play in supporting long term investment outcomes…
Fixed income securities in New Zealand (NZ) and internationally are typically publicly listed government and corporate bonds. The return investors can expect to enjoy from these investments is a fixed amount of interest, often referred to as a “coupon”. The purpose of fixed income securities is to reduce return volatility in an investment portfolio, in effect, reducing the magnitude of any downward movements in equity markets. They also provide a steady income stream and tend to behave differently from growth assets, which is why they are included in most diversified portfolios.
Fixed income plays a particularly important role during periods of market uncertainty. While shares can experience sharp movements, bonds often move more gradually, helping to stabilise overall portfolio performance. This defensive characteristic is one of the key reasons fixed income remains a core component of long-term investment strategies.
Of late, the traditional 60/40 balanced portfolio has come under criticism due to the behaviour of fixed income securities during recent periods of high inflation. In light of the recent periods of higher inflation, Russell Investments conducted research on the value of fixed income securities in a portfolio and found that fixed income securities continue to add diversification value to investment portfolios when inflation is below 3% p.a.
You may recall that in response to the COVID-19 pandemic, governments across the world embarked on a significant spending spree which resulted in inflation spiking above 7% for a short period of time. More recently, geopolitical tensions in the Middle East and the resulting impact on oil prices have also contributed to inflation rising above 3%.
These periods can negatively impact the value of bonds on the basis that the value of a bond is inversely related to movements in interest rates. When inflation normalises, and interest rates decline, the value of bonds tends to recover. No asset class is perfect in all environments, but over a full interest rate cycle and within a low-inflation regime, bonds remain useful.
It is important to note that these periods of elevated inflation are the exception rather than the rule. Over long periods, inflation tends to settle back into more typical ranges, and when it does, fixed income securities generally resume their role as a stabilising force within portfolios. This is why investors often view fixed income through a long-term lens rather than reacting to short term market conditions.
The Reserve Bank of New Zealand Act 1989 revolutionised NZ monetary policy by establishing price stability as the primary goal, making NZ the first country to adopt formal inflation targeting. It granted the Bank operational independence to control inflation, targeting low single digits to reverse high inflation from the 1970s and 1980s. The Act established a Policy Targets Agreement (PTA), setting an initial 0 – 2% inflation target to be achieved by 1992. The price stability mandate has since been updated to 1 – 3% p.a. On this basis, inflation is rarely above 3%, supporting the role of fixed income securities in an investment allocation.
The chart below highlights an important point: bonds have generally provided better diversification benefits when inflation has been low and stable. When inflation has risen above 3%, shares and bonds have tended to move more closely together, reducing some of the protection that bonds normally provide within a diversified portfolio.
While periods of elevated inflation can reduce the effectiveness of bonds as a diversifier, history suggests these environments have generally been temporary.
Including both NZ and international fixed income further strengthens diversification. New Zealand bonds tend to have shorter durations and high credit quality, while international fixed income provides exposure to a wider range of issuers, sectors, and interest rate environments. Together, they help reduce reliance on any single economy or interest rate cycle.
In summary, fixed income securities continue to play a vital role in diversified portfolios. While periods of high inflation can temporarily reduce their effectiveness, the long-term environment, particularly in countries like NZ with stable inflation targets, supports their ongoing value. When combined with growth assets, fixed income helps create portfolios that are more resilient across changing market conditions.
For more on how fixed income securities fit within a broader investment mix, refer to our Asset Allocation article and the other articles on asset classes in the Insights section of our website.
