Factor Investing in Fixed Income (EP.138)

How we model our expected returns hugely impacts our financial decision-making, with poor models leading us to retire either too early or too late. Today’s episode is a deep dive into two topics: how we model expected returns and how fixed income bonds fit into your portfolio allocation. We open the show by talking about the books and news of the week before unpacking the relationship between bond terms, credit, and fixed income returns. We then explore why it’s easier to forecast the expected returns of bonds than stocks, with insights into how this affects your allocation. After reflecting on the predictive power of yield curves and expected capital appreciation and depreciation, we look into how the forward rate can be used to forecast expected term premiums. Touching on conflicting research, we present our conclusions on how you can determine your expected bond returns while also providing a summary of your risk premiums. We round off the topic by assessing alternatives to fixed income investments. From fixed income, we leap into the world of expected return assumptions and how they can best be modelled. We chat about the dangers of operating from poor expected returns models and discuss the successes and drawbacks of the most commonly used ones. While establishing the predictability underpinning average returns, we explain the limits on using historical returns to forecast expected returns. Later, we open up about PWL Capital’s approach to measuring expected returns. We close off another informative episode by sharing this week’s bad advice and answering left-field questions in our ‘Talking Sense’ segment. Tune in to hear more about the role of fixed income bonds and returns models in your portfolio.

Key Points From This Episode:

• We touch on future guest Jennifer Risher’s book, We Need to Talk. [0:05:34]
• Hear about the new Bitcoin ETFs and other cryptocurrency news. [0:08:30]
• Introducing today’s investment topic; fixed income products. [0:12:45]
• Approaches to building fixed income portfolios and forecasting expected returns. [0:15:31]
• Exploring the factors that impact fixed income risks and returns. [0:20:50]
• Using forward rates to predict your fixed income returns. [0:22:31]
• Conflicting research on the power of forward rates to predict term premiums. [0:24:52]
• Why forward rates do contain information about expected term premiums. [0:27:51]
• What Barclays’ intermediate indexes say about fixed income allocation. [0:31:49]
• The summarised formulas for expected bond returns. [0:34:03]
• Evidence on why credit spreads have low explanatory power for default rates. [0:35:07]
• The main takeaways on how we should view bonds and returns. [0:38:20]
• Comparing fixed income with cap-weighted indexing. [0:40:27]
• Why Dimensional Funds looks at credit spreads and yield curves around the world. [0:42:20]
• Introducing today’s planning topic: expected return assumptions. [0:44:55]
• How important expected returns models are to financial decision-making. [0:45:55]
• Different models that are used to derive expected returns. [0:47:20]
• Planning for short-term versus long-term predictability. [0:50:08]
• The danger of using historical returns as the basis for your expected returns. [0:53:20]
• Damodaran’s research on how different forecasting models perform. [0:53:48]
• Insights into PWL Capital’s expected return models. [0:55:07]
• We answer questions in our ‘Talking Sense’ segment. [0:59:26]
• This week’s bad advice; incorporate Bitcoin into your retirement investments. [01:01:36]