The recent evolution of the banking and finance sector is unprecedented. New technologies have always paved the way for innovative and rewarding investment opportunities. Today, there are a number of financial instruments that help investors achieve different goals. Each has its pros and cons. They can be classified based on the risks involved and the returns offered. Every investor has a risk appetite. Some can tolerate higher risk for higher returns, whereas others prefer sure returns and want to hedge all their risks. Every investor has their pick of financial assets. Stocks and fixed income instruments are some of the most popular assets among both retail and institutional investors.
What are fixed income instruments?
These are a type of financial instrument that gives investors guaranteed returns. They also provide capital protection, so that the principal investment value is safe. They offer a fixed interest rate over the investment period and are designed for investors with a low or moderate risk appetite.
The most popular fixed income instruments include the following:
- Fixed deposits (FDs)
- Public Provident Fund (PPF)
- National Savings Certificates (NSCs)
- Treasury bills (T-bills)
- Municipal bonds
Understanding stock investing
Stock investing refers to purchasing ownership shares in a publicly listed company. Different companies are listed on stock exchanges, and each would have a different stock price. When the company’s stock value increases, investors would see an increase in their portfolio value.
A stock price can increase/decrease due to various reasons. It indicates the company’s financial wellbeing, but does not paint a complete picture. Stock values are often speculative and based on factors such as investor sentiment. There is no limit on returns for stock investors; they are contingent on the market value of shares purchased. Both upside and downside are limitless, making stock a relatively risky investment.
Can fixed income deliver stock-like returns?
The simple answer is “yes”, but it can be difficult to achieve, if not impossible. The stock market is infamous for its high volatility, which could even lead to negative returns.
There are also no provisions for capital safety. For example, if you purchased 100 shares of company A at USD10 each and the stock price falls to USD2 tomorrow, you would have USD200 in your account instead of USD1,000. In rare cases, it could even go to zero, equivalent to losing the principal amount. However, this does not happen frequently. The stock market mostly outperforms the fixed income market.
The S&P 500 index is a good indicator of the US stock market’s performance. Average annual returns for the last century were around 10%. The middle band is 8-12%. However, this does not imply that returns are always in this range; there are extreme outliers. For example, the S&P 500 annual return for 2021 was 26.89%, much higher than average. US Treasury bills, a fixed income instrument, have offered stock-like returns in the past. The average yield from 1980 to 1985 was always higher than 10%, according to fixed income credit research reports, comparable to average stock market returns.
How can fixed income instruments deliver stock-like returns?
The Bloomberg US Aggregate Bond Index is down by 8.5% YTD, making investors uncomfortable with their fund allocation to bonds. Although the first half of 2022 was not rewarding for fixed income investors, there are ways to generate stock-equivalent returns with these investments. Two crucial factors that could make this happen are wider credit spreads and higher yields. A credit spread measures the yield difference between Treasury and corporate bonds. A bond’s yield refers to the return on investment in bond investments and is inversely related to the bond’s price.
The Federal Reserve has been increasing the Fed funds (policy) rate to tackle inflationary pressure. It is expected to reach around 3.5%. Higher policy rates, combined with strict monetary policy, would increase yield for fixed income instruments. It would be close to the average S&P 500 annual returns since 2000, roughly around 6.7%. A fixed income portfolio that combines core, investment-grade and high-income (corporate) bonds is ideal for achieving stock-like returns.