Posted by LeGianT on March 11, 2010
Relative performance in fixed income is largely driven by two dimensions: bond maturity and credit quality. Bonds that mature farther in the future are subject to the risk of unexpected changes in interest rates. Bonds with lower credit quality are subject to the risk of default. Extending bond maturities and reducing credit quality increases potential returns.
Since it is impossible to predict what will happen with interest rates in the future, we diversify broadly and use a “variable maturity” approach in most of our portfolios. This approach, which was developed by Professor Eugene Fama, uses the current yield curve to determine optimal maturities and holding periods. To maximize expected returns, we choose shorter maturities in flat or inverted yield curve environments and longer maturities in upwardly sloped curves. Maturities are shifted in response to changes in the current yield curve.
Dimensional follows several different strategies in its fixed income portfolios, each designed to meet specific investor goals.
Even without forecasting changes in today’s yield curve, there exists a myriad of potential strategies, each with a unique expected return. Dimensional offers four US strategies with variable maturity parameters: the One-Year Fixed Income Portfolio; the Five-Year Government Portfolio; the Short-Term Municipal Bond Portfolio for investors seeking income free from federal income tax; and the California Short-Term Municipal Bond Portfolio for investors seeking income that is expected to be free from both federal and California state personal income tax.
Two constant maturity strategies, the Intermediate Government Fixed Income Portfolio and theInflation-Protected Securities Portfolio, seek to target the maturity of a specific portion of the bond market.
Investing in global bonds can increase diversification. The use of non-dollar developed market bonds, however, introduces foreign currency exposure. Currency exposure tends to increase the volatility of an international fixed income portfolio. To reduce this volatility, we hedge currency exposure in three of our global bond portfolios. This enables us to gain the benefits that come from diversifying across many countries without measurably increasing currency risk.
For investors seeking to keep their bond portfolio short and high in quality, the Two-Year Global Fixed Income Portfolio and Five-Year Global Fixed Income Portfolio target highly rated debt issuers. For those willing to take on additional volatility in pursuit of higher expected returns, the Short-Term Extended Quality Portfolio includes issuers whose credit quality is in the lower portion of the investment grade range.
Expected returns across hedged bonds differ because the shape of each yield curve is different. Portfolio maturities and country weightings follow a variable approach based on the expected return matrix generated for each eligible country and can be tilted toward countries with higher expected returns.
For fixed income investors seeking the higher return potential presented by unhedged foreign bonds, Dimensional offers the Selectively Hedged Global Fixed Income Portfolio. Depending on an investor’s risk tolerance and asset allocation, introducing additional currency exposure may do little to alter the volatility of the overall portfolio.
The principal risks of investing in these portfolios may include any of the following: market risk, foreign securities and currencies risk, interest rate risk, inflation-protected securities interest rate risk, credit risk, risk of banking concentration, risk of investing for inflation protection, income risk, call risk, tax liability risk, state-specific risk, and non-diversification risk. These risks are fully described in the prospectus in the section entitled “Principal Risks.”
Mutual funds distributed by DFA Securities LLC.