Fixed-income securities might be the most interesting of the three main asset classes.

They certainly comprise the widest variety of individual instruments, with investments as diverse as bonds and debentures, zeros and strips, mortgage-backed securities, inverse floaters and preferred shares.

Not surprising, there are a number of mutual fund categories that fall under the fixed-income banner, including: Canadian bond, Canadian short-term bond, Canadian mortgage, high-yield bond, foreign bond, Canadian dividend and Canadian income trusts. Even some “alternative strategies” funds might be considered fixed-income in nature.

When looking at fixed-income assets from a portfolio perspective, the key is finding a common denominator that explains what they bring to the portfolio. In that light, fixed-income securities have three identifiable characteristics:

> Definable Lifespans. A hypothetical Government of Canada 4.5% bond due March 1, 2011, will mature on that date and cease to exist thereafter. Mortgage-backed securities have a specified term to maturity, usually five years or less. Preferred shares are typically callable on a certain date. And so on.

> Fixed Income, Or Returns. The aforementioned Canada bond offers a fixed income of 4.5% a year. A $100 strip bond due in one year and purchased now at $97 offers a fixed return of slightly more than 3% in that time.

> Trades On A Yield Basis. The price of a fixed-income security is sensitive to interest rates, rising and falling as rates change. Most often, the price of the security falls when interest rates rise, and vice versa.

The point here is that such a diverse group of securities have a common thread. From the portfolio perspective, this matters because it helps explain the kind of diversification fixed-income brings to the table. For fixed-income assets, the key contributor to diversification is the interest-rate sensitivity.

As you would expect, fixed-income securities affect both a portfolio’s return and its risk. The return effect is straightforward, in that it is proportional to the weighting that fixed-income securities represent in the portfolio. This return effect is the same for equities, cash and any other holdings in the portfolio — the portfolio return is simply a weighted average of the returns of the various securities in the portfolio.

Suppose a portfolio is invested 50% in fixed-income and 50% in equities. Suppose, further, that the fixed-income portion generates a 6% return and the equities provide a 10% return. The portfolio’s overall return is 8%, calculated as (0.5 x 0.06) + (0.5 x 0.10) = 8%.

If the fixed-income weighting is increased at the expense of equities, the portfolio return would be closer to 6%. So, a portfolio invested 60% in fixed-income and 40% in equities would have a return of 7.6%, under the same return conditions as above.

However, the effect of fixed-income securities on portfolio risk is not as straightforward, as it relates to the different sensitivities that fixed-income securities have to market forces.

The main driver of fixed-income returns is changes in the interest rate. Equities returns, on the other hand, respond more to business risk. Returns on cash are hardly affected by changes in business risk and are affected differently than either equities or fixed-income securities by changes in the interest rate.

When the returns on different asset classes respond differently to the same influences, or respond to different influences altogether, that’s when the diver-sification effect kicks in.

If a client’s investments are spread over a number of risks, then no one factor can take a large bite out of the portfolio. With a properly diversified portfolio, even if two or three risks rear their heads at the same time, the effect on the portfolio will still be muted.

If you were to diversify a portfolio across a wide array of risks, there is almost no likelihood that those risks would all gang up on your portfolio at the same time because the returns on the different asset classes are not perfectly correlated. They move at different speeds and, sometimes, in different directions because they respond differently to the risk factors.

So, the effect of fixed-income securities on a portfolio is that they affect the portfolio’s return proportional to their weighting — and they affect portfolio risk disproportionally to their weighting. This means that, given the right circumstances, fixed-income securities can increase portfolio return and decrease portfolio risk at the same time.

@page_break@And there’s the rub. But a good portfolio manager can find those circumstances. IE