Building the fixed-income part of a portfolio

What you will learn

• How to give each part of your fixed-income money a clear job
• How to calculate the weighted duration and yield of a bond allocation
• How to stress-test the allocation against a rate rise
• A decision checklist that uses every lesson of this course

Explanation

How much of a portfolio to hold in bonds overall (asset allocation) and how to rebalance are covered in the ETF course. This lesson works inside the bond part: which bonds, for which purpose, with how much risk.

Step 1: Define the jobs

Fixed income can do different jobs, and each job needs different bonds:

• Liquidity reserve: money you may need any time. Suitable: overnight deposits, money-market funds, Bubills. Duration close to zero.
• Known expenses in 1–5 years: suitable: a ladder or target-maturity ETFs that mature just before each expense.
• Stabiliser for a long-term portfolio with shares: suitable: high-quality government bonds, often via a broad ETF. In many past equity crises, high-quality government bonds held up better than shares, but not always: in 2022, bonds and shares fell together when inflation and rates rose. Treat this as a historical observation, not a promise.
• Extra income: corporate or high-yield bonds. Their risk is closer to equities in a recession, so this part should be limited and diversified.

Step 2: Choose the main risk settings

• Duration: match it to the horizon of each job. A long-duration fund for money needed in two years is a mismatch.
• Credit quality: decide how much below investment grade (high-yield) you accept, if any.
• Currency: euro bonds or hedged foreign bonds for stability; unhedged foreign bonds add currency risk.
• Inflation protection: inflation-linked bonds can protect real value for part of the money, as discussed earlier in the course.

Step 3: Measure the whole

The weighted duration of the allocation is the sum of each part's weight × duration. The same method gives a weighted yield. The approximate loss from a parallel rate rise is weighted duration × yield change. This is a simple stress test: a check of what happens in a bad but plausible scenario.

Step 4: Write it down and review

Write the jobs, amounts, instruments, duration and credit limits on one page. Review once a year or after a large life change, not after every market move. Taxes on interest and gains in Germany (Abgeltungsteuer) are covered in the ETF course; for your own situation, check with a Steuerberater.

Worked example

Hypothetical example: An investor has €40,000 for fixed income. All figures are hypothetical; fees, spreads and taxes are excluded.

1. Weighted duration: (10 × 0.1 + 15 × 2.0 + 15 × 7.0) ÷ 40 = (1 + 30 + 105) ÷ 40 = 3.4 years.
2. Weighted yield: (10 × 2.0% + 15 × 2.3% + 15 × 2.8%) ÷ 40 = 2.4125% ≈ 2.41%, about €965 per year.
3. Stress test, yields +2 percentage points: 3.4 × 2% = 6.8%; €40,000 × 6.8% ≈ €2,720 estimated fall in market value.
4. Most of that fall is in the ETF (7 × 2% = 14% of €15,000 = €2,100). The money for the car sits in the ladder, which repays its nominal at maturity, so the purchase is not at risk.
5. With inflation at a hypothetical 2%, the real yield is roughly 2.41% − 2% ≈ 0.4% before taxes.

Common mistake

Practice activity

An investor has €60,000 for fixed income: €12,000 in an overnight account (duration 0), €18,000 in a ladder (duration 2.5) and €30,000 in an aggregate euro bond ETF (duration 6.5). (a) Calculate the weighted duration. (b) Estimate the fall in market value if yields rise by 1.5 percentage points. (c) Which part causes most of the fall?

Key takeaways

• Give each part of your fixed-income money a job: liquidity, known expenses, stability or extra income.
• Match duration to the time horizon of each job, and limit credit and currency risk on purpose.
• Weighted duration × yield change gives a quick stress test of the whole allocation.
• Write the plan on one page and review it on a schedule, not after every market move.

Next step

You have completed this course; continue with the course "Real Estate & REITs" to study another income-producing asset class and how interest rates affect it.