Bonds can play a critical role in a diversified portfolio, offering the potential for stability during market volatility relative to stocks, consistent income, and the opportunity to rebalance your portfolio to maintain your target asset allocation. But deciding how to buy bonds can feel complicated. You can purchase individual bonds or buy actively or passively managed bond mutual funds or exchange-traded funds (ETFs). Another option is a fixed income separately managed account (SMA).
Fixed income SMAs have some similarities to bond mutual funds, in that both invest in a variety of securities and have a professional manager overseeing buying and selling decisions. A mutual fund, however, is a pooled investment, whereas with an SMA you own the securities directly (SMAs may also hold shares of pooled investments, such as mutual funds and ETFs).
The fee structure of a fixed income SMA is different than a mutual fund. Mutual funds have operating costs that are typically embedded in the share price, while SMAs generally charge an annual advisory fee. In addition, SMA investors may also pay expenses associated with any mutual funds or ETFs held within the account. However, SMAs can offer access to specialized segments of the bond market typically not available to most investors and greater transparency than a pooled investment. They may also offer the ability to customize the strategy to your individual needs.
SMAs are designed to serve as components of your overall investment portfolio. The 3 questions below can help you decide whether you may want to consider a fixed income SMA.
Do your bond investments serve multiple purposes?
Depending on your goals, you may hold bonds for variety of reasons. Bonds with greater liquidity and lower credit risk, such as Treasurys, offer the potential for capital preservation and risk reduction. When stocks fall, these bonds may hold steady or even rise, and can help you diversify a portfolio against higher-risk assets like stocks. Other types of bonds, especially lower-quality or non-investment grade bonds, can offer the potential for additional income, but come with greater credit and liquidity risk. Municipal bonds can also offer tax advantages, especially for higher-income investors, since municipal bond interest is typically exempt from federal income tax and may also be exempt from state or local income tax if you are a resident of the state that issued the bond.
If you are nearing or in retirement, you may also look to bonds to provide a steady stream of income. One way to do this is to build a bond ladder, which is a portfolio of individual bonds with various maturities. As each bond matures, the proceeds are reinvested at the end of the ladder, designed to maintain a steady income stream and reduce interest rate risk over time.
The structure of an SMA enables investors to access a diversified mix of bonds, each serving distinct roles within a well-balanced fixed income portfolio. “An SMA can include muni bonds, corporate bonds, Treasurys, or a combo depending on the investor’s income needs, tax considerations, and more,” explains Donnie Poe, a director in Fidelity’s fixed income SMA group. “In addition, unlike a bond ladder, actively managed fixed income SMAs have the ability to implement a variety of strategies designed to enhance yield and the potential for capital appreciation, with a consistent focus on risk management.”
Do you want greater transparency and personalization of your bond holdings?
The universe of bond investments is enormous and complex, since it includes corporate issues, Treasurys, mortgage-backed securities, municipal bonds, and more. Some investors prefer to outsource the management of all their investment accounts to a professional asset manager, who can determine an asset allocation and select investments guided by a holistic understanding of your goals, concerns, and needs. Other investors prefer to handle responsibilities such as determining their overall asset allocation, diversification within asset classes, and regular rebalancing on their own. An SMA can act as a compromise between the two, as it can allow you to outsource a particular area of your investment strategy, but not cede total control of your portfolio. If you feel relatively confident in your ability to manage a stock portfolio, but are concerned you may lack expertise in bonds, a bond SMA is an option to help fill that gap.
SMAs are also more transparent than fixed income mutual funds. While mutual funds typically only report holdings periodically, SMAs allow you to see what is in your portfolio at any time as well as recent activity associated with your account, including trades that are made and interest payments. Since you directly own the securities in an SMA, you may have the flexibility to exclude specific bonds or entire sectors based on your personal values or investment strategy. Some SMA managers may strategically sell securities that have declined in value to realize potential tax benefits—a technique known as tax-loss harvesting.1
Do you want professional help with your bond investments?
Creating a diversified bond portfolio where you own the bonds directly requires significant time, effort, and investment skill. Selecting bonds comes with numerous considerations including credit quality, liquidity, maturity, taxes, and the potential for changing interest rates that can affect prices. “Many investors aren’t able to spend a lot of time monitoring things like credit risk and liquidity,” says Poe. “If there is a need to sell a bond before maturity, there needs to be an active market for it, so they can get a fair price instead of potentially selling it at a steep discount.”
The size and relative inefficiency of the bond market can also create opportunities for skilled bond managers. SMA managers can respond quickly to changes in interest rates or credit quality, identify opportunities for tax efficiency, and help mitigate unnecessary risk.
The bottom line
SMAs can potentially be a powerful way to outsource part of your investment portfolio to professional managers. At Fidelity, fixed income SMAs charge a gross annual advisory fee that ranges from 0.35% to 0.4%, depending on strategy and total assets invested,2 and require investment minimums of $350,000. You may want to consult a financial professional to discuss whether a fixed income SMA may be a good fit as a component of your overall investment portfolio.