Mastering Fixed Income Trinity: Balancing income, duration and liquidity

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Much like the “Impossible Trinity” in economics, the Fixed Income Trinity highlights that optimizing all three elements simultaneously is unfeasible. Investors must prioritize two, inevitably compromising the third.

Fixed Income Trinity explained

The Trinity revolves around three key aspects:

Income: This is the interest earned on bonds. Lower-rated issuers typically offer higher yields to compensate for added risks, such as the potential for default and lower liquidity.

Duration: Duration measures a bond’s sensitivity to interest rate changes. It helps investors gauge how much a bond’s price will shift when rates fluctuate.

Liquidity: Liquidity refers to how easily an instrument can be traded without significantly affecting its price. Highly rated bonds generally have better liquidity.

Investors cannot fully optimize income, duration, and liquidity simultaneously. Prioritizing any two elements inevitably comes at the expense of the third. Here’s how the trade-offs play out:

Income and Liquidity (Excludes Duration)

Investors seeking higher income from credit instruments while maintaining liquidity often turn to money market instruments. These instruments mature in the short term or can be selectively liquidated, offering flexibility.

This approach sacrifices exposure to long-dated bonds and the potential capital gains from falling interest rates.

Income and Duration (Excludes Liquidity)

By taking credit exposure through long-dated instruments, investors aim to combine higher income with the opportunity for capital appreciation when interest rates decline.

Lower-rated, long-dated instruments tend to be illiquid, making it difficult to exit positions when needed.

Duration and Liquidity (Excludes Income)

Prioritizing liquidity and interest rate sensitivity leads investors to focus on highly rated bonds, which offer stability and ease of trade.

These bonds provide significantly lower income compared to credit instruments.

Ultimately, improving any two aspects of the Fixed Income Trinity requires accepting limitations in the third. The right combination varies based on an investor’s unique goals, risk tolerance, and market outlook.

Choosing investment vehicles

Investors today have access to a wide range of fixed-income instruments that can be tailored to their specific needs. This “bouquet” includes traditional options like fixed deposits and government bonds, as well as more complex offerings such as AAA to BBB-rated corporate bonds, structured credit instruments, and pass-through certificates (PTCs).

Despite this variety, filtering, investing in, and monitoring these instruments is a complex and time-consuming process for most investors. Managed solutions—such as mutual funds, alternative investment funds (AIFs), and portfolio management services (PMS)—simplify these tasks and offer structured approaches to fixed-income investing.

Mutual Funds: The structure of mutual funds provides on-demand redemption, making liquidity their primary anchor. Liquidity is typically achieved through investments in high-quality bonds, with duration often serving as an optional secondary focus. This prioritization results in lower yields, as higher income becomes the compromised element.

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Alternative Investment Funds (AIFs): Categories II and III of AIFs primarily focus on generating high income. Some of these funds offer periodic liquidity windows as a secondary feature, but full liquidity is generally restricted. Duration exposure is usually minimal or completely absent, reflecting their focus on income generation over other elements.

Portfolio Management Services (PMS): PMS solutions are among the few investment options that allow investors to customize their portfolios across all three elements of the Fixed Income Trinity. 

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Investors can decide which elements to prioritize based on their specific needs and financial goals. Despite their flexibility and potential, PMS remains an underutilized investment vehicle for many.

Limitations

Like any framework, the Fixed Income Trinity has its constraints. 

Predicting interest rate movements or credit cycles is inherently difficult, adding uncertainty to investment decisions. In stressed market conditions, even instruments deemed liquid may become illiquid, complicating portfolio management. 

Furthermore, when interest rates decline, the transmission of benefits to yields is most pronounced in highly-rated instruments, moderate in mid-rated ones, and negligible in low-rated instruments.

Conclusion

The Fixed Income Trinity offers a valuable perspective on navigating the complexities of bond investments.

In India’s dynamic financial environment—where interest rates, credit conditions, and investment vehicles are in constant flux—adaptability is essential. Whether you are an individual seeking steady income, a high-net-worth investor aiming to diversify, or a corporate entity preserving funds for specific purposes, leveraging the Trinity framework can help you strike the right balance in your fixed income portfolio.

Successful investing isn’t about avoiding trade-offs—it’s about making informed, strategic ones.

Bhupendra Meel, Head – PMS & Alternative – Fixed Income, Bandhan AMC. Views expressed in this column are personal.