Investing

While investors need to be diligent about their fixed interest investment choices, returns from fixed income in recent years have been far superior to equities, with a fraction of the volatility and, in most cases, the risk.

A good set of numbers

According to boutique fund manager Altius, prices as measured by the consumer price index have increased 16.27 per cent since mid-2006 (as at late 2011). Over the same time, the S&P/ASX 200 Accumulation Index returned 1.15 per cent, which represents a loss of 15.1 per cent after inflation.

The UBS Bank Bill Index (the common benchmark for cash and term deposits) returned about 34 per cent in the same period, a real return of about 18 per cent. Inflation-linked bonds (as measured by the UBS Inflation-linked Bond Index) returned 39.6 per cent, a real return of 23 per cent.

Australian bonds (measured by the UBS Composite Bond Index) which is heavily weighted to Australian federal and state government bonds, returned 42 per cent.

The UBS Credit Index, a basket of investment-grade corporate securities governed by Australian law, returned 43.2 per cent over the same five-year period.

Boring is the new exciting

“What this tells us is the traditional role of equities as a hedge against inflation and the chief driver of portfolio returns hasn’t worked. Investors need to look at the funds they are in to see if they are properly diversified and assess whether they should have a much higher weighting to fixed income,” says Altius Asset Management chief investment officer Bill Bovingdon.

“The boring part of a portfolio has become exciting again.”

iPac Securities chief investment officer Jeff Rogers says investors who remain nervous of equities and are looking to the safety and income of fixed income – including cash and government bonds – need to understand the time horizon they are investing for and the risks they are willing to take.

Different strokes

The strategies will be quite different depending on where they are in life and the level of equities they are comfortable with, he says.

Strategies that include a high level of equities might use government bonds, which have a low correlation to equities, as a way to mitigate risk.

If investors want less equities but a portfolio with income, then high-grade corporate bonds might be the answer.

Rogers says the middle ground for an investor who needs income and capital in the near term might be term deposits.

Stephen Nash, director of strategy and market development at FIIG (Fixed Income Investment Group) Securities, says fixed income investors can be as defensive or aggressive as they like.

“The important thing is they can create an asset stream that matches their liability stream in an effective manner; unlike equities, which do not return capital,” says Nash.

“Fixed income helps investors cover all the associated investment risks as well as offer a direct hedge against inflation; something that investors in the UK are finding out about, with low equity growth and high inflation,” he says.

No surprises

Tyndall Asset Management head of fixed income Roger Bridges says one thing investors don’t want from their fixed income portfolios is any of the surprises felt in 2009 when the risks they were taking didn’t match the returns.

“Even conservative investors found they had risk in their portfolios they weren’t ready for,” he says. Bridges says investors were back to realising that fixed interest is a conservative or defensive asset class, which should give you a return on your money as well as return your money.

High-yielding bank accounts and term deposits and managed funds are where most individuals would now get their direct fixed income exposure.

The issue with bank accounts is they are subject particularly to changes in interest rates and, in the case of term deposits, attract high penalties if the funds are withdrawn before the term is up.

Exposure to fixed income can also be obtained through managed funds which, hopefully, ensure that risks are diversified across a large number of securities or issuers.

The five most important factors to consider when it comes to fixed income in a portfolio are:

1. Returns

Cash might be at the top of the list as the safest place to put your money but the reality is that rates of return can go down and inflation will quickly erode the future value of cash.

“A lot of people go to cash but the Reserve Bank can cut rates and so your return on your money can disappear,” says Tyndall AM’s Roger Bridges. He adds the danger with all investments is that people go looking for the highest returns.

“When people are seeking safety they should worry about the return of the capital they put in rather than the rate of return,” he says.

2. Liquidity

How quickly you need the money that is being invested will help determine the right mix of fixed income investments.

If there is an immediate need for capital then a cash management account is one option. Term deposits are another, but investors need to be aware of the penalties associated with a term deposit.

Most fixed income funds will offer instant access to invested funds but be aware that unit prices will reflect the underlying investments of the fund.

3. Diversification

Contrary to popular opinion, the fixed income universe is both broad and diverse, with an abundance of investment opportunities, says PIMCO’s Peter Dorian.

“Investors need to take advantage of this by holding a good mix of government, credit and asset-backed securities,” he says.

4. Risks

Fixed income is not without its risks including: credit risk (the risk that the issuer may not be able to meet commitments, in terms of making principal or coupon payments on time); interest rate risk (when rates rise the price of a bond falls); liquidity risk (risk that a security may not be traded within tight time constraints, due to a lack of buyers and sellers); longevity risk (an investor outlives the forecast time horizon in an investment plan) and inflation risk (returns are not protected against inflation).

5. Time horizon

Knowing the purpose and time horizon for your investments will help to determine the best types of fixed income. Are you looking for growth or income – or a mixture of both?