This article appeared in the February 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Fixed income ETFs make it easier to enhance returns and better diversify portfolios.
By Robin Bowerman, Vanguard
Just as new year resolutions to lead a healthier lifestyle can get less resolute as the year progresses, your investment portfolio can also drift off course over time because of market movements that push your asset allocation beyond your target weight - that is, the allocation of your portfolio across assets such as shares, fixed interest, cash and property.
A new year offers a fresh perspective with which to assess if your portfolio still fits your long-term goals and is providing adequate balance and diversification to suit your risk appetite.
No one is complaining after a strong performance from the Australian sharemarket in 2012 saw the S&P/ASX 300 index gain 16 per cent. But the counterpoint to that is you may find your portfolio tipping too far towards the more volatile growth assets.
It may be time to rebalance it with additional defensive or less volatile assets. The proportions will depend very much on your personal risk preferences and time horizon, but getting the asset allocation mix right is one of the most important decisions an investor makes.
Personal preferences may see some investors leaning towards cash or term deposits to safeguard their investments. Australian fixed income remains a true diversifier to the higher risk attributes of shares - Vanguard's research shows this holds true in almost all market conditions and even more so in times of market stress.
Listed fixed-income ETFs available
Until early 2012, investors seeking fixed-income investments were not able to find such securities through the listed market environment. However, the introduction of fixed-income ETFs (exchange-traded funds) has changed that and investors can now invest in these funds in the same way as trading shares.
Using a pooled fund - be it in listed form such as an ETF or unlisted such as a traditional managed fund - offers the advantages of diversification, cash flow management, lower costs (than investing in the individual bonds that make up the fund) and increased liquidity.
ETFs work in the same way as traditional managed funds in that they invest in a number of securities or, in the case of fixed-income ETFs in bonds, and issue units that provide the investor with a diversified exposure to the fund's underlying bonds or securities. Purchasing a unit gives exposure to the whole portfolio in which the fund invests.
All fixed-income ETFs listed for investment in Australia are index funds and so track a market index, such as the UBS Composite Bond Index™, which Vanguard's Australian Fixed Interest Index ETF tracks. This index is made up of more than 400 different bonds, including government, semi-government, supranational, sovereign and corporate bonds - which by any measure is a diversified portfolio of bonds.
Bonds reduce overall risk
It may not be overly obvious what fixed income can offer because this is an asset class that has been hard to access for many retail Australian investors in the past and is perhaps not well understood or even considered at all.
Yet investing in good-quality fixed income or bonds can introduce three key elements to a portfolio: diversification, a steady income stream and capital stability.
One of the most important roles bonds play in a portfolio is to help reduce risk, by dampening the volatility of, and providing diversification to, sharemarket returns. This is why bonds can be described as defensive assets.
Although the prices of bonds will fluctuate according to interest rate and economic cycles, historically they have been nowhere near as volatile as share prices.
The chart below shows bond returns have tended to be positive even when returns for Australian shares have been negative. This is what analysts refer to when they say there is a low or negative correlation between the returns of bond markets and sharemarkets. It is this low or negative correlation between asset classes that provides the diversification every well-balanced portfolio needs.
Calendar year returns for Australian shares and bonds chart - from December 1989 to December 2011
Source: UBS, IRESS, Vanguard calculations, January 2012*
A major objective of many investors moving into their retirement years is to ensure their portfolio is set up to generate an income stream. It is tempting to look to high-yielding shares to provide this component and overlook fixed income, whereas a more robust approach is to have a balance of both.
Most of the investment return for bonds is made up of coupon income. For a broad portfolio of bonds, these coupon (or interest) payments can constitute a reliable stream of income.
Bonds can also provide capital stability. The principal invested in a bond is returned to the investor when it matures, which makes a bond an effective capital-preservation tool, assuming of course that the issuer is of high credit quality. For example, government bonds, which are backed by the full faith and credit of a sovereign government, are often referred to as risk-free because a government theoretically can raise taxes or create additional currency to meet its obligations when its bonds mature.
Bonds versus term deposits
You may still not be convinced that you should choose to use fixed income in your portfolio when you can easily invest in a bank term deposit, a familiar place to put savings.
Although term deposits have a proper role to play and have been an attractive option since the GFC, with banks offering good rates, you could think of them as a short-term savings vehicle rather than an investment, whereas fixed income should be thought of as a longer-term investment rather than short-term saving.
It is worth noting that while term deposits are capital-protected, they are not totally free of risk. They come with an element of reinvestment risk in that your money is rolled out of one, perhaps attractive, term deposit with a great interest rate, into a less attractive deposit with a lower rate. They also introduce liquidity risk where you may not be able to access your money without incurring a penalty.
Fixed income traditionally offers higher expected returns over the long term for investors willing to take on slightly more risk. These higher returns are compensation for investors taking on increased levels of interest rate risk and credit risk exposure.
Perhaps the best resolution for this is to tune out the "noise" and headlines that can compel investors to tinker with best-laid plans. Instead, start the year ensuring your portfolio is properly balanced to reflect individual needs, time horizon and risk tolerances with the right mix of shares, property, bonds and cash.
About the author
Robin Bowerman is Principal, Head of Market Development and Communications, at Vanguard.
* "The mark and name UBS Composite Bond Index™ is proprietary to UBS AG ("UBS"). Any use of this index or its name must be with the express written consent of UBS AG acting through its Australia Branch.
Fixed income Exchange Traded Funds has useful information on the features, benefits and risks of bond ETFs.
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