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Fixed income: The role of bonds

January 2015

Fixed income has often been unfairly overlooked by investors. We consider the role it can play in a balanced portfolio.

Assets which produce steady, consistent income while preserving capital have a natural attraction for investors. 

There are few defensive assets which meet those criteria: among them are cash, term deposits, and bonds – with the last often overlooked.

The global bond market is estimated at $US100 trillion compared to global equities at $US66 trillion1 but the average self-managed super fund (SMSF) allocates just 7 per cent of its portfolio to the asset class, according to a recent survey by the Financial Services Council2.

By comparison, large MySuper balanced funds have a strategic asset allocation to bonds of 18 per cent, according to research house Chant West3

SMSFs have instead preferred to invest in Australian equities (23 per cent) and bank deposits/cash (35 per cent)4 – a strategy which Credit Suisse analysts have described as “trying to re-create the return and volatility profile of corporate debt through their barbell position in equities and cash5.”

Some investors seek to create a similar return and volatility profile with a balanced bond portfolio which aims to provide a higher yield than cash but with lower volatility than equities.

There are many kinds of fixed income securities, such as government, semi-government, corporate, high-yield, mortgage, emerging market, and inflation-linked debt. 

Bonds pay a set interest rate to the bondholder for the life of the security. In the event of an insolvency, bondholders, have a higher priority claim against the assets of the company than shareholders.

Nevertheless, different types of bonds rank at different points along the risk-return spectrum.

For example, some government bonds are considered close to risk-free, given the extremely low probability of that government defaulting on repayments. Corporate bonds are regularly issued by companies to fund their activities and tend to pay a higher interest rate because there is perceived to be a greater risk that a company will default on its repayments.

Corporate bonds come in many forms, each with its own unique risk/return profile.  For example, if a company enters into administration, investors in senior debt-secured bonds are repaid their capital before investors in converting preference shares. Hybrid securities have risk/return characteristics of both bonds and shares.

Portfolio specialist John Valtwies, who works for global bond manager PIMCO, says a wide variety of bonds can diversify a portfolio by preserving capital and producing a steady income stream. 

“As time goes on there's an increasing demand for income and we know at the moment, with low term deposit rates and an expectation these rates may be low for some time, that income needs still need to be met.” 

“In order to meet those needs, we need to look at other instruments that can help to meet those requirements.”

The Reserve Bank of Australia has cut official interest rates to historic lows6, eroding returns on bank term deposits and prompting investors to seek income elsewhere. High-yielding blue-chip shares have attracted significant support from investors searching for income however, shares can be more volatile than bonds. 

However, bond returns can be significantly impacted by interest rates. 

When rates fall, the capital value of fixed interest securities typically rises and when interest rates rise, the capital value of fixed interest securities typically declines although bond managers may offset this risk in numerous ways, such as investing in securities which are less sensitive to interest rate moves or in regions where interest rates are not rising.

1. Source: PIMCO.
2. FSC report ‘State of the Industry’ 2014. Survey of 600 SMSF trustees conducted between October 2 and 14, 2014.
3. Chant West super survey. December 2013.
4. FSC report ‘State of the Industry’ 2014. Survey of 600 SMSF trustees conducted between October 2 and 14, 2014.
5. Credit Suisse ‘Rise of the Selfies’ report. January 17, 2014.
6. RBA cash rate target.