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Why you should look at fixed interest
This article appeared in the April 2012 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.
The allocation of shares versus fixed interest debate applies to your portfolio too.
By Robin Bowerman, Vanguard
The perennial juggling act for any investor is balancing risk against potential reward. We would all like to have a high-return, low-risk portfolio. Sadly, the world is not made that way.
In the broader superannuation world the debate about how much risk is enough is heating up partly in response to volatile sharemarkets and partly in response to superannuation trustees questioning the key asset allocation settings within default super funds.
It is common for default super funds to have around 70 per cent of assets invested in "growth" assets which typically means either local or international sharemarket investments.
Although this debate is typically being had at the institutional end of town (that is, super funds) it is just as relevant for the individual investor's portfolio, particularly if they have a self-managed super fund.
Ken Henry's concern
The former head of Treasury, Dr Ken Henry, added plenty of fuel to the fire at a recent investment seminar promoted by the Association of Superannuation Funds of Australia (ASFA) when he directly questioned the appropriateness of such high portfolio exposures to shares. His concern was that super fund members in Australia are over exposed to sharemarket volatility compared to comparable countries globally.
At a simple level this is a discussion about the right asset allocation mix between shares and fixed income. But what is often not addressed is the fundamental purpose of fixed-income investments and their role in a portfolio.
(Editor's note: To learn about the features, benefits and risks of interest rate securities do the ASX's free online interest rate securities course.)
On the face it, Australian investors have never been that engaged with fixed income or bond investing. Levels of exposure to domestic fixed-income assets at September 2011 were around 11 per cent, having steadily declined over 20 years (source: ABS).
However, that definition of fixed income excludes the massive build-up in cash and bank term deposits in recent years.
There are various reasons for this lack of engagement by retail investors with bond investing including historically low performance and the relative underdevelopment of our corporate bond markets. Other investment vehicles have also acted as substitutes for fixed income - mortgage trusts and listed property trusts to name two.
But there is also an element of education that has been missing, a vital ingredient if retail investors are going to have confidence to invest and essential to ensure they understand what it is they are buying.
To that end, a good basic knowledge of the fixed-income asset class can be gained by covering three main areas: what bonds are and what makes up the fixed-income marketplace; the role fixed income plays in a portfolio; and the asset allocation decision of proportions of growth to defensive assets.
Huge global fixed-income market
It may surprise many investors to know that the fixed-income marketplace globally is almost twice the size of the sharemarket, yet far less well understood. So what makes up this marketplace?
Simply speaking, a bond is a commitment by a borrower to an investor to pay a coupon (similar to a dividend) on fixed dates for a set term and repay the principal upon the maturity of the loan. Typically, coupons are fixed for the life of the bond. The coupon rate will vary according to the prevailing level of interest at the time of the loan, the term of the loan and the borrower's creditworthiness.
But within that simple definition is a whole spectrum of risk and complexity. At one end of the risk scale are bonds issued by the Federal Government. At the other are "junk" bonds where companies have poorer credit ratings and therefore are forced to pay higher coupon rates.
(Editor's note: The ASX interest rate securities market also provides a range of listed instruments that provide fixed and floating rate returns.)
The value of the bond is inversely proportional to the interest rate, or yield. So as interest rates decline, all else being equal, the value of a fixed coupon bond increases. Conversely, as interest rates rise, the value of existing bonds decreases as they carry a lower rate of coupon compared to new bonds issued for the same term.
Unlisted bonds are bought and sold on an over-the-counter basis - that is, directly between two parties - which differs from equities in that they are traded on an exchange. In Australia and overseas, bonds are issued by governments, semi-government organisations and corporations.
- Government bonds are issued directly by a government and are explicitly guaranteed. In Australia the Federal Government issues Commonwealth Securities to help pay for major government projects.
- Semi-government bonds are not issued directly by a government, but might have a direct or implied guarantee. For instance, state governments and other entities that have a government guarantee, such as the World Bank, issue bonds to support their financial needs or to finance public projects.
- Large public companies issue bonds to fund expansion and other major projects. Corporate bonds differ in two important ways to government bonds: yield and credit quality. Generally, corporate bonds are thought to have a higher level of risk than government or semi-government bonds, so they typically offer higher yields.
- An international bond's stability depends on its country of origin, its issuer and its credit rating. Experience shows that some countries' bonds will be less stable than others.
Primary role of fixed income
The role of fixed income is primarily to provide regular income, capital stability and diversification benefits to a portfolio by buffering a portfolio against cyclical downturns.
One thing that cannot be denied is that high-quality fixed-income bonds proved their defensive worth during the height of the GFC.
There has been a marked increase in volatility since 2008, particularly among sharemarket asset classes. As a result, Australian investors - particularly those with self-managed super funds - have retreated strongly to the security of bank term deposits. Although that is not surprising given the capital security and relatively attractive interest rates, there is considerably more to fixed-income investing than term deposits can offer.
In 2008, when the GFC was at its height, the Australian sharemarket fell 38.9 per cent; Australian fixed interest, as measured by the UBS Australian Composite Bond Index, rose 14.9 per cent. In 2011, when Australian shares were again in negative territory to the tune of minus 11 per cent, Australian fixed interest again provided a haven with a return of 11.4 per cent.
There is a danger hidden within these returns: they are extraordinary for an asset class that is more about risk management and capital security than double-digit returns. As mentioned earlier, behavioural influences could tempt investors to follow past performance rather than the principles of a diversified portfolio strategy.
That is not to say a review of your portfolio asset allocation between growth and fixed-income assets is inappropriate. Rather, that if changes are being contemplated to the asset allocation it should be for the right reasons.
Over the long term, an asset allocation to high-quality fixed income at a low cost should be expected to produce a modest return, but reduce volatility in a balanced portfolio and provide regular income in the form of coupon payments.
So what is the correct level of bonds or fixed income in your portfolio and how do you go about incorporating fixed income into your asset mix to gain this exposure?
Any decisions on asset allocation should start by establishing goals, working out a timeframe (how long until you need to cash in your investment) and then evaluating your risk profile. Once you develop and execute your asset allocations, regular rebalancing helps to keep the portfolio on track.
Your risk profile relates to how comfortable or otherwise you are to levels of risk in the investment mix. Generally, the higher the expected return of an investment, the higher the risk, so on the spectrum cash follows fixed income, follows property, follows equities (or shares). And generally risks are lessened the longer the investor's holding period.
If you consider yourself a conservative investor, a rule of thumb that Vanguard's founder, Jack Bogle, likes to cite to determine what the portfolio mix should be, is that the defensive allocation should be proportional to your age. For example, if you are 40 you should hold 40 per cent fixed-income assets (therefore 60 per cent growth assets); at 60 you should have a 60/40 split between bonds and equities, and so on.
This approach may not be suitable for everyone, which is why a good financial adviser can add a lot of value by considering your overall financial situation and help to determine your propensity for risk.
Accessing individual bonds is different to acquiring individual securities as bonds are not traded on an exchange but "over the counter". This can be a barrier for self-directed investors because of a cumbersome investment process and an often large capital outlay. Accessing fixed income through managed funds is perhaps a more efficient way to add this asset class to a portfolio.
With fixed-income exchange-traded funds (ETFs) being launched on ASX, investors can now access fixed income via this index fund vehicle in the same way as they buy and sell shares, making this asset class much more readily available.
About the author
Robin Bowerman is Principal, Corporate Affairs & Market Development, at Vanguard Australia.
The ASX interest rate securities course is especially popular with long-term investors who want more predictable income through ASX-listed bonds or hybrid securities that have fixed or floating interest rates. More companies are expected to launch interest-rate securities this year, so it is a good time to learn about this market.
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