Partner wisely
Are you taking on too much portfolio risk?
Introduction
Fixed income can provide predictable income, diversification from equities and capital preservation for investment portfolios.
The Reserve Bank of Australia (RBA) said in June that COVID-19 is “likely to have long-lasting effects on the economy” and that the outlook remains “highly uncertain” as Australia suffers its largest economic contraction since th 1930s.1
The uncertain economic outlook and wildly fluctuating equities markets reinforces the need for investors to have diversified portfolios, to preserve capital and to have predictable income. Fixed income securities provide all three.
Benefits of
fixed income
Fixed income securities, such as corporate bonds, are like IOUs that make predictable interest payments (known as coupon payments), usually every six or 12 months. The original investment is then repaid in full at the agreed maturity date.
In having predictable income, fixed income differs from equities where dividend payments can go up, down, be deferred (as ANZ and Westpac did in May) or cut altogether.
And while investors in high-quality fixed income are extremely likely to be repaid their original investment at maturity, when equity investors sell their shares they may receive more or less than their original investment. This will depend on the company’s individual performance, the broader share market’s performance and the stage of the economic cycle.
With a very low correlation between equities and high-grade fixed income, adding fixed income helps to bring diversification to investment portfolios.
Additionally, during times of economic stress where share markets sell-off, central banks like the RBA often ease interest rates to help stimulate the economy, which in turn can result in the price of fixed income securities increasing.
Sector returns during equity market drawdowns (%)
| Period | Shares | Bonds |
|---|---|---|
| September 1987 to February 1988 | -43.5 | 5.1 |
| July 1990 to December 1990 | -16.2 | 9.9 |
| May 1992 to October 1992 | -13.5 | 4.3 |
| January 2002 to February 2003 | -15.0 | 10.3 |
| October 2007 to February 2009 | -48.3 | 15.5 |
| March 2011 to September 2011 | -15.5 | 7.1 |
| Event averages | -25.3 | 8.7 |
Source: Janus Henderson Investors, Bloomberg, Shares = All Ords Accum, Bonds = Bloomberg Ausbond Composite Bond Index (All Maturities) previously UBSA Composite (All Maturities).
Just because fixed income tends to have a low or negative correlation to equity market returns, it doesn’t come without its own set of risks.
Getting to know the
three primary fixed
income risks
Interest rate risk: Because the coupon payments are fixed, the value of that stream of payments will fall if interest rates rise and vice versa. Interest rate movements are the major cause of price changes in fixed income markets.
Inflation risk: For similar reasons, if inflation rises, the value of the stream of fixed coupon payments and the principal investment to be repaid are less, so prices of fixed income securities will fall accordingly.
Credit risk: This refers to the possibility that coupon payments and repayment of the principal at maturity aren’t made in full and on time. Australian government fixed income doesn’t carry credit risk, but corporate fixed income securities do. For this reason, corporate fixed income pays comparatively larger coupon payments than government bonds to compensate for the credit risk.
Each of these risks can be actively managed and mitigated because unlike fixed term investments, bonds don’t need to be held until maturity, they can be traded in the market, allowing portfolios to be repositioned in order to enhance portfolio returns and preserve capital.
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Knowing when and what proportion of the defensive part of your portfolio to allocate to cash, floating rate credit, fixed interest, higher yielding securities is not a simple process. Together we’ll navigate uncertainty.
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1 https://rba.gov.au/monetary-policy/rba-board-minutes/2020/2020-06-02.html