Flex your fixed income muscle

Storm Financial, Timbercorp, Great Southern, MFS. The stories of investors, and particularly retirees, losing their life savings on investments in these companies and their related products is horrific.

It’s a harsh tale, but it emphasises the importance of diversified asset allocation in a portfolio, not only across investment classes, but also within each class.

A glance at a typical investor’s portfolio would show it is far from balanced.

The average Australian has a hankering for a bit of risk and is overweight property and equities at the expense of lower risk asset classes, such as fixed income.

However, the recent volatility in stock markets and falling property prices highlight the need for fixed income in any portfolio.

The question is how much fixed income is enough? As with many investment decisions, there is no definitive answer to this question. The amount will vary depending on the age of the investor, but even then, what is appropriate will depend on individual risk appetites.

Typically, younger investors want and can afford more risk as they have longer to rebuild their portfolios after a cyclical low or recession.

Those investors that have specific requirements for a project or retirement should move to a lower risk portfolio to ensure capital preservation. Growth and higher returns, while attractive, are more risky strategies and subject a portfolio to losses that may be irrecoverable.

Previous surveys on asset allocation show that the average Australian do-it-yourself investor has just 2 per cent in fixed income compared with 20 per cent in equities. This figure is too low and we will look at where fixed income fits in a balanced portfolio.

Fixed income in a balanced portfolio

One of the advantages of fixed income assets is that they pay a fixed return over a defined period offering stability and certainty of income.

Those products acting as purely income-producing (term deposits, money market securities such as bank bills, negotiable certificates of deposit and commercial paper) are the least risky and should constitute a reasonable portion of any portfolio.

Bonds and higher risk fixed income products, on the other hand, as well as providing income may also contain an element of capital gain or loss.

Bonds are traded on secondary markets and their prices are constantly changing depending on many conditions. A major factor influencing bond prices is interest rates.

It is essential to understand that bonds have these two characteristics of income and capital gain/loss, as most people think only of the income aspect.

Importantly, it is the capital gain/loss that performs an insulation function for your portfolio, as explained below. For this reason, bonds are an essential part of a balanced portfolio, as they help to reduce the volatility of returns in divergent growth scenarios. While the idea is not new, it stems from the fact that, in most cases, the total returns from bonds and equities move in opposite directions.

Credit and duration

Like any product, there are times to trade fixed income assets for others to maximise returns throughout the cycle. However, before we examine when that is appropriate, we will look at two key determinants in assessing fixed income allocation: duration and credit.

Duration is the impact of the movement in interest rates on the value of a fixed income investment. Buying longer-duration fixed income investments (assets with a longer term to their maturity date) when interest rates are high means that investors can benefit when interest rates fall.

This outcome is usually associated with a slowdown in the underlying economy, which in turn usually results in underperformance from higher risk assets, such as equities.

Credit risk is the likelihood of the issuer being able to repay the obligations associated with the security.

Depending on the weakness in the underlying economy, getting duration right does not necessarily work in isolation. This is where credit selection plays an important role and timing is also an issue.

In terms of a dramatic cyclical downturn, investors tend to remain in zero risk or government-issued fixed income assets. This will ensure that investors can lock in gains when interest rates fall and maintain access to liquidity.

High-growth economy

Strong economic growth usually means the stock market performs well and delivers high returns to investors.

From 1992 to 2008, strong global stock market outperformance was evident. Governments typically acted to constrain growth by tightening monetary policy (increasing interest rates, making it more expensive to borrow and thus acting to reduce investment), so that inflation was contained.

Bond markets suffer under these conditions, as long-term bonds anticipate movements in short-term interest rates. Higher rates equate to lower bond prices. For example, if an investor holds a long-dated bond with a 10-year maturity and 5 per cent yield, and long-dated bonds rise in yield by 1 per cent, the investor can expect the capital value of the bond will fall by around 10 per cent (or 1 per cent per year for the 10 years till maturity).

On the plus side, the decline in capital value is partly offset by the 5 per cent yield of the bond.

Over one year, therefore, the total return from bonds is 5 per cent yield, less 10 per cent capital fall, or negative 5 per cent.

Here, a 50 per cent allocation to long bonds would mean that bonds drag the portfolio down by 2.5 per cent (negative 5 per cent with a 50 per cent allocation), yet the portfolio might gain 20 per cent in equities, meaning that the portfolio return is around 7.5 per cent — that is, 10 per cent from equities (20 per cent return with a 50 per cent allocation), less 2.5 per cent from bonds (negative 5 per cent with a 50 per cent allocation).

See Graph 1.

Low-growth economy

In a low-growth, or recessionary scenario, the opposite occurs. Equity prices decline and governments ease monetary policy — that is, reduce interest rates hoping to stimulate investment and spending.

Long-dated bonds tend to anticipate lower interest rates and face value price increases. Assuming we use the same bond as the high-growth economy example above, the face value of the bond might appreciate 1 per cent, leading to a 10 per cent capital gain on the bond portfolio.

Since the bond yielded 5 per cent over the period, yield return is 5 per cent, while the capital return is 10 per cent taking total return to 15 per cent. This means, for a 50 per cent allocation to bonds, the total return from bonds would be 50 per cent of 15 per cent, or 7.5 per cent.

The equity contribution of the portfolio is negative 10 per cent (negative 20 per cent with a 50 per cent allocation), and the bond contribution is positive 7.5 per cent (15 per cent with a 50 per cent allocation); where total portfolio return is negative 2.5 per cent (negative 10 per cent from equities, and positive 7.5 per cent from bonds). See Graph 2.

Essentially, the use of bonds in a portfolio can be used to balance the cyclicality of shares. Again, this leads to the question of what is the appropriate level of fixed income securities to hold in a portfolio.

A simple formula

Portfolio allocations depend very much on the investor, their aims, amounts they can invest and, of course, the time span and possible access to funds. There are a multitude of scenarios, all with advantages and disadvantages.

We would advocate a minimum allocation to fixed income of 30 per cent, with 10 per cent in the least risky income producing, short-term money market securities.

For investors with specific objectives, a much higher allocation to fixed income should be considered. For not-for-profit associations, such as charities, hospitals, churches, schools and universities and local government councils, a 100 per cent fixed income allocation may be appropriate.

Some simple ideas are:

• the older and closer to retirement you are the more protective you should be and decrease exposure to high-risk asset classes. Nearing retirement age is not the time for increasing risk even if investors have not saved enough;
• invest small amounts in high risk, large amounts in low risk;
• borrowing or gearing increases risk through exposure to interest rate movements; and
• equities equal 100 minus your age, so if your client is 40 years old, the percentage of their portfolio held in equities would be 60 per cent, declining as they near retirement.

Thus, investors need to increase the percentage of fixed income assets as a percentage of their total portfolio as they age.

Rebalancing a portfolio

Regularly rebalancing a portfolio takes advantage of the best conditions in both equity and fixed income markets. As seen by the examples above, equity and fixed income securities tend to operate best under opposing market conditions.

Equities perform best in strong and growing economies while bonds and fixed income products that have an element of capital gain or loss perform best under contracting conditions (see case study).

Profits are taken in rising equity markets and reinvested in lower performing fixed income markets — which is opportune in that as all markets are cyclical, buying in fixed income when cheap enables investors to take advantage of that market when conditions change. Of course, the reverse is true when fixed income outperforms equities.

Rebalancing takes heed of the basic investment principle of selling in a high market and buying in a cheap one, maximising earnings potential over time.