Why bother with fixed interest?
With term deposit rates still on a relative high and the annuities which help fund investors’ years in retirement, why should one bother with fixed interest? Tim Wong answers this question.
High term deposit rates, annuities that address the risk of outliving one’s assets, and high-yielding hybrid securities have all attracted attention from investors and financial advisers looking to balance out the risks in investment portfolios.
All this has prompted many to ask: why bother with fixed interest?
The answer is simple – high-quality fixed interest strategies are best-placed as an insurance policy, should risky assets like equities turn south.
Their ability to do so surpasses that of annuities and hybrids, and even capital stable and government-backed term deposits. This is because many (although not all) bond strategies possess the characteristic of interest rate duration.
When interest rates fall, the value of a fixed interest portfolio rises. The bond portfolio is worth more because these securities pay higher coupon interest than what's on offer in the market. By contrast, although term deposits maintain capital stability, they're not marked-to-market, and so miss out on this revaluation effect.
Why is duration important?
Falling interest rates typically coincide with slowing economic growth and increased risk aversion.
High-grade bonds providing a regular income stream are perceived as a 'safe haven', and are therefore more highly-valued.
They effectively diversify a portfolio's exposure to risky asset classes, as their value typically rises when equities fall. Duration is not without risks though – it increases a portfolio's sensitivity to interest rate changes detrimentally if interest rates rise.
This occurred in 1994, when many Australian bond strategies lost money.
Nonetheless, duration gives to fixed interest diversifying qualities that supersede even term deposits.
Falling yields are ripe for bonds, which provide the portfolio insurance that term deposits lack. (It's not all one-way traffic – at certain points in the cycle, term deposits can outperform a vanilla fixed interest strategy, such as when Australian interest rates rose in 2006–07.)
What then of hybrids?
We believe that hybrids have severe shortcomings for use as a portfolio's defensive anchor. Firstly, they possess the characteristics of both debt and equity. Like equities, hybrids have tended to fall in value when growth slows.
This often coincides with rising credit spreads, concerns about a company’s ability to service its debt, and in a worst-case scenario, deferred distributions.
Investors in PaperlinX PPX and Elders Limited ELD hybrids suffered, as these companies ceased paying their income distributions.
Additionally, hybrids rank behind other bondholders – significantly diminishing the hybrid's worth in times of stress and giving it more equity-like qualities.
Issuers can also include unfavourable terms such as retaining the option to convert or retiring the security before maturity to refinance at lower interest rates.
Liquidity can also be problematic when risk aversion spikes – hybrids can be thinly traded, as was the case in 2008.
We therefore urge investors and financial advisers not to treat hybrids as purely defensive debt. They can exhibit equity-like characteristics at the most inopportune times and lack the safeguards of high-grade bonds.
Hybrids often contain an array of complex terms that can make them tricky to understand.
No two hybrids are the same – while one may behave like a debt security, another could include terms that make it do anything but. Hybrids can play a role in a broader fixed interest allocation, but require careful and judicious use.
Annuities are often used as a component of the defensive portion of a portfolio.
While this is potentially a valid strategy, annuities are primarily designed to address longevity risks.
Many investors fear outliving their assets, and annuities provide a known income stream for the remainder of one's life.
Nonetheless, annuities are not a substitute for a high-quality fixed interest investment. It comes back to duration.
Annuities may provide greater certainty of capital and income, but when equities are struggling and interest rates falling, high-quality, duration-sensitive securities should rise in value – all other things being equal.
Conversely, the holder of an annuity will continue to receive the same payments – no bad thing, but nowhere near as beneficial when the remainder of their portfolio is falling in value.
In conclusion, there are valid reasons for including term deposits, hybrids, and annuities in an investment portfolio.
However, none of these should be relied upon as a defensive anchor. The lack of interest rate duration prevents term deposits and annuities from providing the 'insurance policy' effect many high-quality fixed interest strategies offer.
And the risks and inherent complexities of hybrids are severe shortcomings that make them unsuitable for this role.
Tim Wong is a senior research analyst at Morningstar.
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