Is fixed interest back in vogue?

The equity market bull run over the last four and a half years has impacted investor’s perceptions of fixed interest as an asset class.

With equity and listed property markets delivering annual returns in the vicinity of 20 per cent, many investors have questioned why they hold bonds. At the same time, some income seeking investors have turned to sub-investment grade debt instruments in their efforts to secure higher yields.

The recent equity market turmoil reinforces the importance of including bonds in a diversified investment strategy. There is, however, a case for holding bonds in a diversified portfolio in all market conditions, whether volatile or not. Why?

Diversification

Bonds are a defensive asset class and should provide a stabilising effect during periods of share market weakness.

One of the best ways to demonstrate the diversification benefits of fixed interest is to look at the correlation data. Table 1 shows the correlation between fixed interest and equities and listed property trusts over the last 10 years. As the data shows, fixed interest is negatively correlated with equity markets and, importantly, this correlation does not change significantly over different time periods.

Asset classes with correlations below one are important for diversification, as they improve portfolio efficiency by lowering return volatility. Negative correlations, like those between fixed interest and equities, offer more substantial diversification benefits.

Fixed interest has typically produced positive returns when equity markets have fallen, so including fixed interest assets in a portfolio can help offset or reduce negative returns during periods of market volatility. For portfolios with a low risk aversion and a higher allocation to equity assets, an allocation to fixed interest can reduce the extremes of portfolio returns and reduce total risk or standard deviation. For those with a higher risk aversion, it helps to preserve capital.

A question of performance

The strong equity returns over the last few years have caused the marginalisation of bonds to a certain extent. In an effort to become more appealing to investors, product manufacturers have spiced up their offerings, introducing higher yielding or sub-prime investments. However, in the pursuit of higher yields, we are now seeing compelling evidence of higher — in some cases much higher — levels of risk.

Products that looked great when credit markets were strong have given up much of their returns in the last six to 12 months during this period of volatility. In contrast, the benchmark return (shown in table 2) has outperformed the majority of active managers over the last 12 months based on Mercer survey data to March 31, 2008.

Staying true to label

Index funds attempt to capture the returns of an underlying index by holding all (or a sample) of the individual stocks or bonds represented in the index. As a result, the fund returns should be equal to the market index return less fund fees.

Unlike an active fund manager, an index manager makes no attempt to analyse which shares, bonds or other securities are likely to go up or down in value. The philosophy behind this approach is that by buying and holding a broadly diversified portfolio of securities, the cost of investing can be significantly reduced over time and can lead to better long-term returns.

Understanding the risks

Even though indexing is an excellent foundation for an investment portfolio, many investors are attracted to the distinctive investment philosophies offered by actively managed funds. However, by combining both active and index funds, you can greatly improve the risk/return profile, overall costs and tax efficiency of portfolios. This portfolio construction is the core/satellite approach to investing.

Recent experience highlights why investors need to look beyond the yield and understand the capital flows backing the security. Some investors in structured credit products were unknowingly exposed to sub-prime investments. These types of products pool a range of debts like residential mortgages or credit cards into parcels, which are then segmented into a range of risk profiles and sold to different investors.

On the surface, these investments appeared to provide a low risk way for investors to achieve higher yields. In reality, they masked the real risk of the underlying securities — a mix of sub-investment grade and higher graded debt securities — so investors weren’t really sure what they were getting.

Indexing for efficiency and diversification

Bonds are a defensive allocation and if the arguments for indexing are compelling in equity markets, they are even more compelling in the bond space, where it is difficult for active managers to outperform. For active managers to outperform, they need to select securities from a universe of assets with a broad range of returns.

Index funds are broadly diversified, which means that you are less exposed to the performance fluctuations of individual shares or securities. The overall effect is that you moderate the volatility of your portfolio and ‘smooth out’ your investment returns over time. Index funds invest in a wide selection of securities in the relevant index, holding significantly more securities than most active funds with the same benchmark.

Indexing has gained popularity both in Australia and abroad over the past three decades, providing a low cost, tax efficient investment vehicle that is especially well-suited to the current investing climate, where it’s increasingly looking like a diversified allocation to quality, investment grade bonds could be the height of fashion for diversified portfolios this season.

Roger McIntosh is principal and head of fixed interest and investment solutions at Vanguard Investments Australia.