Why portfolio diversification matters more than ever

Kirsty Dullahide explains why in times of uncertainty, a diversified portfolio will continue to serve the needs of clients.

Diversification is one of the first investment principles we learn. We all know and understand this point.

The extreme investment experience of the last two years was a blunt reminder why diversification is such a foundation rule.

But this experience also taught us to look more closely at exactly what we’re investing in and to properly consider both the risk profile and the returns on offer for a particular asset class.

Fixed interest not a homogenised safe haven

There is a wide range of instruments under the fixed interest label from the familiar and comfortingly dull domestic government bond, through to more exotic and opaque collateralised debt obligations.

Prior to the global financial crisis (GFC), many investors had inadvertently taken on increasing amounts of risk in their portfolios, some of which had inappropriately crept in under the apparent safe haven guise of fixed interest.

When the GFC broke, this resulted in a painful lesson.

So, as investors began their flight to safety — and stayed there — their focus was not simply fixed interest. It had, after all, played a part in the problem.

The new safe haven was domestic bank term deposits.

For banks, the situation regarding term deposits became fortuitous.

As recent funding sources froze and then became increasingly expensive, they were able to quickly revert to funding support from their local customers.

Investors, in turn, were happy to place their money with a government guaranteed, top rated bank at an attractive rate for a relatively short period of time.

Over the past two years, as investors remained broadly defensive, fixed interest has generally performed in line with its risk profile, market volatility and market expectations.

• Bond yields fell significantly (prices rose accordingly) through much of 2008 as the GFC worsened and the general economic outlook soured.
• An improving economic environment through late 2009, together with rising official interest rates, saw bond yields rise (and prices fall).
• Renewed global economic worries in the June 2010 quarter brought on by a worsening European fiscal position, an uninspiring US outlook and concerns about China’s slowing growth again saw bond yields fall (and prices rise).

But where to from here?

Defence as offensive?

Recently fixed interest investments have achieved positive returns despite the declines in equity markets. Despite this, it is important to note fixed interest assets have simply performed as intended.

Investors should not be confused about the performance characteristics of each part of their portfolio. Regarding higher returning (generally higher risk) fixed interest as a quasi replacement for equity returns would be a potentially perilous error.

Fundamentally, the nature of an investor’s return — and therefore risk — is different for fixed interest and equity.

Consider corporate credit.

• If a company faces financial difficulty; both its equity and its bond (debt) providers can lose their capital investment. Bond investors have a right to be paid back their capital before a shareholder, but if there’s nothing in the pot this may not mean much.
• On the upside, an equity investor (shareholder) is able to participate in a company’s profit growth whereas a bond investor’s upside potential is capped to receiving its full capital and coupon payments.

Most important for investors, then, is that they continue to remain alert to the risks of their fixed interest investments and ensure their defensive allocation remain the safe haven they were intended to be.

Can the good times last for term deposits?

A key factor for term deposit investors to consider is likely future returns, relative to the risks being undertaken.

Although bank deposits continue to enjoy a government guarantee, it is due to be removed in late 2011. After this, deposits will be backed by the institution’s credit quality.

Recently, banks have generally achieved their target level of term deposit funding and, looking ahead, it is expected they will increasingly shift their focus to profit optimisation (ie, reducing interest payments).

As a result, we consider future returns for term deposits will likely continue to fall from current levels.

The result of this shift will mean investors seeking relatively higher returns will need to sacrifice liquidity and lock in their money for longer periods, or to accept a significantly lower return for a shorter investment term.

This will require investors to make a delicate decision between meaningful returns versus material credit and timing risk.

Where, what and for how long?

During the past two years credit spreads — the difference between government bond yields and corporate yields — in Australia and overseas for non-government issuers have been volatile.

Investors have generally placed more value on risk and demanded a higher return.

In Australia, during the early part of 2009, credit spreads moved out to more than 250 basis points (BPS) for companies rated ‘AA’ by Standard & Poor’s; and above 500 bps for ‘BBB’ rated companies.

However, over the last year, spreads have declined by as much as half. And this trend will likely continue if corporate fundamentals further improve.

For those investors brave enough to invest when credit spreads were wide, the recent reductions in spreads have provided good gains.

But these spreads have now stabilised — albeit at higher levels than before 2008. They now offer less opportunity for further enhanced returns; although it’s conceivable they could blow out again if economic conditions deteriorate.

US versus Australia versus emerging bond markets

For government bonds in Australia, our view is determined by whether we believe the domestic economy will push forward, hover, or be further affected by international uncertainty.

Current interest rates reflect a position close to neutral.

Strong GDP figures released in August, robust employment figures, and the ability to service Asia’s continued growth point to some pressure building on inflation, official interest rates and, therefore, bond yields.

Nonetheless, some risks remain for global growth that could negatively impact the local economy.

For government bonds issued overseas, the story appears less attractive.

Countries considered safe, such as the US, offer only very modest returns to investors.

The US 10-year bond yield is around 2.5 per cent per annum, reflecting expectations of minimal economic growth or inflation for an extended period of time.

And there seems little scope for an investor to achieve better medium-term returns than these relatively low yields.

Looking ahead, there may be potentially increased returns to be found in other developed countries that do not fall under the traditional safe haven banner, provided investors are comfortable with significant political and sovereign default risk.

Emerging market spreads have recently widened to their highest level since September 2009, and may represent an opportunity if the fiscal situation of these economies fares better than those of developed nations.

But returns in these markets will likely experience significant volatility. In this context, Australia is looking like the best place to be.

Thinking globally, but investing locally

For investors considering where to place money in Australia, there are many things to juggle:

• Europe’s recent fiscal problems and the slowed pace of recovery in the US means bond yields are delicately poised.
• Despite the recent contraction, corporate credit spreads remain relatively wide. But investor sentiment for risk dictates that this is a volatile sector.
• Term deposit rates, which have been so attractive recently, are likely to fall as banks seek to shift investors into longer-term securities.

As we all know, the world can change quickly. Markets even faster. And, with volatility anticipated to continue, now might be time to consider the defensive value of investing with a strategic bond fund.

In a volatile environment, deploying a full time sector specific expert — by investing in a bond fund — can add both value and peace of mind to an investor’s portfolio.

Not surprisingly, most investors look to their defensive asset exposures for liquidity. So a highly illiquid term deposit is not generally seen as ideal.

By contrast, because bond funds invest across a wide range of fixed interest securities, many of which, are highly liquid, investments can generally be sold and redeemed within three days.

For investors, although the what, how, when and where will continue to change, having a sensibly diverse portfolio will likely continue to serve their best interests.

Kirsty Dullahide is general manager, investments and strategy, at Australian Unity Investments.