SMSF Investing Education & Strategies

Why Fixed Income ?

An asset class worth learning about.

by Elizabeth Moran
FIIG Securities.

Did you know that in 2010 the international bond market was worth US $49.7trillion and that the Australian market was worth $225.4bn? The global bond market is huge and has grown at 9.8% on average over the last ten years.

Yet, most Australian investors have little or no understanding of the benefits of fixed income. The asset class offers a means to diversify and protect investors’ portfolios making it worth learning about.

 

One of the key benefits is that investments are lower risk and more stable than the higher risk asset classes of property and equities and fixed income securities are often counter-cyclical. Fixed income offers a broad spectrum of products, risks, returns and maturities to provide a diversified and balanced portfolio solution for investors.

 

 

What is fixed income?

Fixed income refers to debt securities (for example bonds) that pay a defined distribution (the coupon) for a given period of time (the term) and repay the face value of the security at maturity. A fixed income security or bond is a loan from an investor to the issuer of the security. Issuers of fixed income securities in Australia include the Commonwealth Government, state governments, domestic and foreign banks, corporations and infrastructure assets. The specific structure of a fixed income security can vary significantly depending on the issuer, term and maturity, coupon type and where it sits in the capital structure.

 

 

Why invest in fixed income?

From an investor’s perspective, the primary purpose of the fixed income asset class is to provide a low risk, reliable income stream and to preserve capital. Fixed income offers investors:

 

1. Capital stability

One of the key characteristics of most fixed income investments is the repayment of capital at maturity, or in some cases, over the life of the bond. Of course, capital repayment is subject to the ability of the issuer of the bond to meet this obligation. One of the lowest risk fixed income products is a Commonwealth Government bond issued by the Australian Government.

 

Higher risk products like subordinated debt (bonds) and hybrid securities issued by a range of corporations including high and low risk entities offer much higher returns than government bonds. As long as investors are comfortable with the underlying credit quality of the issuer, these assets can provide stability and diversity in a portfolio while offering higher returns.

 

There is a wide range of fixed income products that sit between the low risk, Commonwealth Government bonds and the higher risk corporate hybrids allowing investors are to target their individual risk and return appetite.

 

2. Regular income

Fixed income securities provide a regular income stream through coupon payments where the dates and amount of the coupon payable are defined at the time of issue. As a result, a portfolio of fixed income securities can be tailored to meet an investors’ cash flow requirements (both size, and timing).

 

3. Diversification

Diversification spreads investment across a range of assets, maturities, industries and risks with the aim of reducing the impact of any one investment in a portfolio. Fixed income allows diversification away from the two most cyclical asset classes – equities and property.

 

Fixed income products can counter-balance higher risk investments in a portfolio and they can serve to even out returns in times of high volatility. Most, if not all, balanced investment portfolios should contain a significant fixed income allocation to ensure investors of their continued ability to meet ongoing business and personal commitments.

 

4. Ability to earn better returns than bank deposits

Many investors use term deposits which provide minimal risk but generally earn relatively low returns. One of the many strategies investors can employ is to invest in other fixed income products offered by the same financial institution which may offer higher returns. By undertaking this strategy, the investor retains exposure to the same company (assured of its credit quality and ongoing viability) but improves overall return by taking a subordinated position within the overall capital structure.

 

5. Ability to diversify the range of portfolio maturities

Bond maturities typically vary between one and ten years. In addition, bonds are tradable securities and can be sold before maturity. The investment return, when a bond is sold prior to maturity, may differ from the initial yield.

 

6. Liquidity

Cash is an important component in a portfolio. Investors with cash can use it to pay their bills and maintain their positions. Equally, very low risk and highly liquid fixed income investments such as government bonds can be sold at short notice if required. Liquidity is a fundamental factor in building a portfolio.

 

An important function of liquidity is being able to sell an asset quickly without significant loss. Assets that cannot be easily sold or traded in a secondary market need an appropriate return to compensate for illiquidity.

 

7. Protection against loss in a cyclical downturn

Generally, a fixed income allocation in your portfolio will act to protect it during a cyclical downturn. A greater allocation will provide greater protection. Setting your asset allocation and regularly rebalancing your portfolio, assuming a set fixed income allocation, should provide ongoing protection.

 

Elizabeth Moran
Director – Education and Fixed Income Research - FIIG Securities.

 

2011 FIIG Securities Limited. The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced, distributed or transmitted to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

 

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