Fixed income has matured as an asset class, driven by the global rise in cash rates, resulting in increased yields. Heightened market volatility has also emphasised the need for diversification away from equities and property. Additionally, Australia’s fixed income market has witnessed ongoing development, leading to widening credit spreads or expected returns over the cash rate. Initially, large institutional investors and their asset consultants sought fixed income investments, but now the demand is extending to financial advisers and both wholesale and retail investors seeking stability in their portfolios. While there is widespread demand for this asset class, the underlying reasons for such demand vary. This article seeks to explore the main reasons for this demand and how that may shape what form of fixed income could be better suited to achieving the desired outcome within one’s portfolio.
Reason 1: A Source of Portfolio Return
Investors are primarily attracted to fixed income due to its historically elevated expected returns, which typically range from 5-10% per annum. This return compares favourably to other asset classes on a risk-adjusted basis. Investors seeking these returns can decide how sensitive they want their expected returns to be in response to changes in interest rates and demand for such investments. For instance, an investor who believes the RBA cash rate will decrease and the demand for a particular fixed income asset will rise may be better suited to a long duration strategy. Such a strategy offers the potential for additional returns if these events occur, albeit with added risk. However, if an investor predicts interest rate movements incorrectly, they may experience softer or even negative returns. Alternatively, investing in shorter duration or shorter-term assets provides less sensitivity to interest rate changes and therefore, is considered an inflation fighting or ‘real return profile’ strategy as returns should move up and down with the cash rate.
Reason 2: Regular Income
Typically, investor returns are derived from interest payments, which benefit from being contractual obligations. This differs from equities or hybrids, where such payments are discretionary or less certain. Furthermore, generating income from fixed income investments can be a cost-effective investment, unlike property investments that involve expenses such as upkeep or vacancies. For investors with income generation as a priority, it is important to examine the investment’s running yield, net of expected management or other costs, as it serves as the best indicator of likely income streams.
Reason 3: Capital Stability and Portfolio Diversification
However, the extent to which fixed income provides these benefits can vary. Investors prioritising capital stability should consider engaging a fund manager with dedicated resources and specialised skills to understand the nuances of the market and promptly act if a fixed income asset deteriorates. Investing through a fund also allows access to a more diversified portfolio compared to individual investments. For example, it is not uncommon to invest in a Fund and gain access to many hundreds if not thousands of underlying assets. When evaluating such funds, investors should carefully consider the fees involved and, most importantly, examine the track record of the fund managers. Questions such as the fund’s duration of operation, whether it delivers on its objectives (such as low volatility), and the managers’ previous track record with other organisations are crucial. In fixed income, experience counts, and we too often see firms renamed and ills obfuscated.
Reason 4: Immunization
Immunization is a strategy commonly utilized in institutional portfolios but can also be relevant for individual investors with specific return requirements. Fixed income investments, given their capital stability and income generating nature, are often employed in this strategy. For example, an investor may aim to achieve a return of the RBA cash rate +4% to meet a predetermined projection of ongoing expenses that need to be funded. In other words, seeking to match investment income with outgoings helps to ‘immunize’ the risk of a shortfall assuming those projections. Alternatively, the investor may seek to preserve the inflation-adjusted value of their portfolio while receiving a consistent 4% annual income stream. By investing in fixed income assets that offer more predictable income payments, investors can aim to align their monthly needs with the projected payments from the investment. While the concept may appear complex, it demonstrates how the reliability of returns or income payments can provide investors with greater certainty about their future financial situation.
Alignment of Objectives
Investors should approach their fixed income allocation as a means to adjust their portfolio’s risk profile, rather than solely focusing on driving returns. By recognising this subtle distinction, investors can effectively prioritise their needs and align them with the appropriate fixed income investment objectives, such as income generation, diversification, immunisation, inflation-fighting return profile, or capital stability. Placing greater emphasis on the desired outcome enables the selection of investments that are best suited to achieving those goals.
