Beyond term deposits – What does a modern fixed income portfolio look like

 

Term deposits (TD’s) have long played an important role in many portfolios, providing both an income stream and a predictable return profile with capital stability, particularly for those who qualify for the Australian Government Guarantee. With increased global financial market volatility, many investors are asking what other low-volatility assets can help anchor their portfolio to chart a more predictable path through global uncertainty.

In approaching this, one may ask “how much more can I get from investing in fixed-income”. While important, this isn’t the right question to ask. A better question to ask is, “If a government-guaranteed term deposit is near zero risk, how much more risk am I willing to take?” Firstly, this depends on what role would this allocation plays in your portfolio. For example, is it similar to a term deposit with the primary drivers being income and capital stability or is it trying to deliver high returns acknowledging the greater risk and volatility that it entails?

Investors may also consider, where is this money coming from. For example, if the proposed investment amount is being held in cash and an investor isn’t trying to increase the portfolio’s risk budget or risk appetite, this suggests a lower-risk form of fixed income is appropriate. Should the money come from selling equities which many regards as higher risk, and there is no desire to change the portfolio’s overall risk profile, perhaps there is a greater risk appetite.

 

Investment options and varying degrees of liquidity

Examining risk further, there are three very broad categories that an investor should consider, being liquidity, investment term, and appetite for capital loss. In Australia, there are several investment options that offer varying degrees of liquidity. Some solutions offer the ability to exit their investment daily, either by redeeming from a fund or selling it on an exchange. Whereas other options offer less liquidity such as monthly redemptions or in the extreme, impose ‘lock ups’ which means an investor cannot access their capital during that term. It’s worth noting here that investing through a Fund which offers say daily pricing but is investing in illiquid assets should be considered differently from a Fund with daily pricing yet holds liquid assets. In general, the less frequent the redemption terms are, the higher the expected return. Practically speaking, an investor could ask, am I willing to forgo the ability to sell my investment from a daily schedule to monthly in exchange for a higher return?

 

Liquidity vs Duration

When building a modern fixed-income portfolio, it’s important to consider the ‘duration’ or ‘maturity profile’ of your investments. Simply put, this is how long your capital will be invested before it’s returned.  This is different from liquidity which recognizes you may be able to sell that investment either in the market or by redeeming from a fund. By way of example, purchasing a 10-year Australian Government bond may be quite liquid in that there is an established market to sell them however it is the longer duration or longer maturity in that technically, capital isn’t repaid for 10 years. The maturity influences the investment’s risk profile by making its current price more sensitive to changes in interest rates. If an investor believes interest rates are high and are likely to fall, one may prefer a longer maturity asset where its price rises as interest rates fall and vice versa. If an investor doesn’t wish to take on this risk, a short-maturity investment may be more appropriate as historically, its value little changes with interest rates.

 

Understanding the Asymmetric Return Profile: Why Fixed Income Can Be A Safer Bet.

Investing in fixed income requires an appreciation of how to differentiate it from other asset classes such as equities. For example, fixed income has, what is known as, an ‘asymmetric return profile.’ That is, the maximum return an investor can achieve is the expected yield to maturity (excluding any trading gains/losses) although they could lose 100% of their capital whereas equity can deliver the same downside but with a theoretical infinite return upside. This makes Fixed Income sound like a poor investment until one adjusts for the likelihood of those outcomes. A key difference between fixed income and equity is that traditional fixed income has a contractual obligation to make regular interest or coupon payments whereas, with equity, that decision is purely discretionary. In the event of tougher times, a fixed income obligation ranks above equity in that it must be repaid before an equity investor and therefore, is considerably lower risk. Fixed income noteholders may also impose specific so-called ‘covenants’ which give them greater control over the counterparty. For example, if any of the fundamentals of that counterparty deteriorate then there is a contractual obligation to have it repaid in full. Over our 7-year track record, we have found such covenants play a critical role in protecting capital with an investor in our flagship Fund investing $100 at inception would today be worth $153.55 and over that time, lost just $0.005. This compares to an equivalent investment in Australian Shares being worth just $146.54 (assuming equivalent timing and reinvestment of all dividends).

 

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Once an investor understands their need for liquidity and how exposed they wish their investment to be to interest rates, one can more readily reduce the range of possible investment solutions before making an assessment on the chance of capital loss within each. For those who are seeking greater liquidity, public market bonds while lower on the expected return spectrum, are some of the most liquid. For investors willing to forgo some liquidity in exchange for a higher expected return, then there are a range of Private Credit Fund Managers in Australia who primarily focus on lending to non-investment grade corporates, financing development sites, or so-called asset-backed securities in which Manning specialises where investments are secured by hundreds if not 1,000’s of underlying loans.

 

As prefaced before, fixed income is all about avoiding capital loss and therefore, extracting the maximum benefits of this asset class. Being aware of and able to assess the risks is the key to investment success.