Asset allocation is one of the most important decisions an investor faces.
While an allocation to fixed income is generally acknowledged as a core building block of a balanced portfolio, in today’s low interest rate world some investors may be reluctant to commit significant funds to fixed income, in the belief that returns will be correspondingly low.
However, this view typically reflects a focus on the interest component of a bond’s returns and ignores the capital returns that can be made from an investment in fixed income.
Fixed rate bond returns
Bonds produce two forms of return:
While it’s simple to understand the income stream from a bond, it’s worth recapping how capital returns come about.
A fixed rate bond’s price is not fixed. When interest rates change, the price of the bond changes as the coupons it pays become either more or less attractive to investors.
When market interest rates increase, the bond’s coupons (which are fixed) become relatively less attractive, and so the bond’s price typically falls. When market interest rates fall, the coupons become relatively more attractive, and the price typically rises. In other words, there is an inverse relationship between a bond’s yield and its price.
So how large can the capital return (or loss) from a bond be?
In a falling interest rate environment like the one we have been experiencing for several years, the capital returns can be significant, and can exceed the income component of a bond’s return. Conversely in a rising interest rate environment, these capital returns can be negative.
This applies both to individual bonds and to bond funds, which is how most investors get exposure to fixed income.
For example, BetaShares Australian Investment Grade Corporate Bond ETF (ASX: CRED) invests in a portfolio of high quality Australian fixed-rate corporate bonds. Over the 12 months to 31 October 2019, CRED returned 13.97%, the majority of which came from the rise in value of the bonds in the fund’s portfolio.
While the potential for returns of this size is attractive in itself, it’s the portfolio diversification and defensive benefits that are the main reasons we believe an allocation to fixed income is important.
Bond returns historically have shown a low correlation with the returns from equities, which can be especially important in market downturns.
The chart below shows how in periods of sharemarket weakness, fixed income exposure can provide welcome portfolio diversification. The chart illustrates four periods in the last ten years in which the Australian sharemarket (as represented by the S&P/ASX 200 index) fell significantly, and shows the returns from two fixed income indices over the same timeframes:
Bond returns during periods of equity market weakness: 2008 - 2018
In all four periods of equity market weakness, the two fixed income indices produced positive returns. For investors who had a portion of their portfolio in fixed income, the losses suffered on their share portfolios could have been mitigated by the gains made on their fixed income investments during these periods.
Do all fixed income investments provide the same diversification benefits?
The short answer to this question is a resounding ‘No!’.
There are a couple of things to think about:
How much a bond’s price changes in response to changes in interest rates depends on its duration – the timeframe over which its cashflows are received.
Duration is a measure of sensitivity to movements in interest rates. The longer the duration of a bond, or bond portfolio, the more its price will change in response to changes in interest rates.
In a falling interest rate environment, it may be better to have a bond portfolio with longer duration, so as to gain the most benefit from rate decreases. If you are choosing between several bond funds for your fixed income allocation, it’s worth checking the duration of each fund’s bond portfolio.
It’s important to consider the credit quality of the bonds in a fixed income fund’s portfolio.
Bonds of lower credit quality generally offer a greater return – but that comes at the cost of increased risk that the bond issuer will default on its payment obligations.
It also comes at the cost of diversification.
The higher the credit risk of a fixed income investment, the more ‘equity-like’ the exposure will be, and therefore the less the diversification it will offer from your share investments. As a result, high-yield – but sub-investment grade – bonds are more likely to suffer from negative returns at the same time as equities during periods of market stress (the times you most want the benefits of diversification!).
The issuer of a bond fund typically will provide information on the average credit rating of the bonds in the portfolio. It’s worth checking this figure (perhaps at the same time you check the duration of the portfolio).
We believe that in the current interest rate environment, investors should consider focusing on funds/portfolios that hold Government bonds and high-quality corporate bonds, preferably of longer duration.
For more information on Fixed Income and BetaShares range of Fixed Income exposures see https://www.betashares.com.au/campaigns/fixed-income-etfs/
The information is general in nature only and does not constitute personal financial advice. It does not take into account any person’s financial objectives, situation or needs. It has been prepared by BetaShares Capital Limited (ABN 78 139 566 868 AFSL 341181) (BetaShares). The information is not a recommendation to make any investment or adopt any investment strategy. Past performance is not indicative of future performance. Investments in BetaShares Funds are subject to investment risk and investors may not get back the full amount originally invested. Any person wishing to invest in BetaShares Funds should obtain a copy of the relevant PDS from www.betashares.com.au and obtain financial and tax advice in light of their individual circumstances. Future outcomes are inherently uncertain. Actual outcomes may differ materially from those contemplated in any opinions, estimates or other forward-looking statements provided.
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