When share markets are performing well investors don’t seem to care too much about  protecting their portfolio.  For those that do, the defence strategy does not venture too much further than having an allocation to cash.  Fixed income can be a more effective defensive mechanism.

The role of fixed income in a portfolio

Fixed interest securities play a crucial defensive role in an investment portfolio due to the diversification benefits they provide against equities.

Consider a deteriorating economic scenario.  Here, policymakers generally respond to a slowing economy by cutting interest rates.  As there is an inverse relationship between bond prices and interest rates, bond investors enjoy a capital gain while equities are generally producing negative returns.

An example of this came in 2011.  Australian equities generated a negative return as the market became concerned about global recession and the possible brake up of the European Union.  At the same time, the Australian fixed income market generated a strong positive return, well above cash.

Term deposits and cash provide income but don’t provide the same level of protection  as they don’t offer any potential for capital growth.

Why would you hold fixed income when yields are at historic lows?

There is no disputing that fixed interest securities can experience capital losses when  interest rates are rising.  When interest rates are at historical lows, the odds are that interest rates will start to go up soon.  So the question that any rationale investor would be asking themselves is…why invest in an asset that you know is going to experience capital losses.

There are many techniques available to active fixed income managers that allow them to  manage fixed income portfolios when interest rates start to rise.  The types of strategies that may be implemented in an increasing rate environment to deliver positive returns  include:

• Investing in short dated bonds.  These securities are much less sensitive to  interest rate changes.
• Investing in floating rate notes (FRN’s).  FRN’s pay a fixed margin above an agreed level.   They avoid the downside of rising interest rates by giving up some of the potential upside if rates fall.
• Using interest rate swaps to swap fixed rates for floating.
• Inflation linked bonds.  The coupon paid on inflation linked bonds is linked to the inflation rate.  This helps protect returns in a high inflation environment.

Are there any other sources of income?

Yes, there definitely are.  But they don’t offer the same level of diversification to equities and they are more volatile.  The types of securities I’m talking about here are hybrids and high yield debt.

Conclusion

The future for bond and equity markets will continue to be volatile.  Both investment classes are required to ensure true portfolio diversification. In volatile markets, an active fixed income manager can add value to portfolio construction by analysing the market and moving in and out as appropriate.

The recovery of the global economy has been far from smooth. Regardless of whether investors believe the global economy will recover, or will deteriorate further, having some fixed income exposure, especially to provide duration, is important to maintain a balanced portfolio.

Bye for now

Dan’s Corner

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Any advice contained in this webpage is of a general nature only and does not take into  account the objectives, financial situation or needs of any particular person. Therefore, before making any decision, you should consider the appropriateness of the advice with regard to those matters. Please click here 2013_Nov 13_FSCG_v10.11d_PFG Financial Services Pty Ltd to find out more about our financial advice services.

Source: Chris Dickman Senior Portfolio Manager with Altius Asset Management Self
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