Fixed income is an important part of any investor’s armoury. Fixed income can serve several different purposes such as generating a consistent flow of income, providing defensive exposure and portfolio diversification.
Consistent flow of income
Generally, equities do not provide a steady cash flow to investors. Equities tend to pay dividends as earnings allow, and generally on a semi-annual or annual basis. For those seeking a more stable flow of income, fixed income allows investors to understand the cash flows that they can expect to receive at the time of investment. This can be useful for investors to plan expense requirements such as funding a pension.
The fixed income asset class is generally less volatile than equities given the expected cash flows are more predictable. This can be useful in protecting capital when investor sentiment is weak or bearish, and this can be used to invest in risky assets once the investor believes that the risky assets have fallen far enough to be considered cheap.
It has long been said that the only free lunch with regards to investment is diversification. Diversification is the basis of modern theory which state that a well-diversified portfolio improves risk adjusted returns. Fixed income assets generally have a low or negative correlation to equities, and the lower the correlation, the better the diversification benefits.
Therefore, regardless of what type of investor you are and what your objectives are, fixed income should always be a consideration for investment portfolios.
FIXED INCOME IN A RISING YEILD ENVIRONMENT
Fixed income has had a great tailwind of falling rates and quantitative easing for years, but this tailwind looks to be reversing as the outlook for the future seems to be rising rates and quantitative lightening as global growth and inflation pressures pick up. In a rising rate environment, fixed income yields will likely rise while quantitative lightening means less demand.
For traditional bonds, this means the potential for capital loss as these securities have fixed coupons and being priced on higher yields means lower capital value in order to match the market’s risk-reward appetite. However, the fixed income universe is vast, and despite the asset class name, fixed income assets do not always have fixed yields. While the fixed income universe includes fixed coupon government bonds, it also includes other income assets such as variable or floating rate coupon corporate bonds, asset-backed and securitised loans, and inflation-linked securities. The coupons on some of these assets are linked to a benchmark, and therefore the coupon rates vary according to these benchmarks, meaning that for a floating rate corporate bond, the coupon it pays will rise as bond yields rise, and in the absence of other factors, a rising bond yield will not affect the capital values of these securities.
Investors can also manage the risk of capital loss of fixed coupon bonds in a rising yield environment by managing the duration of their fixed income portfolio. Duration is a measure of the sensitivity of the portfolio to movements in yields, and is based on the size of coupon payments and time to maturity of a bond. Generally, a higher coupon rate or a shorter time to maturity leads to a lower duration. In a rising yield environment, a lower portfolio duration would reduce capital loss.
If managed appropriately, fixed income portfolios can still provide good risk-adjusted returns in a rising yield environment despite capital losses, as the investor continues to receive income while re-investing capital into the higher yield assets as other assets mature. Therefore, investors need to give consideration to how they are positioned within their fixed income portfolios but should continue to invest in the asset class despite the outlook of higher yields.
Market sentiment on all asset classes is constantly changing. It is important to recognise any threats, to preserve investment capital or to identify early Investment opportunities to maximise any return advantage.
At Bentleys Wealth Advisors we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.
If this and any of the other articles have raised questions regarding your personal situation, please contact Bentleys Wealth Advisors on +61 2 9220 0700.