A new calendar year is a good time to take a breather and consider your investment objectives for 2018. I’m not going to discuss the best sectors, the price of oil or potential bubbles, rather the relatively lower risk, defensive part of your portfolio – your fixed income allocation.
So, what is fixed income? It is deposits, government and corporate bonds, some more technical structured products and hybrids, however, they have evolved and these days the risks are more like the underlying shares.
Fixed income investors are particularly interested in the direction of interest rates, inflation and where we are in the economic cycle.
If, like the average SMSF investor, you have around 25 per cent of your portfolio in deposits, you’ll need to make a call on where interest rates are headed. Longer terms usually offer better returns. This week, I saw a five year term deposit paying over 3.5 per cent per annum, a premium of around 1 per cent over a one year term, better than I’ve seen in a while. Still, it’s not much of an incentive to lock away your money for five years!
Like term deposits, you need to think about interest rates for other fixed income securities. If you think interest rates are moving higher, you’d invest for a short term so that when the investment matures, you can reinvest at a higher rate. Or you would have a preference for floating rate bonds where interest is adjusted quarterly. Ultimately, higher interest rates are better for investors.
Interest rates are expected to creep up. Not necessarily the Reserve Bank cash rate, but certainly US government treasury rates which would very likely see higher Australian government bond rates, especially over the longer term. As government bonds act as a benchmark for fixed income securities – rates on other fixed income securities may rise.
The strategies listed below are based on the following:
- The ‘lower for longer’ interest rate theme continues. While we expect higher interest rates, it’s a very slow and winding road. Central banks want to avoid downturns and keep in lock step with other central banks for fear of attracting foreign investment and pushing up the value of domestic currencies.
- While central banks are desperate to boost inflation, they haven’t been very successful. The sleeping dragon, inflation, is contained for another year, but as it breathes fire best to have some defence.
- Companies generally are in pretty good shape. Most have reasonable funding available for the coming years and higher projected growth should improve profitability. Assuming the banks remain on a steady path and there’s no credit crunch, I’d expect company default rates to remain fairly low.
1. Bid for new issues
Demand for new issues is high and frequently supports higher prices once the bonds begin trading, offering traders short term profits.
2. Diversify – don’t put all your eggs in one basket
A concentrated portfolio is less resilient. I know it is a bit of a cliché, but spreading investments smooths overall returns and makes the most of opportunities in any market. In the fixed income world, that means having an allocation to fixed and floating securities and possibly some inflation linked bonds for their good relative value. Even though we don’t expect inflation to reassert itself, it’s a risk that shouldn’t be ignored, particularly for those in retirement. While I might think interest rates will move higher, there’s no guarantee so best to hedge your position whatever it is. If you have close to 100 per cent invested in any asset class, sector or thesis, it’s too much. Diversify.
3. Add floating rate securities
If interest rates go up, so should your interest income. One of our favoured themes has been investing in residential mortgage backed securities that are floating rate and low risk but offer superior returns over similarly rated corporate bonds.
Hybrids are also generally floating rate but concentrated in the finance sector and more volatile than other fixed income securities; not as defensive as they once were.
4. Keep maturity dates relatively short
Stick to terms of a year or less for fixed deposits and stagger your investments so that some funds roll every quarter. When it comes to corporate bonds, you can afford to extend the term given they are tradeable. Less than five years is preferable. I’d still suggest holding some longer dated securities if the premium over shorter dated ones is sufficient.
5. Reduce overall risk
High yield/ sub investment grade bonds have been a favoured trade. But the credit spread or the additional return you are getting paid over benchmark rates to take on extra risk has been declining and we expect this to continue. Have a look for better rated, shorter dated bonds to reduce overall risk.
6. Take some profit
If you are sitting on capital gains, especially on some of the high yield bonds, now might be a good time to take profits and rebalance.