Navigating the fixed-income maze
Christine St Anne  |  24/01/2013Text size  Decrease  Increase  |  

Christine St. Anne: When it comes to the fixed income asset class, investors are faced with a plethora of choice. To navigate the choice on offer and what fixed income means to your portfolio; I am joined by Morningstar's Kathryn Young. Kathryn, welcome.

Kathryn Young: Thanks so much for having me, Christine.

St. Anne: Kathryn, what are the main categories in fixed-income?

Young: It's a good question, Christine, actually because many people think that fixed-interest; it's all the same. It's just one big asset class, not a lot of difference there, and there actually are quite a few different sectors within fixed interest.

At Morningstar, we have six different categories that we cover in fixed-interest, but you can really talk about them in three main categories.

So, one is domestic bond, so that covers Australian Commonwealth bonds, the state government bonds, and in some credit, a lot of bank's incorporate bonds. But then there is also global bonds which cover governments from around the world – investment-grade countries around the world issued by governments. There is also some credit involved in global bonds. And then the third sector is just credit itself. And so, by credit I mean bonds that are issued by corporations. And credit bonds typically tend to have a bit higher yield than government bonds, because there are some credit risks related there. So, for example, credit risk is the risk that the corporation goes bust and doesn't repay you your money.

St. Anne: In an environment of falling interest rates, Kathryn, what role do these assets play in a portfolio?

Young: Fixed-income assets always play the same role. They also play a defensive role typically; income-generation role, and they provide diversification to balance out the equity part, the share parts of an investor's portfolio, but that role becomes especially pertinent and visible when interest rates are falling. Typically, when interest rates are falling, it's associated with economic weakness and often risk aversion among most investors.

So, when there is economic weakness and investor risk aversion, shares are typically falling, and in that case when interest rates are falling, bond prices go up. And so, what happens is the bond part of your portfolio is doing well at the time when your equity part of your portfolio isn't doing as well. So, you can see that it really – it helps balance out and cushion some of those losses.

St. Anne: With the hunt for yield, can these assets boost the income of an investor's portfolio?

Young: A lot of people are really talking about this because with yields on government bonds; really all bonds, the yields are at or near historic close, and so that means that they're not generating as a much income as people had gotten used to. So, a lot of investors are turning to credit-sensitive bonds issued by corporations for the most part at a time like this, because as I mentioned before the yield on those bonds tends to be higher to compensate investors for the credit risks.

So, many professional investors and many retail investors are looking to credit at a time like this, especially because many corporations globally are in good shape or have been in good shape since the global financial crisis, so there people feel more comfortable taking on that credit risk.

I think it's important to point out though that if investors are looking to corporate bonds to credit sensitive securities that it's -- I would advise most to consider using a mutual fund or unit trust, so that there is a professional manager and professional researchers looking at the credit risk involving those bonds, because it can be quite complicated for a person who has another job to do.

St. Anne: Finally, Kathryn, how could investors access these strategies?

Young: First and foremost, you need to decide what kind of strategy is appropriate for you. So, we talked about domestic bonds, global bonds and credit sensitive bonds. So, we always recommend that people stay well diversified. And so one simple way to do that might be to look at, Morningstar has a category called global Australia bonds and what that is, is just one fund that offers exposure to global bonds, to domestic bonds, and often will have some credit exposure as well. So, one of those strategies might be an easy place to start, because then you have a manager who is allocating across those different sectors and keeping you well diversified.

The second thing that you want to do is make sure that the security that you're looking at has a risk profile that matches what you intend to do with that money. So, for example, if you're just looking to invest money that you might need to use in the next two years, say to buy house or to fund your lifestyle, then you want to make sure that it's a very low, low risk type of security. So, in that case you might look at for at term deposit, but you might also look at a very short-term fund. And we have a category for that as well it's just called Australia short-term fixed interest. So, with that that risk profile would match up with what your goal is.

Another way to look at risk portfolio of a more diversified fund would be to look at the fund's performance since 2008. If it has a lot of credit risk, that fund probably lost money in 2008, because a lot of corporate bonds struggled during the global financial crisis the worst of it. So, that might help to give you a sense of how much credit risk is really in that fund. But you could also look to some other statistics, such as its credit quality breakdown. A lot of funds, funds that have a lot of their assets invested in non-investment grade bonds that might be -- that would indicate that it's a higher credit risk profile.

And then lastly, you want to make sure that the manager - if you choose a fund, you want to make sure that the manager has the resources to be able to do the right research effectively and you can tell that in many ways. A very simple thing to do would just look at how long the track record of the fund is. It might help to give you a little bit more confidence if the fund has a very long track record; investors have been investing with this firm for a long time. You also want to take a good look at fees. Fees are especially important within fixed interest, because the range of returns offered by fixed interest is lower. So, that means that fees necessarily take a bigger bite out of the income and the returns that the investor gets. So, you want to pay a special attention to fees.

St. Anne: Kathryn, thank you so much for your time today.

Young: Absolutely, happy to help.

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