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9 ways to get fixed income exposure

Glenn Freeman  |  22 Jan 2020Text size  Decrease  Increase  |  
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Equity market volatility, low rates and diversification benefits are some of the reasons to consider credit assets.

Fixed income is key part of a well-constructed portfolio, particularly as equity market volatility continues and interest rates plumb new depths.

Credit assets usually behave differently to equities. Given fixed income's lower volatility and reduced currency risk, it is crucial for more conservative investors.

In this article, we look at three of Morningstar's preferred strategies from each of these vehicles:

  • Fixed income funds
  • Exchange-traded funds
  • Hybrid investments.

Investor interest in fixed income will continue to rise in 2020 as official interest rates head toward zero, according to John Likos, director of BondAdviser.

"It’s hard to see credit continuing to rally as it has done for over 20 years now, although a continued low interest rate environment should continue to provide a supportive tailwind," Likos says.

But with a number of ways to get exposure to fixed income – you can buy bonds directly, through actively managed funds or passive exchange-traded funds – choosing the right vehicle can be tricky.

"With the large inflow of listed credit instruments on the ASX in 2019, it’s easy to assume they are often similar in risk, but they’re not," Likos says. "So, undertaking your due diligence, particularly at this late stage of the credit cycle is critical."

Investors must also keep in mind the macroeconomic outlook: "Credit quality and geopolitical risks remain right at top of the risk table. Interest rates, not so much as it’s hard to see them increasing anytime soon, anywhere."

Fixed income funds

The diversification benefits of bond funds outweigh any concerns around costs or managers' ability to outperform, according to Morningstar columnist John Rekenthaler.
(Incidentally, you may wish to revisit his recent take on what he sees as myths around investing.)

As for Morningstar’s preferred picks in the category, the following Medal-rated global bond funds are worth retaining. For two of the three, costs were called out as high but not excessive.

Pimco Global Bond (10883)

Analyst rating: Silver
Morningstar rating: Five-star

Morningstar manager research director Tim Wong likes the way the team that manages this fund takes into account the longer-term macroeconomic outlook. 

"We appreciate the team’s discipline in refraining from simply chasing yield at the expense of higher risk and are confident that PIMCO can build a top-performing portfolio of diverse bets, particularly when accounting for risk," Wong says.

The fund invests mainly in investment-grade, developed market government, semi-government and corporate bonds.

Legg Mason Brandywine Opportunistic Fixed Income (16192)

Analyst rating: Silver
Morningstar rating: Three-star

Senior manager research analyst Andrew Miles believes this fund is a "stellar option” for long-term investors.

It favours emerging markets, and has largely avoided low- and negative-yielding countries like Japan and parts of the Eurozone.

"This group focuses on sovereigns but is not averse to taking advantage of opportunities in corporate debt," Miles says.

It uses macroeconomic and valuation analysis to identify countries with attractive real yields, with an approach that doesn't simply focus on global bond indexes as many other funds in the space do.

"Instead, the portfolio tilts toward countries with low debt levels, some with little to no index representation," Miles says.

The fund's performance since March 2011 has beaten the index and most of its peers by a couple of percentage points.

Miles says the fee is expensive compared to others but notes the Brandywine fund has a lot more flexibility than the average global bond fund.

Colchester Global Government Bond (40930)

Analyst rating: Silver
Morningstar rating: Three-star

Following a simple, robust process, this fund's long-term performance comfortably beats the Barclays Global Aggregate benchmark and its peers.

The Colchester fund's performance track record, having only launched in September 2014, is still too brief to assets its object of delivery benchmark-plus-2 per cent returns, says Wong.
But he notes the team's managed portfolios following the same approach beat the benchmark soundly between 2011 and 2018.

"Fees are above average. But this blemish doesn’t detract from this strategy’s strong competitive standing," Wong says.

"It’s a superior choice for a core global fixed income allocation, in our view."

Exchange-traded funds

From less than a dozen five years ago, there are now almost 30 Australian-domiciled global fixed income ETFs.

Morningstar Australia provides research coverage on three fixed income ETFs, all from Vanguard's shop, and two of them hold Bronze Medals.

Vanguard Global Aggregate Bond Index ETF (VBND) offers diversified bond exposure for just 0.2 per cent.

The index comprises of government- and government-related securities, credit, and securitised assets from around the world, with the main issuers as US, Japan, Europe, and the UK.

Morningstar's Wong says the ETF's diversified bond exposure means it can play a core role within an investor's broader portfolio.

Vanguard International Fixed Interest ETF (VIF) is also a credible low-cost way of accessing global bond exposure.

The ETF only holds investment-grade securities, but lacks exposure to credit-sensitive bond issuances and has relatively long duration.

Duration is a measure of how long it takes for an investor to be repaid a bond's price, tracking the sensitivity of bond prices to interest rate changes.

But this structure provides for greater liquidity and lower trading costs without sacrificing exposures. This lack of credit sensitivity and long duration means it is also appropriate as a key player within a portfolio.

Stand-alone bonds

Bond prices are highly volatile, requiring regular monitoring that is usually only provided by a professional adviser. Advisers are also often best-placed to assess the credit worthiness of debt assets and to exploit any opportunities.

As Rekenthaler explained in his recent column, the cost argument for buying bonds directly rather than through a professional manager doesn't hold up.

Upfront commissions and high annual expense ratios were once common but have seen been replaced by more transparent fee structures.

"And directly purchased bonds aren't free either," Rekenthaler says, referring to a 2015 study in the US that showed average retail costs on corporate bonds was 0.77 per cent.

Bonds are typically issued with face values of around $1,000, but to get decent pricing you may need to buy a block of several bonds.

Morningstar US columnists Christine Benz and Tom Lauricella suggest it may cost more than $100,000 to assemble a reasonably diverse portfolio of individual bonds.

"By contrast, bond-fund investors assemble a very broadly diversified portfolio of bonds for a low cost – corporate bonds, government bonds, and bonds backed by assets like mortgages – thereby aiming to reduce the damage that any one holding can inflict on their overall portfolios."

Hybrid investments

Hybrids are a form of investment that combines features of both equities and debt vehicles.
They can be complex as different issuers have different terms and conditions. As with individual bonds, professionals are usually better placed to assess these and provide recommendations appropriate for individual circumstances.

Morningstar's research on hybrids is provided by BondAdviser, which currently nominates three hybrids as "buy".

Nufarm Subordinated Step-Up Securities

BondAdviser notes that the release of fiscal 2019 results by pesticide maker Nufarm prompted an upgrade of its recommendation, which was changed to a buy in September.

  • Firstly, a condition of the sale is that Nufarm must repurchase the $97.5 million of preference securities it issued to Sumitomo in August, reversing the subordination effect we cited as a negative at the time.
  • Secondly, in addition to releasing significant amounts of working capital, the all-cash sale will provide Nufarm with $951 million to substantially deleverage its balance sheet, which greatly restricted the company’s ability to pursue growth opportunities
  • Lastly, the transactions make it unlikely that Nufarm suspends distribution payments on the securities as management looks to resume dividend payments upon completion of the deleveraging of its balance sheet.

Macquarie Income Securities

As of the start of November, this hybrid security has been rated as a buy.

"Macquarie Bank Limited (MBL) is distinctly different to the parent entity, Macquarie Group Limited (MQG)," says BondAdviser in its latest note about the security.

"The bank is a ring-fenced entity which is regulated by APRA in the same way as all other Australian banks. This means investors have greater transparency when investing in Macquarie Bank Capital securities (relative to MQG).

"It also means we can broadly compare it against other second-tier banks from a relative value perspective."

BondAdviser says the marginal cost of funding for the bank is the biggest driver of its recommendation.

AMP Capital Notes (AMPPA)

This security has held a buy recommendation since August 2019.

"The August half-year results in 2019 showed a new path to the sale of AMP Life and also a large capital raising," says BondAdviser.

"Although the sale is probably neutral overall, we view the capital raising positively and particularly so, given it will be progressively expended in transforming the bank.

"We believe that material risks to the Group are now in sight and either fully provisioned for or managed well."

is senior editor for Morningstar Australia

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