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How to diversify your portfolio: Australian and global fixed interest

Lex Hall  |  30 Aug 2018Text size  Decrease  Increase  |  
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It's often said that the mark of a true diversifier is an asset class that shelters your portfolio when the proverbial hits the fan. And one asset class that boasts this characteristic is fixed interest, often likened to an insurance policy: unsexy but safe when volatility strikes riskier assets such as shares or property.

Fixed interest is synonymous with bonds - a form of interest-bearing IOU. There are several types of bonds, with different lifespans, or "durations", from safer government bonds to more risky corporate bonds.

In short, when you buy a $1000 bond you're effectively lending money to the issuer, the government or company, so it can fund its spending. It agrees to pay your principal back in, say, 10 years but along the way rewards you with a small interest payment of $50 a year - a 5 per cent "coupon rate" - a couple of times a year. A stable, predictable income stream.

"The global bond market offers investors a wide range of investments that they may otherwise be missing out on," says Morningstar associate director, fixed income strategies, Tim Wong. "Global government bonds, credit, securitised debt, and even currency bets can perform very differently to equities and cash and help a portfolio handle a greater variety of market conditions – both good and bad.”

Fixed interest may occupy a lower rung on the risk spectrum, but investors should remember that bonds are sensitive to interest rates. Falling interest rates tend to push up bond prices, and vice versa. When current interest rates are greater than a bond's coupon rate, the bond will sell below its face value at a discount. When interest rates are less than the coupon rate, the bond can be sold at a premium — higher than the face value.

Consider a 10-year, $5000 bond with a coupon rate of 5 per cent. If interest rates go up, new bond issues might have coupon rates of 6 per cent. This means an investor can earn more interest from buying a new bond instead of yours. This reduces your bond's value, causing you to sell it at a discounted price.

If interest rates fall, and the coupon rate of new issues falls to 4 per cent, your bond becomes more valuable, because investors can earn more interest from buying your bond than a new issue. They may be willing to pay more than $5000 to earn the better interest rate, allowing you to sell it for a premium.

Fixed interest comparison chart

Source: Morningstar Direct

Currency losses are another factor to consider, Wong says. "A sharp fall in the Australian dollar can lead to currency hedge losses that need to be funded out of income, which can lower or even cancel out a distribution entirely." 

It's also crucial to consider the credit rating, or quality, of bond. In short, the ability of an issuer to repay its debts. All other things being equal, the lower a bond's credit quality, the higher its yield. That's why you can find a high-yield bond fund with a yield of 7-8 per cent or more, while many investment-grade bond funds offer yields around 4 per cent. Because investment-grade issuers are more likely to meet their obligations, investors trade higher income for greater certainty.

AAA indicates the highest credit quality and D the lowest. So if you hold a bond rated AAA, AA, A, and BBB it's likely you'll collect all of your coupons and principal. Bonds rated BB, B, CCC, CC, and C are non-investment-grade, or high-yield, bonds. That means there's a good chance that the bond issuer will renege on its obligations, or default. In fact, D, the lowest grade, is reserved for bonds that are already in default. Lower-rated bonds tend to drop in value when the economy is in recession or when investors think the economy is likely to fall into a recession.

Bond funds and exchange-traded funds can be a flexible way to gain exposure to markets and sectors around the world. Among our selection is PIMCO's Australian Bond fund, which Wong rates as an excellent core defensive allocation. It invests in Australian cash, government, semi-government, and corporate securities, much like its Bloomberg AusBond Composite 0+Yr Index benchmark. Wong also rates PIMCO's Global fund, which takes a benchmark-aware approach, sticking chiefly to investment-grade government and corporate bonds in developed markets, venturing into high-yield, inflation-linked bonds, and securitised and emerging-markets debt when opportunities emerge.

Some passive options from Vanguard offer exposure to local and global bonds, such as Vanguard Index Diversified Bond 6342. Other fixed-interest options include cash ETFs such as Betashares' High Interest Cash ETF AAA and funds for short-term fixed interest investments.

 

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Lex Hall is content editor, Morningstar Australia

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