Smart Investor: Should you have more fixed income in your portfolio?

Smart Investor: Acid Test, April 2011

Should you put more fixed income in your portfolio?

Do you want more stability in your portfolio? Yes/No

The main reason most people put bonds, and fixed income (also known as fixed interest) products generally, in their portfolio is because they add predictable stability. While shares can soar and plunge with the mood of the market – and never more so than in the financial crisis – bonds take the edge off the volatility and provide a safe, steady anchor to the portfolio. Remember, though, that not all bonds are the same, and not all are safe as houses.

Do you think shares are going to trade sideways or even down in the near term? Yes/No

If you do, then your money will be better served by a higher allocation to bonds. They might not deliver any more than shares, but they will give a return at lower risk. The problem with answering this question is there is a wide range of opinion on what shares are going to do next, and you can find vocal supporters of the view that they will go up, stay flat, or decline this year.

Do you think global growth is going to remain sluggish this year? Yes/No

If you think the global economy is suddenly going to start sprinting again, then reallocating to bonds is not all that smart: shares are more likely to deliver a better return in that environment. But here, too, there’s a divergence of opinion. A common view is that Europe is still stuck for a while, but Asia is booming – perhaps too much so. The single biggest driver of bond performance in the world in 2011 will be the US economy. If the various government efforts to motivate business momentum and consumer demand pay off, then shares will probably do better than bonds; and, as money correspondingly leaves bonds for shares, it becomes self-fulfilling that bonds lag. If, though, the stupor of US housing, consumer spending and job creation continues, bonds will probably remain the better place to be. Likewise, the more you think the world economy is going to thrive this year, the less sense it makes to re-allocate towards bonds.

Do you want to try out the different types of opportunities in fixed income? Yes/No

Some people think of bonds as plain old Aussie government bonds or Treasuries. They will never make you very much money but they will also never fail. In fact, there is a huge and sophisticated range of available product out there – corporate bonds, both Australian and foreign; high yield, from issuers with what is known as a sub-investment grade rating; structured debt; mortgage-backed securities; and numerous other variations. Few investors want to take this on directly but there are plenty of specialist managed funds in Australia, often sold as credit funds, that play the whole range of available product in this area. They tend to do very well… or very badly.

Are you guided by historical performance?

Kapstream Capital recently pointed out that Australian bonds have outperformed both the Australian share market and global shares (the S&P 500) since 2000: 6.4% a year versus 3.9% and minus 1.4% respectively (excluding dividends on the shares). If you think that’s illustrative of the way things are going to stay in future, bonds look a good bet. If you think this just reflects the fact that the period since 2000 embraces both the tech stock crash and the global financial crisis, and hence is not illustrative of the future, that’s different.

Do you think interest rates are going to start rising? Yes/No

When interest rates start moving, that affects the yield from bonds. Different bonds react in different ways – floating rate bonds, for instance, move as other rates move – but good fund managers ought to be able to find opportunity. The consensus seems to be that central banks in the west will keep interest rates at historic lows, while in Asia they will rise (in fact, they’re already rising).

Do you want to focus on Australian bonds? Yes/No

Many local fund managers see Australian bonds as a better bet than global or US bonds. Australian bonds, measured by the UBS Composite Index, returned around 6% in 2010, and are expected to do the same (some say as much as 8%) in 2011. US bonds clearly won’t do that; Australian bonds also have the advantage of eliminating any currency concerns.

So you believe banks are recovering? Yes/No

Banks are among the biggest issuers of bonds around the world, and if you believe they are recovering from the financial crisis  – particularly in the US and Europe – then debt from financials starts to become interesting and creates opportunities for fund managers.

Are you a believer in emerging markets? Yes/No

There is a host of emerging market debt available, from sovereigns (countries) to banks and companies, and more and more fund managers believe the best risk-adjusted returns can be found here. But this is uncertain ground and it is imperative you find a fund manager that knows what it’s talking about in these regions.

Are you looking to change your risk profile?

Before you think about tactical plays based on what the market’s doing, you should be clear on what your usual allocation is. Do you have a clear sense of how much of a role bonds should ordinarily play in your portfolio? For some people, for example, this is around the 30% range. Discuss with your financial planner what your risk profile is and how to implement it with asset allocation.

Mostly yes: Go ahead and invest in more bonds: stability, with potentially better returns than stocks anyway.

Mostly no: It’s the wrong time to be putting money into bonds – the revival of the world economy is coming so I’m in shares.

Some yes, some no: Keep a steady allocation to bonds and wait for further direction before changing your strategy.