Why fixed interest

Diversification

Diversification is a key to achieving good long-term returns. Investors who allocate money to fixed-interest assets, such as bonds, create a cushion against the investment losses that can occur when there is a downturn in equity markets. This is because market factors that have a negative impact on shares, such as slowing economic growth, have historically had little to no impact on bonds or have even boosted their performance. Unlike shares, bonds tend to perform well in periods of economic weakness.
 
While some long-term investors have a high tolerance for volatility, or fluctuations in returns, most investors prefer a portfolio that includes fixed-interest assets because they can help smooth out these fluctuations and reduce the risk of sudden falls in value.


More Predictable Returns:

Source: Bloomberg and Barclays Capital as at 30 November 2012. Bonds are represented by the Barclays Capital Global Aggregate Bond Index. Stocks are represented by the MSCI World Index


The Benefits of Diversification

Source: Source: Bloomberg, PIMCO,
Case Study period for August 2007 to March 2010


Although diversification doesn't insure against investment losses, an investor can diversify a portfolio across different asset classes that perform independently in market cycles to reduce the risk of low, or even negative, investment returns. The graph above demonstrates the diversification benefits provided by bonds during a particularly volatile time for risk assets. While equity valuations fell sharply through 2007 and 2008, fixed income assets appreciated strongly on investor demand for more stable assets. As a result, a blended portfolio of fixed income and equities performed far better and experienced far less volatility than a concentrated 100% equity portfolio.

Income

Traditionally, investors held bonds for income. A bond is a loan, so the investor can expect to receive a steady stream of interest payments until it matures.

Reinvesting the interest can increase capital appreciation over time, due to the effect of compounding. While shares might also provide income through dividend payments, companies make dividend payments at their discretion. Bond issuers, however, must make coupon payments on a regular basis. The predictability of interest income is a central attraction for institutional investors, such as superannuation funds, because they can use the income to meet their liabilities.

Security

Also similar to a loan, a bond is expected to repay the principal at maturity. So capital preservation is another major reason investors buy bonds.

In addition, fixed interest assets are generally less volatile than shares. Periods of negative returns tend to be short and modest compared to equities. As the chart below shows, since 1996 there has only been one brief period when bonds posted negative 12-month returns.


Fewer Negative Returns:

Source: Bloomberg as at 30 November 2012.

Rising rates

When interest rates rise, bond prices fall and a bond portfolio can suffer losses.¹ However, the benefits to investors of reinvesting in bonds at lower prices and higher yields can eventually more than compensate investors in a higher interest-rate environment.


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¹This is due to the inverse relationship between a bond's price and yield. A bond's price reflects the value of the income that it provides through regular coupon interest payments. When interest rates rise, older bonds may become less valuable as their coupons are relatively low and therefore older bonds trade at a discount which reduces the value of the investor's capital.



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