Increased caution when using fixed income to lower overall portfolio risk
Much has been written on potential challenges facing fixed income investors globally. The question that continually gets asked is, ‘is the fixed income story really coming to an end?’, and if so, ‘what can clients do about it?’
Near the end of 2008, the US Federal Reserve decreased its FED funds rate to almost zero, and this is where it has stayed for more than six and a half years. Many major developed economies followed suit. There are signs that rates globally will start to increase and their effect on clients holding large fixed income positions could be significant.
Given the above, one would think that investors would be lowering their fixed income exposure, but over the last year flows into fixed-income funds have eclipsed that of equity. On Colonial First State’s FirstChoice platform, fixed income has taken in 42% more assets than equity portfolios over the last 12 months. Over the same period, retail flows in the US show an even stronger difference, with $51.8 billion of inflows to fixed income versus $16.2 billion of outflows from equities. What could explain this?
First, markets are starting to experience some volatility and are coming off recent highs. Advisers and clients still remember the emotional and financial scars from the bear markets they experienced in the early 2000s and the global financial crisis. Many cannot, or are unwilling to take equity market risk and now prefer the predictability of fixed income.
Second, in many developed nations, populations are aging. As investors age, their investment time horizon decreases and their need for predictable cash flow increases.
Finally, over the last decade as interest rates have dropped, the value of fixed income portfolios has risen. When you include the coupon, this asset class has been a boon for investors, contributing to gains in client discretionary and model portfolios while affording investors excellent liquidity. To put this in perspective, in 2007, 10-year Australian Bonds averaged 6.0%; in 2015 they have averaged 2.7%.
As rates rise
Most advisers and clients understand that there is an inverse relationship between fixed income values and yields. Keeping credit quality and maturity constant, when interest rates rise, bond prices fall. What is rarely understood is the magnitude of the price change. For example, if a 10-year bond rate rises 1% from 4% to 5%, the bond could see its price fall 7.8%. If rates rose 2% to 6%, it could lose 14.9%. Considering the average 10-year Australian Government bond from 2000-2014 was 5.16%, a return to the norm is very possible.
In an environment where rates were higher, the higher coupons could balance some of the loss when interest rate rose. But given that today rates are near all-time lows, there is almost no buffer. The client sees a tremendous loss on the bond funds and continues to earn a low coupon rate.
Low rates and their associated decreased income have been felt strongly by pensioners. This has led many advisers to move up the fixed income risk spectrum in search of yield, resulting in the use of lower quality bonds and longer-duration assets.
Fixed income has always been viewed as a ‘safe’ asset class. It is viewed as an anchor in many portfolios as it brings in a source of income, reduces volatility and has been used historically as an important diversifier to equity. How will clients react when the asset class they think is meant to reduce risk, potentially does the opposite?
Sanlam Managed Risk Funds
Every investor wants to maximise their return and reduce risk. Currently, the risk/return profile for fixed income is not a great one. An investor who takes on high risk that interest-rate upticks will erode the value of the investment and see a low return (coupon) for taking on this risk. There are multiple factors why investors invest in this asset class, but one consistent theory is that pure equity exposure is simply too risky.
Clients need solutions that allow them to take equity exposure while providing a mechanism to protect them should markets decline. Enter Sanlam Managed Risk Funds. These funds utilise an investment strategy that seeks to capture upside potential while minimizing loss due to unexpected movements in the market.
The fact that the strategy is designed to decrease the risk of investing in equities is attractive to clients with large cash or fixed income positions because it allows them another avenue to manage risk in their portfolios. Another competitive advantage is that clients benefit from the franking credits associated with Australian equity exposure, all with lower overall risk.
At some point rates will rise globally. Advisers need options on how to protect their client’s portfolios or be ready to explain the potential underperformance and risk within certain asset classes.
To find out more about the Sanlam Managed Risk Funds, please contact your Business Development Manager or Adviser Services on 13 18 36, or visit our website at colonialfirststate.com.au/investments
This article represents an assessment of the market environment at a speciﬁc point in time and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Certain sections of this article may contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions.
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