Investment Choices

Fixed Interest

Investing in fixed interest

Background

Fixed interest is one of the oldest investments in the world, and the one that most people are intuitively familiar with due to bank deposit products. They are easy to understand and many people have had at least some experience with them.

However what is less well known is that the world of fixed interest contains many investment options outside of these simple bank products. Whilst many SMSF investors have heard of assets like bonds, they tend to be somewhat hazy on the details.

Below we’ll go through some of the options in fixed interest investing and look at how fixed interest is used in a portfolio.

Term deposits

Term deposits are often the main form of fixed interest investment that most investors are initially aware of. They are easy to understand, in that they pay a set rate of interest, usually quoted as an annualised rate (say 2% pa), they have a set term (ranging from 1 month to a number of years) and the capital value does not change.

However, in the current age of ultra-low interest rates, term deposits have become somewhat unattractive. If inflation is running at say 2%, and an investor is getting 2%pa on a term deposit, then their “real rate of return” (which takes into account inflation) is zero.

For this reason, many investors in term deposits have had to look elsewhere for reasonable returns.

Note that term deposits with APRA regulated banks and building societies in Australia are capital guaranteed by the Government of amounts up to $250,000, per institution, per entity. So if this security of capital is the primary concern at a particular point in time, then term deposits can certainly still have a role to play.

Bonds

The bond market is easily the biggest securities market in the world, and includes both Government and corporate bonds.

When an investor buys a bond, they are essentially lending money to the bond issuer, who in turn promises to pay a certain amount of interest, at specific time intervals, and to repay the capital at a date in the future (the maturity date).

Government bonds are generally considered the safest type of bond, as the investor is essentially lending money to a Government, who theoretically should have a low probability of default (i.e. not paying it back) although some countries are deemed more credit worthy than others.

Corporate bonds are much the same, except that it is a company who the investor is lending money to, and hence the risk is higher than with Government bonds. Due to this higher risk, corporate bonds generally pay a higher interest rate than Government bonds.

Fixed or floating rate

For the Government bonds and most of the corporate bonds we mentioned above, the rate of interest paid is set at the start when the bonds are issued. So for example, if a bond with an initial price (or face value) of $100 has a fixed interest rate of 4% pa, then for the life of the bond until the maturity date, this bond will pay $4 each year in interest.

However, there are some bonds (mostly issued by financial companies such as banks) who have what are called floating rates. In this case the bond is paying a certain amount (say 2% for example) over and above a benchmark interest rate that changes as official interest rates change. So using our example above, we might have a bond with $100 face value again, but this time it pays 2%pa above the 90 day bank bill swap rate (BBSW – this is a common short term interest rate benchmark). So lets assume the BBSW is 2%, to give an initial total interest rate of 4%, just like in the fixed rate example. This time however, the bond does not continue to pay $4 until maturity. It will change as the BBSW rate changes. For example, if the RBA raises interest rates and the BBSW rises to 3%, then the total annualised interest rate that the bond will pay in the next payment period will have changed to 5%. Conversely, if the BBSW fell to 1%, the annualised interest rate payable at the next payment date would be 3% pa. So it “floats” based on the changes in interest rates.

Risks

Whilst bonds are defensive assets, and held at the lower risk end of diversified portfolios, they are not entirely without risks.

Interest rate risk

If a bond is bought at face value when its first issued, and then held to maturity, (and assuming there is no default in paying back the capital) then there is no pricing risk. If it cost $100, then $100 gets paid back.

But what if the investor needs to sell the bond before it matures ? Bonds have a price, just like shares do. And the way the price behaves depends on whether it is a fixed or floating rate bond.

For fixed rate bonds, the price of a bond generally moves in the opposite direction of interest rates. That is, if interest rates in general go up, the price of bonds fall. This is called the “interest rate risk” of fixed rate bonds. The sensitivity to bond prices of these interest rate moves depends on how long they have until maturity.

For floating rate bonds, the risk is different. For them, interest rate risk is more to do with the fact that if interest rates fall, the interest payments fall. Due to this, the price of the bonds stay far more stable with regard to interest rate changes.

Credit Risk

Credit risk refers to the risk of an issue not being able to make their interest or principal payments when they are due (known as a default). Credit ratings agencies examine bond issuers and provide a credit rating, based on their assessment of the issuer’s ability to meet its obligations. This ranges from AAA (very good) to D (not good).

Liquidity risk

Liquidity risk is simply the risk that an investor cannot find a buyer when they wish to sell their bonds. In reality, this is mostly a risk for corporate bonds where the issue size is small. For the vast majority of highly rated corporate bonds with a large issuance, or well rated Government bonds, the risk is much lower for an individual.

Inflation linked bonds

Another risk for bonds is that of inflation risk. Inflation is the increase in the cost of goods and services across the economy. If inflation starts to rise, interest rates tend to rise also, and hence fixed rate bond prices tend to fall.

Inflation linked bonds are designed to help protect against the negative effects of inflation. The capital value of the bond will adjust up for the impact of inflation, and the fixed interest rate will be paid on this higher capital amount. These bonds can be useful for time in the economic cycle where inflation is accelerating.

Direct or managed

Just like with shares, SMSFs can invest directly into bonds or can invest via a managed vehicle such as a managed fund or ETF.

Direct

On the ASX, there are two different types of Government bonds.

  1. Exchange traded Treasury bonds, and
  2. Exchange traded Treasury indexed bonds (these are inflation linked bonds).

There are a small number of corporate bonds directly listed, and there are also a number of direct bonds that can be accessed via what are called XTBs – these are actually a managed fund structure, where there is only one underlying asset, being that particular bond. There are also a few brokers who with deal for DIY investors directly into the wholesale over-the-counter bond market.

Managed

This is by far the most common way that most people are exposed to fixed interest and bond markets. Managed bond funds and ETFs can either follow particular bond / fixed interest indices, or can be actively managed by the fund manager with the objective of outperforming their index.

These funds may invest in Government or corporate bonds (or both), and some can also invest in a range of other debt securities on the wholesale fixed interest markets that individuals can’t really get direct access to. Investors also have the choice of sticking with just the Australian market, or alternatively getting international exposure to global fixed interest.

 

Using fixed interest in a portfolio

Fixed interest is generally the key player in the defensive assets of a diversified SMSF investment portfolio, and serve a number of functions:

Reducing risk & volatility

Whilst assets such as shares are the stars of the show in terms of growing a portfolio value, this comes with the added risk and volatility inherent in that asset class. By diversifying with fixed interest, the overall volatility of a portfolio can be significantly reduced, especially as fixed rate bonds tend to out-perform when shares are under-performing.

Income

Once upon a time, fixed interest also used to be the key asset class for producing income in a portfolio. However in this era of ultra-low interest rates, actual interest rate payments on Government bonds can be quite low, and so corporate bonds (which pay a higher rate) have come more to the fore. Note also that although share dividends might be higher, there is no obligation on companies to pay dividends whilst bond issuers are absolutely obligated to make their interest rate (or coupon) payments.

Strategic allocation

Investors may also use bonds as strategic allocations in a portfolio at certain points in the economic cycle. Fixed rate bonds tend to out-perform the most in times of economic slowdown – more specifically when economic growth is decelerating and inflation is also decelerating. This is the exact opposite for shares, which tend to under-perform the most in that type of setup. Hence if an investor believes these economic conditions to be imminent, bonds can be an important strategic allocation for a portfolio.

 

 

Research

Fixed interest is an important allocation for SMSF investors who are running diversified portfolios.

However, as can be seen from above, it is not as simple as just investing in a few term deposits.

Lonsec are experienced hands with researching fixed interest. Our research includes the fixed interest ETFs listed on the ASX, as well as the fixed interest managed funds listed on the mFunds platform

You can use the filters on the ETF and managed funds pages in the Members research Portal to search for Recommended funds, and you can also download Product Viewpoint pdf reports. These are a two-page summaries which includes information of what the fund is, performance tables, how to use the fund in a portfolio, the “rating” of the fund, Lonsec’s overall opinion of the fund, fund manager profile, Lonsec’s suggested risk profile suitability, and it’s strengths and weaknesses.

CLICK HERE to find out more.

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