Free | Investment Ideas

Investment Ideas in Fixed Interest

Following on from our recent Fixed Income Review that was published for members, let’s have a look at some investment ideas in the fixed income space using our research tables, and specifically using ETF’s given their ease of transacting for anyone with a broker trading account.

One of the big themes for the past year in financial markets has been the movements in bond yields, especially the benchmark 10 year bond rates in the US and in Australia. This in turn directly affects fixed income / bond market investments. In the depths of COVID, bond yields fell significantly, which enabled bond funds and ETFs (particularly those with ‘duration’ such as Government bond ETFs or index bond ETFs) to provide good returns during that period. These solid returns from bonds helped partially offset the falls in the equity market for those who had balanced or conservative asset allocations in their investment portfolio which included a healthy allocation to fixed income. In other words, bonds did their job.

However, since November 2020 when the COVID vaccine become real and the world tilted into the ‘reflation’ regime, we’ve had the opposite effect as the global economy has recovered, business cycle indicators and inflation numbers have been hitting multi year (in some case multi decade) highs, and bond yields have risen steeply from the lows.

The net result has been a significant dispersion in the returns from the different types of fixed income investments.

Using the research table screen

If our members go into our Investment Research section, and click on ETFs, we get the ETFs research table.

To set the scene, the first thing we are going to do is look at which fixed income ETFs have actually had negative 1 year returns (all returns are as at the end of May 2021).

Using the filter, we choose ‘Fixed Interest’ under Asset Class, and under ‘Return 1 yr%’ we put in there less than (<)0. This instantaneously provides a list of 12 ETFs that made negative returns over the past year.

The thing that stands out is that the top 10 are all fixed income ETFs that invest either fully in Government bonds, or invest in an index (which themselves have a big allocation to Government bonds, with some fixed rate corporate bonds). This makes complete sense given what we know has happened to Government bond yields over the past year.

Does this make them bad investments ? No, it just means that in the particular environment we have been in for the recent past, rising yields have been tough for them.

Now, lets switch this around and look at who the top performers were. If we use the filter to just search for ‘Fixed Interest’ in the asset class, and then click on the ‘1 year return’ column, we can now see this list in order of best to worst performance.

Topping the list is an emerging markets fixed income ETF, and some other global fixed income ETFs in that space. The thing that stands out however is the volatility that this comes with. The volatility measure on the right hand side of the tables is one of the distinguishing features of our research tables, which differentiates it from other generic performance tables.

It’s not just about return, but also volatility

So when we think of the role of fixed interest in a portfolio, it’s not just about return. The volatility is also important, as fixed interest is often the part of the portfolio where we accept lower returns in return for greater stability. If a fixed income investment does not come with that stability, then one has to wonder if it really belongs in the defensive end of the portfolio.

So lets take a different approach with the filter. This time, lets scan for fixed interest ETFs, that have had a decent one year return (greater than 3%), but also have had low volatility (a one year volatility measure of less than 2). To provide some context on volatility, an index share market ETF has a longer term volatility number of around 14, while an index bond ETF has one of around 3 to 4.

This scan provides a much smaller list as follows:

The resultant list features three unconstrained bond funds and a hybrids fund, which are all actively managed and follow very specific strategies that are not dependant on the movement of interest rates. Hence, these have outperformed in this environment of rising rates.  The other is SUBD (the VanEck Subordinated Debt ETF). Note part of this good 1 year return is the base effects, in that it dropped 8% in March 2020, and has been on a grinding recovery since then. So the tip here is to also go onto the website of an ETF you are interested in, look for the performance graph, and see what sort of a drawdown (if any) they had in March 2020 when COVID really hit the markets. The other caveat here is that most of the ETFs on this list don’t have 3 year returns, so we’ve just been looking at the past year. So again, an ETFs website will list its return since inception, and if it has a managed fund equivalent, it may have some longer history you can go on (like XARO for example).

Blending styles into a portfolio

So does this mean we lump all our fixed income eggs into these baskets ? Probably not. The index / Government bond ETFs we referenced earlier still have their place, they have just had a rough time of it with bond yields rising in a short space of time. As mentioned above, in the depths of COVID these ETFs did very well. In fact, this month so far bond yields have actually come off, and hence those ETFs will be outperforming this month.

For longer term investors who do not want to make calls on the direction of bond yields, the answer is often to blend different fixed income fund / ETF styles into a portfolio with multiple exposures. For examples, members can go to the Model Portfolios section to look at the current exposures in the Lonsec Listed Balanced model portfolio.

 

Author: Graham Parkes

Issued by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Warning: Past performance is not a reliable indicator of future performance. Any advice is General Advice without considering the objectives, financial situation and needs of any person. Before making a decision read the PDS and consider your financial circumstances or seek personal advice. Disclaimer: Lonsec gives no warranty of accuracy or completeness of information in this document, which is compiled from information from public and third-party sources. Opinions are reasonably held by Lonsec at compilation. Lonsec assumes no obligation to update this document after publication. Except for liability which can’t be excluded, Lonsec, its directors, officers, employees and agents disclaim all liability for any error, inaccuracy, misstatement or omission, or any loss suffered through relying on the document or any information. ©2021 Lonsec. All rights reserved. This report may also contain third party material that is subject to copyright. To the extent that copyright subsists in a third party it remains with the original owner and permission may be required to reuse the material. Any unauthorised reproduction of this information is prohibited. 

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