By Tim Hewson
20 February 2009
While many Australian economists debate the merits of Keynesian economic theory to solve the problems of the global market, there is one thing that they all agree upon - Australian Fixed Interest delivered its best performance in fourteen years.
Most surprising of all was the polarisation of this typically staid and conservative asset class when compared to the performance of more popular assets like Equities.
According to Morningstar, Australian Fixed Interest out-performed Australian Equities by nearly 54% last year, International Equities by close to 40%, Australian Small Caps by more than 68%, and Listed Property by more than a staggering 70%.
So, how do you construct your portfolio and allocate your assets when volatility, uncertainty, and a lack of liquidity look set to continue in 2009?
Not all Fixed Interest performs the same
A common misconception is that all Fixed Interest assets are the same. It is within the inherent nature of these assets that their differences become apparent. And it is these differences that will provide investors with the opportunity to make reasonable returns over 2009.
Australian Government Bonds and US Treasuries had a stellar year last year as desperate investors fled to the safety of sovereign debt and the liquidity of cash to protect their portfolios from downward spiralling equity markets. As a result, Government bond prices went up and yields were pushed to unsustainably low levels.
In recent years, investors have invested heavily in sub investment g rade assets, and as a result, 2008 was a year that many would like to forget as credit spreads blew out to unprecedented levels and liquidity dried up almost overnight.
Credit spreads on US Investment Grade Corporate Bonds blew out to levels twice that of those experienced in the Great Depression, and spreads on many of these assets remain at levels that are wider than those of CCC rated assets prior to the credit crunch.
Recent default rate forecasts from Moody's Investor Service suggest the 12 month default rate on US corporate debt will increase from 10.4 %to over 15 %.
This implies that at least another 300 investment grade companies will likely default on their bonds in the next 12 months.
Why the long face?
For far too long Fixed Interest has played the role of the 'poor cousin' to growth asset classes like equities as investors zealously seek to maximise returns.
Investors typically forget the basic principles of portfolio construction, and over-allocated to equities and forget about the benefits of diversifying into boring old Fixed Interest.
The fact that Fixed Interest is so boring is exactly what makes it so interesting.
The key to portfolio construction is the benefit of diversification, capital preservation, the ability to generate income, and its negative correlation to Equities.
So when equities are down, Fixed Interest is likely to be popular with investors because of its ability to preserve capital and dampen portfolio volatility.
Fixed Interest investments typically contain two important components, Capital and Income.
When you invest in a bond you are undertaking a contractual obligation with the issuer that they will pay you your Capital in full at an agreed maturity date as well as regular Income (Coupons) at an agreed rate at regular intervals until maturity.
One of the more appealing features of Fixed Interest is its liquidity and ability to be traded. So investors can easily traverse the yield curve and gravitate to opportunities. The ability to generate income is also an advantage when other asset classes aren't performing. Income can help balance out any interim volatility of growth assets within a portfolio, and also provide for interim liquidity to prevent the sale of assets if rebalancing is required.
It also allow investors to allocate to new investment opportunities as they arise instead of having to liquidate a portion of their portfolio.
Allocating to Fixed Interest
The ideal allocation for any investor will be determined by their need for liquidity, income, capital preservation as well as the amount of capital they are prepared to risk in order to achieve their desired investment objective.
In general, the more risk averse an investor is, and the more defensive they are in their investment approach, the higher the allocation to Fixed Interest.
Defensive Investor
A defensive investor focused principally on long-term capital preservation should maintain at least 70% of their portfolio in a mix of Cash and Fixed Interest. The allocation to Fixed Interest may be broken further down between Australian and International Fixed Interest, and with the addition of each level of segmentation comes more diversification. The broader the diversification, the less likely your portfolio is to be subject to the underperformance of a single investment.
Source: Morningstar
Moderate Growth Investor
In contrast, an investor who maintains a reasonable degree of capital protection, but is prepared to risk some capital for moderate long-term growth might make a 30% allocation to Cash and Fixed Interest, and the rest to growth assets. However, unlike our defensive investor, the moderate growth investor is likely to have a lesser allocation to Cash (only 10%) and a 20% allocation to Fixed Interest - again split between Australian and International Fixed Interest.
Source: Morningstar
Aggressive Growth Investor
Aggressive growth investors typically have a high pain threshold for risk and are focused on capital growth rather than capital preservation. As a result, the aggressive growth investor is prepared to adopt significant portfolio volatility and will usually allocate up to as much as 85% of their portfolio to growth assets like equities (Australian and International) and Property, with only 15% exposure to defensive investments split between Cash and Fixed Interest. In this case, the allocation to Fixed Interest is typically designed to improve portfolio diversification and to mitigate the extreme volatility within a higher risk portfolio.
Source: Morningstar
Selecting the right investment mix
Ultimately nobody likes to lose money, but unfortunately this is often the most effective way for investors to accurately measure their risk tolerance.
A simpler and less expensive method is to ask yourself out of every $100 you invest, how much would you be prepared to lose over a selected timeframe in order to achieve your investment goal?
Risk means different things to different people, so if you can't explain the risks of an investment to someone else, you shouldn't be investing in it in the first place.
Outsource to a professional
Outsourcing investment management to professional fund manager is a very effective way to diversify your investment portfolio, but before selecting a fund, you need to do your research and understand what you are investing in as not all Fixed Interest funds are the same.
Important notice: past performance is not a reliable indicator of future performance.
