Contrary to the mainstream, some analysts are preferring cash and advising minimal or no exposure to fixed income or, if fixed income is essential, corporate bonds over government bonds.
One industry source questioned the wisdom of allocating more of investors’ portfolios to fixed income as Australian bond yields hit historic lows in early June.
Tyndall Asset Management head of fixed income Roger Bridges cautiously agreed fixed income had risks and that they could differ from those investors were used to in their share portfolio.
These risks include interest rates, inflation, credit, currency, liquidity and reinvestment.
The industry analyst, however, advised holding minimal or no exposure to fixed income – given the historically low level of yields around the world currently – and allocating those exposures to cash.
Not all fixed income was the same, InvestorDaily was told, so investors wanting to maintain their bond exposures should look to bias their portfolios to corporate bonds over government bonds.
Investors would generate higher yields from their portfolio and, in many instances, gain exposure to entities with lower debt levels, as opposed to the bonds issued by an increasing number of governments battling debt burdens.
Bridges said, however, that government bonds were usually highly liquid and so could be sold without losing much, if any, of their initial purchase value.
“Non-government bonds, such as semi-government or corporate bonds, have lower liquidity and therefore carry higher risk,” he said.
Active fixed-income managers could help manage these risks through various strategies and buying securities in different weights to the index, or even those not included in it.
Inflation-linked bonds could mitigate inflation risk – a strategy not available to passive fund managers because such bonds did not usually form part of a standard fixed-income index.
“Likewise, residential mortgage-backed securities also don’t usually form part of domestic fixed-income indices,” Bridges said.
“However, they can offer extremely good value and good returns with low risk and portfolio diversification benefits.”
The key risk with term deposits was reinvestment risk, he said.
“Investors are learning that they can’t reinvest their cash at the same, higher, rates of interest that were available to them two or three years ago. So although their capital is relatively protected, the income from that capital is declining,” he said.
During periods of volatility and uncertainty, fixed income should outperform term deposits, because term deposits did not ‘mark to market’, he said.
“Bonds, on the other hand, are continually repriced, which means bond investors can benefit from capital appreciation in markets where fixed-income investments are performing well.
“Furthermore, when interest rates are falling, bonds tend to pay higher returns than term deposits.”
Another problem with term deposits was that they did not provide diversification, he said.
“It’s a common misconception that term deposits have good diversification compared to equities,” he said.
“However, term deposits have been positively correlated with equities during four periods over the past 10 years. Bonds, on the other hand, are usually negatively (often strongly negatively) correlated with equities, other than for a short period between 2004 and 2005.”
