In a “lower for longer” rate environment, investors are naturally being drawn to funds and listed investment trusts (LITs) that are promising high yields for relatively low levels of risk.
And there is no shortage of them on the market – from funds that include exotic Queensland islands to LITs that invest in a complex collection of high-yield global bonds.
However, when considering any investment, it is important to remember some of the key lessons from the global financial crisis – that high returns come with higher risk and that we should always be sceptical of financial products that are difficult to understand.
As Australia’s leading non-bank lender, Metrics specialises in understanding the opportunities and risks in fixed income investments. Here we tackle three common fixed income issues and explore some ways investors can add stability to their portfolios.
Risks of investing globally
Investors often include international bonds in their portfolios to take advantage of higher interest rates or yields and to diversify their holdings. However, the potentially higher rate of return is accompanied by increased risk arising from adverse currency fluctuations, which can cause investment volatility and ultimately impact returns.
While there are fewer investment opportunities in the Australian market, for investors seeking stability – one of the primary drivers for investing in fixed income – we therefore believe there are sound reasons to maintain a domestic focus.
Not only does investing in Australian assets remove foreign exchange risk from the equation, but investors are also protected by Australia’s strong corporate insolvency laws.
Australian law is focused on giving priority to the interests of creditors, especially secured lenders, in comparison to other developed nations such as the US and the UK, which are now perceived to be much more focused on the rights of the debtor company.
Too much credit risk
Globally, credit markets are now at a point in the cycle where risks are becoming more apparent. Over the past 10 years businesses across the globe have loaded up on debt, credit quality is deteriorating and compensation for credit risk has declined as yields have collapsed. In short, credit investors now face a lot more risk, for a lot less return.
For listed fixed income offerings such as LITs, investors should therefore pay close attention to fluctuations in capital, as well as the underlying investments in the fund and the downside protections on offer.
A high-quality fixed income fund or LIT will not only pay regular income but should also offer capital stability by investing in a well-researched portfolio of assets that offer built-in protections for investors. In the case of corporate loans, these can include floating interest rates and lender protections such as covenants, controls and appropriate security which bring inherent stability to a portfolio.
Not enough diversification
Whether you are investing in a bond portfolio or a corporate loan fund, portfolio diversification should be a key consideration. While corporate loss rates in Australia are low, diversified funds help manage downside risks by spreading funding across a range of sectors, risk profiles and investment terms.
So do your homework before undertaking any investment and remember – if it seems too good to be true, it probably is.
