Risks around bonds increase as interest rates rise. At the same time, returns from fixed-income instruments such as cash and term deposits improve. This has portfolio implications, of which advisers need to be aware when determining the correct defensive exposures for clients.
Nathan Nash, a director of financial advice firm Scarlett Financial, says with term deposits at record lows, investors need to consider alternative options for interest income.
“In some instances, investors have ventured up the risk scale to use high-yielding equities such as bank stocks, Telstra, listed infrastructure and property trusts. With this additional income has come additional volatility, especially in recent times with bonds yields increasing,” he explains.
In this environment, chief investment officer of financial advice firm ClearView, Justin McLaughlin, says managed funds remain the easiest way for retail investors to achieve fixed-interest exposure.
“The key for fixed-income investing for the next 12 to 24 months is to have a degree of protection around that investment,” McLaughlin explains. “The interest rate cycle is moving up and that means investments with longer duration are potentially at risk.”
He says funds that don’t have too long a duration but also use absolute return-style investing could be interesting for clients to explore. The Kapstream Absolute Return Income Fund, the Macquarie Income Opportunities Fund and the PIMCO Global RealReturn Fund are in this category.
“They all have risk management, as well as an element of income intent in their overall investment objectives, which is important this year,” he says.
Annuities and ASX-listed hybrid securities, as well as mFunds, are other options for fixed-income exposure.
Rising interest rates pose risks for bonds and other fixed-interest investments that advisers need to take into account. This is because fixed-interest investments issued after a rate rise tend to offer a higher rate of return than instruments issued before the rate increase, making older instruments that pay a lower rate of return less attractive. This puts pricing pressure on bonds.
There are also risks to consider when investing in hybrid instruments, which contain a mix of debt and equity. As McLaughlin notes, hybrids are subordinated securities. They rank lower in the capital structure than traditional bonds, but higher than shares. If these instruments suffer a loss, they can, in certain circumstances, be converted into shares. But this situation usually happens at a time when the securities’ values are depressed.
“I don’t foresee any immediate risks for hybrids,” McLaughlin explains. “But through 2017, we’ll probably see the apartment boom peter out. A weaker economy and construction sector might put pressure on bank hybrids in that environment.”
Nash says many retail investors don’t have enough knowledge about fixed-interest investments, as they believe they are simple to understand.
“Retail investors can take a static approach to fixed interest, when they should actively manage these investments to account for the interest rate cycle and credit risk,” he says.
Nash also warns investors can assume government debt is low risk and put all their defensive exposure in this asset class. But government debt has a poor outlook as interest rates rise.
“The recent timing of a number of listed government debt options for retail clients is unfortunately quite poor at this point in the cycle,” he says.
An emerging theme is access to institutional debt at the retail level, through listed alternatives.
Nash explains: “This is a great tool for advisers when providing investment options to clients, as long as the necessary expertise is applied. This is a real risk for retail investors, as they are generally under-informed on fixed-interest investment and this can lead to poor investor outcomes.”
