Fixed interest:

Bonds and cash are out of favour but there are strong reasons to include them in a portfolio

Susan Hely Bonds still have a role to play

Fixed interest is a dilemma for investors. The returns are ridiculously low – even slipping into negative territory – but investors are told by experts to keep part of their wealth in these products.

While Australian and world sharemarkets are buoyant, fixed-interest returns are uninspiring. For example, the Australian sharemarket’s S&P/ASX 200 gained 7.33% and the US market’s S&P 500 jumped 16% for the year to the end of July while the S&P/ASX Australian Fixed Interest Index lost 0.25% and the S&P/ASX Australian Government Bond Index slid by 1.75%.

But still investors are urged not to dump fixed interest from their portfolios altogether.

“We are sticking to the principle that it is appropriate to hold a relatively high proportion of the portfolio in fixed interest,” says Riccardo Briganti, investment specialist, applied research and solutions team, at BT Financial Group.

If you look at the returns of the past 10 years, fixed interest has beaten shares with 6.2%pa compared with 3.6%pa for Australian shares to the end of June this year. “If risk is your highest concern, you can protect your portfolio,” says Briganti.

Fixed interest still plays a clear role as a diversifying and balancing asset class to offset sharemarket volatility. For this reason balanced portfolios typically hold 25% in fixed-interest investments such as bonds and cash. Some super funds have eased back on fixed interest and dialled up their infrastructure holdings, particularly those utility investments that deliver a bond-like return.

Retail investors have gone underweight on fixed interest. They favour bank hybrid securities that pay a higher yield but this can be risky (see breakout).

Bonds

The outlook for bonds isn’t bright. In fact, investment groups such as Vanguard continue to revise down fixed-interest returns. Vanguard’s outlook for bonds is the most guarded since 2006, given the environment of low interest rates and low earnings yields. It says the expected 10-year median return for the global fixed-income market is in the 1% to 3% range. This resembles the historical bond returns of the 1950s and 1960s.

“Despite this outlook, we encourage investors to evaluate the role of fixed income from a perspective of balance and diversification rather than outright return,” says Joe Davis, Vanguard’s global chief economist.

“High-grade or investment-grade bonds act as ballast in a portfolio, buffering losses from riskier assets such as equities. Several segments of the Australian bond market, such as credit and government bonds, have 10-year median expected returns centred in the 2.5%-3.5% and 1.5%-2.5% range respectively,” says Davis.

The Australian credit bond index is in the 2.5%-3.5% range, which is slightly higher than that of the government bond index. Inflation-linked bonds are showing negative returns over shorter investment horizons because of their sensitivity to a rise in real rates.

One of the most popular ways to hold fixed interest is through a diversified fixed-income managed fund that invests in government, global, Australian and corporate bonds. (See tables, page 72.) But increasingly there are other vehicles, such as low-cost, diversified exchange-traded funds that track a particular index. These offer wide diversification as a

buffer against any defaults by a bond issuer. For example, the Vanguard Australian Fixed Interest ETF (ASX: VAF) holds 520 securities.

Fixed-income ETFs

You can buy fixed-income funds in the same way you buy shares through the ASX. Around $400 million flowed into fixed-income ETFs in the six months to June 30. There has been a spate of new fixed-income listings and there are 18 Australian fixed-income funds and five global bond ETFs.

You can buy Australian government, semi-government and corporate bonds. They can be fixed, floating rate or inflation linked. Global bonds include both emerging and main markets. “In lower interest rate environments there is naturally greater enthusiasm for corporate bonds where yields are higher,” says Jason Davis of Strategic Income. “However, there is also less liquidity and greater risk, especially as you delve into the BBB part of the market.”

He recommends that investors check not only the average credit rating but also the composition and any credit rating rules in the index specification and how often these are reviewed between rebalance dates.

The two main corporate bond ETFs are Russell Australian Select Corporate Bond (RCB) and Vanguard Australian Corporate Fixed Interest Index (VACF), the latter covering local companies issuing corporate debt as well as the expanding “kangaroo bond” market, which gives investors exposure to overseas companies such as Apple without the currency risk.

Jason Davis says that investment fees (MERs) and spreads for these corporate bond ETFs are higher than for government debt ETFs, reflecting the fact that the provider and market maker have to do more work to make these products operate efficiently.

“When searching for better yields via corporate and global bond offerings, investors need to be mindful of potential liquidity issues and the different economic markets that the bond issuers operate in,” says Davis. “Investors should understand how rapidly credit premiums can move, and along with the greater chance of forfeiture these have the potential to cause nasty repercussions for returns.”

Cash ETFs

The success of the BetaShares Australian High Interest Cash exchange traded funds (AAA), which has $1.2 billion under management, has spawned three new cash ETFs this year. The BetaShares fund, which started in 2012, returned a net 2.05% to the end of July compared with the current cash rate of 1.5%. The annual fee is 0.18%.

“With Australian interest rates stuck at record low levels and banks not readily offering flexible and commercially priced products to large retail savers, it is not surprising that the BetaShares cash ETF has been so successful,” says Jason Davis.

The cash ETFs are an alternative to traditional cash investments such as term deposits and they tend to invest in deposit products and track cash market indices such as the RBA Cash Rate Index and the AusBond Bank Bill Index. They don’t require you to open bank accounts or roll over a term deposit as they trade on the ASX. There is no locked-in investment period, nor are there the potential break fees and forfeiting of interest that occur if you withdraw funds before a term deposit matures.

With a bank term deposit, amounts up to $250,000 are guaranteed by the federal government but there is no guarantee for a cash ETF. Also there are brokerage and investment fees for ETFs that don’t exist with a term deposit.

The new cash ETFs include iShares Core Cash (BILL), iShares Enhanced Cash (ISEC) and UBS IQ Cash (MONY).

BetaShares’ Alex Vynokur says he expects fixed-income ETFs to continue to grow as investors, particularly self-managed super funds, put together balanced portfolios using ETFs. “Such growth is expected to be supported due to the increased product choice now available across both fixed and floating rate bonds,” he says.