22nd April 2009
Australian Fixed Interest as an asset class – an appealing option in volatile times – Part 1
In a 2-part series of our Investment News, we are going to look at fixed interest as an asset class, and suggest that it can be an appealing option in volatile times. In our view, fixed interest should form part of a diversified investment portfolio. Much of the discussion is based on research undertaken by leading research house, Morningstar.
At La Trobe, we include an investment in mortgages in the "fixed interest" asset class.
According to Morningstar, Australian fixed interest as an asset class 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. 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 grade 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-allocate 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.
When you invest in mortgages, either directly or indirectly, you benefit from the regular payments that the borrower makes, with the security of a registered mortgage over property. Within the fixed interest asset class, mortgage investments are generally designed to have stable capital value, differentiating them from bonds and other fixed interest assets with fluctuating value.
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 allows investors to allocate to new investment opportunities as they arise instead of having to liquidate a portion of their portfolio.
In next week's Investment News, we look at how investment portfolios can be constructed for investors with different goals and objectives.
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Head of Funds Management
t +61 3 8610 2811
Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.
La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.
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