04 July 2013
Interested in fixing?
So what is an investor to do? In last month’s Investor Insight, we discussed some worrying signs that investors might once again be over-exposing their portfolios to risky assets like equities. We considered the question of volatility and the implications of the recent stock market falls. We also reviewed some research
indicating that investing when stock market values are relatively high exposes investors to a significant risk of long term investment underperformance.
But what else is there to invest in? To read the financial press, one would think that the only investments worth considering are shares and (possibly) investment properties.
The truth, of course, is that there are far more options than those. Professional money managers and advisers know the importance of balancing exposures to ‘growth’ assets, like shares and property, with solid exposures to more capital stable, income producing assets. This type of investment is frequently described as ‘fixed interest’.
In this month’s Investor Insight, we will briefly consider the world of ‘fixed interest’ investment and the benefits it can bring to any balanced portfolio.
Types of fixed interest investments
The term ‘fixed interest’ covers a diverse range of investment products. As a general rule, these products provide investors with increased capital stability and less volatile returns than those produced by the ‘growth’ assets. Some key examples of fixed interest investment products include:
2. Term deposits;
3. Hybrid products; and
4. Mortgage funds.
In essence, a bond is an undertaking by an ‘issuer’ (classically a government or corporation) to pay the bondholder (the investor) a principal amount plus interest (generally paid at fixed intervals). The investor in a bond is effectively a ‘lender’ to the bond issuer. This provides an important advantage in the event that the bond issuer enters financial difficulty – the bondholder will be a creditor and will therefore have the right to recover his or her debt before shareholders receive anything.
At least in theory, bondholders pay for the increased security of their investment with a lower rate of return. Thus, bonds are generally considered to be at the safer end of the risk spectrum, with significant protection from the volatility of equities markets.
It should be noted, however, that bonds are also sold on secondary markets. For investors who wish to trade on these markets, the capital value of their bonds is exposed to market volatility. For example, fixed interest bonds decrease in value when interest rates go up and increase in value when interest rates go down. Floating rate or inflation linked bonds can protect against the risk of market price changes caused by interest rate movements.
Most investors are familiar with term deposits. They are deposits with banks that pay a fixed rate of return for a set term. Term deposits may range in term from one month to ten or more years.
The most pressing consideration for investors today, of course, is the low rates of return being paid by term deposits. In many cases, the rates of returns paid on term deposits are barely above the inflation rate – meaning that they are simply not producing enough money for investors to live on without diminishing the purchasing power of their portfolio. With significant inflationary risks still threatening Australia, this issue is likely to become even more pressing in the near future.
Hybrid products are products that have features of both debt and equity. In some ways they are like bonds and in some ways they are like equities. Unfortunately for most investors, these products are extremely complex and are the subject of an enormous number of variations. The golden rule when looking to invest in any hybrid product is to understand the product and BEWARE!
For more information on hybrid products, visit https://www.moneysmart.gov.au/investing/complex-investments/hybrid-securities-and-notes
Mortgage funds operate by receiving investments from investors and investing them in loans to borrowers. The payments made by the borrowers generate the returns for investors and investors also benefit from the mortgages taken over the borrowers’ security properties.
The La Trobe Australian Mortgage Fund’s Pooled Mortgages Option is designed to offer some of the strongest characteristics of the other fixed interest product categories. For example, like a bond, it is a debt product. Unlike a bond however, the debt is diversified among over 1,000 borrowers. Like a term deposit, it pays a variable interest rate monthly and is for a fixed one year term. Unlike a term deposit, it pays a return well in excess of the inflation and official cash rates. It should always be noted, however, that an investment in a mortgage fund is not a bank deposit and is not subject to the current government guarantee on bank deposits.
The above mix translates to a history of performance competitive with any other fixed interest investment.
We emphasise again that this does not mean that investors should avoid share markets. It simply means that they need to be very careful about choosing their investments and their level of exposure to those investments. It is doubly important that investors at or near retirement consider carefully whether they are over-exposed to shares. After all, six years after the GFC, the All Ordinaries remains around 25% below its peak in real terms.
For this reason, you should consider whether you are sufficiently exposed to fixed interest investments. They are unlikely to produce the stellar returns that the share market produces in good years, but they may play a powerful role in ‘de-risking’ portfolios and protecting portfolios from the volatility of equities markets.
Head of Funds Management
The following awards and ratings were given to the Pooled Mortgage Option within the La Trobe Financial Mortgage Fund