What to look for in the current fixed interest environment

The fixed interest market is currently proving challenging for advisers to navigate as yields continue to decline. In this article, we detail what advisers should be looking for and what to be cautious of.

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Transparency – understanding true exposure

There are a variety of approaches advisers use when constructing a fixed interest exposure for clients. Some advisers, for example, blend a variety of managed fixed interest funds and then add a few hybrid securities. Alternatively, they may have a research team construct a portfolio. These approaches mean the adviser will generally have little transparency over the underlying exposures in a portfolio. This can lead to clients unwittingly having too much exposure to certain subsectors they may not necessarily want exposure to.

Advisers need to drill down into client portfolios to obtain an aggregate view of exposures. They can then make better portfolio construction decisions and identify the return drivers which are relevant at different points in the market cycle. An adviser can also potentially take steps to reduce exposure to unwanted risks, as well as being able to run stress and scenario testing and liquidity analysis. Superior transparency enables an adviser to better protect clients’ capital and to seek out opportunities to enhance returns.

Maintain diversification at the subsector level

Advisers who decide to use a range of managed funds should ensure the investment managers have complementary investment approaches. This reduces the risk, particularly late in the market cycle, of the managers all being strongly positively correlated to each other. Advisers should select investment managers who use different strategies and invest in a variety of assets to capture a broad range of return opportunities. Diversification across strategies and assets should lead to a smoother portfolio return over the long term.

Decide what to prioritise – income or capital preservation?

At this late stage in the market cycle it’s important to understand the reasons for investing in fixed interest. For some clients it’s to provide an exposure that is negatively correlated to share markets, which means it’s expected that the fixed interest allocation will increase in value if share markets decline sharply. The other motivator for clients investing in fixed interest is to provide a regular income.

Knowing whether income or capital preservation is the primary motivator will help with building the right type of fixed interest portfolio. Advisers can sometimes become overly focused on yield, leading to a portfolio that is overweight credit and contains little duration. With low duration, the portfolio may no longer respond positively to a sharp decline in share markets. In fact, a portfolio with a high-weighting to credit sectors will likely decline if there is a share market fall because credit spreads will widen, leading to potential capital losses.

Very low yields mean advisers may be concerned about suffering capital losses on fixed interest investments if there is an increase in interest rates. While this is a risk, low-yielding fixed interest investments can still provide useful capital gains in the event of a sharp decline in share markets. These gains will be driven by ‘a flight to safety’. This means advisers whose primary motivator is capital preservation should still consider investing in sovereign fixed interest despite low current yields.

Be cautious of hybrids

Hybrids are sometimes not fully understood by advisers who may underestimate their risk. While the yield on certain hybrid issues may seem attractive, it’s often not worth the risk. This is because of where they sit in the capital structure – generally slightly better than general equity. They have, in partial jest, been said to sometimes produce bond-like returns with equity-like risk. The other reason to be cautious of hybrids is their poor liquidity which is caused by usually being held by investors until maturity so secondary market trading is thin and typically worse than that of normal equity from the same issuer. In times of share market stress this lack of liquidity can result in wide spreads, making it difficult to be able to sell quickly at a reasonable price.

Advantages of a multi-manager fund

Depending on the in-house resources available to them, advisers could consider investing in a diversified multi-manager fund. This type of fund can offer several advantages compared to advisers building their own fixed interest exposure. The primary one is risk control driven by the ability to ‘see through’ the portfolio. By using tailored mandates, it’s possible to measure and analyse every individual security in the overall fund. This helps identify unwanted risks, like currency exposure, which can then be managed or hedged.

The IOOF MultiMix Diversified Fixed Interest Trust is managed by Osvaldo Acosta. The fund aims to provide a low to medium risk, income producing investment over the medium term by investing in a diversified portfolio of fixed interest investments.

The fund may be suitable for investors with an investment horizon of two to three years, with a low to medium level of risk tolerance and who are predominantly seeking income-generated returns through a well-diversified fixed interest portfolio.

More information

To learn more, please contact Charles Kneale, IOOF Investment Specialist, on 03 8614 4774 or email charles.kneale@ioof.com.au