Thanks for letting me sleep easy, Fixed Income, but…

By: Siobhan Cassidy, MoneyMarketing Contributor

Including Fixed Income in a portfolio gives some peace of mind but, the experts say, investors shouldn’t be too complacent. Nothing is 100% fire-proof. Fixed Income broadly refers to those types of investment securities that pay investors fixed interest until their maturity date, at which point the original amount (principal) is repaid. The asset class includes a wide range of instruments, from fixed deposits and money market funds to multi-asset income funds and bonds.

“Fixed Income as an asset class has grown in complexity and scale over time and is now the foundation of any investment portfolio looking to provide a high degree of income generation with a lower degree of volatility for a specific profile of investor,” says Nadir Thokan, Senior Discretionary Fund Management Specialist at Investment Solutions by Alexforbes.

He explains that Fixed Income can be classified into money market instruments, when the term to maturity is less than 12 months, or bonds (term greater than 12 months). Bonds can be further divided into nominal bonds, where regular interest or coupon payments are fixed, and inflation-linked bonds, where regular coupons or interest payments are adjusted for inflation.

Mzimasi Mabece, Head of Domestic Fixed Income at Melville Douglas, Standard Bank’s Boutique Fund Manager, describes a Fixed Income security as an ‘I owe you’ type of a security, while Sean Segar, Co-Head of Old Mutual Cash and Liquidity Solutions, calls the money markets, a sub-set of Fixed Income, the “ultimate positive return asset class”. He describes a diverse asset class that provides a steady income stream, making it “one of the few investments that does what it says on the can”.

However differently the experts might characterise Fixed Income, there is a consensus that the asset class significantly augments a diversified portfolio. The advantages of Fixed Income include predictable income streams, capital preservation, low volatility, liquidity and liability-hedging abilities.

Thokan explains that Fixed Income can effectively be modelled for inclusion within a diversified balanced portfolio with a very high degree of confidence. The asset class’s lack of ‘mystery’ can sometimes lull the unsuspecting investor into “a false sense of confidence”, he says, pointing to recent credit default events in the local taxi financing industry as “good examples of how complacency around the predictiveness of future cashflows can turn out to be a significant negative surprise”.

Fixed income comes in many forms – from fixed deposits to long-dated bonds at the other end of the risk spectrum – and each has unique uses in a financial plan. Financial advisers can also blend Fixed Income into balanced portfolios to provide liquidity and diversification, since it has a low correlation with other asset classes, as well as providing an income stream. But, says Wynand Gouws, CFP®, Wealth Manager at Gradidge Mahura, the amount of Fixed Income in a portfolio depends on the investor’s objectives and risk appetite.

Monthly income needs

Gouws says that for those who prefer to “bucket” their investments, cash is useful for providing income in living annuities. A few years’ worth of income can be invested in cash to provide for the monthly income payments. “Not paying income from other assets means that when markets are down, you will not be forced to sell assets at a loss. Many clients prefer this strategy as it gives them peace of mind,” he says. Alexforbes’s Thokan says Fixed Interest can also be used to reduce the interest rate risk associated with future liabilities. Be they retirement benefits a pension fund has committed to pay to its members, the university education parents want to fund for their children, or retirement living expenses, liabilities are measured by their present value, calculated using a market interest rate.

“As interest rates change, so will the present value of liabilities. This creates a risk that the future level of interest rates may mean that the value of liabilities is greater than the value of assets. This risk can be hedged by matching the interest rate sensitivity of Fixed Income allocations with the sensitivity of future liabilities,” he says.

According to Old Mutual’s Segar: “Fixed income can be used in many ways, each category with its own role. For example, corporate treasurers use money market funds as an alternative to bank call accounts due to their stable capital, liquidity, and higher yields.”

He adds: “While income funds may not focus as much on capital preservation as money market funds do, their more attractive yields appeal to investors who want higher yields and are willing to tolerate small capital fluctuations. Long-dated bonds produce predictable, regular income streams with the principal preserved, and can also be used to match future liabilities. Bonds are also traded by speculators as values can fluctuate.”

Investors must factor in tax since the return from Fixed Income comprises predominantly of interest, which is taxable. “However, since retirement funds are shielded from tax, the net after-tax returns from Fixed Income assets in retirement funds are extremely attractive, especially on a risk-adjusted basis,” adds Segar. Gouws agrees that investors must bear this in mind but notes that “for many investors, the stability of cash is more important than generating double-digit inflation-beating returns”.

Flexibility

A cash component in a portfolio also provides flexibility, says Segar. “It provides optionality for advisers to act quickly when opportunities arise, while earning steady positive returns,” he says.

Mabece adds that Fixed Income securities, particularly sovereign bonds, are highly liquid, which helps with portfolio rebalancing. “Fixed Income can be used as a source of capital to fund growth asset classes when growth allocations fall below targeted strategic allocations.” Also, in a credit event such as bankruptcy or liquidation, Fixed Income securities (debt instruments) rank ahead of equity in terms of claims on assets. Since companies and governments issue debt securities to raise money to fund operations “default risk is the ultimate risk to Fixed Income investors and the credit quality of issued debt becomes very important”. Segar agrees, adding that “the value of a guarantee is only as good as the guarantor”. A danger of the apparent safety of Fixed Income, he says, is that “many investors assume that if something is guaranteed it cannot fail.

“There may be a perception that the asset class lacks surprises, but not fully understanding one’s Fixed Income exposure could prove to be a mistake,” he says. For example, not all yield descriptors are equal. Investors need to understand the difference between nominal versus effective yields (effective factors in compounding through re-investment of interest), and gross versus net yields, as well as pre-tax/post- tax yields when doing their comparisons.

Another key risk is inflation. Says Mabece: “Fixed rates are great to reduce risk, but once an investor is locked in, they cannot increase that rate. During inflationary periods, Fixed Income securities are less favourable as the rate the investors is locked into in the past is likely less than the current rate of return for new bond issuances.”

Black Swan events

The big surprises are normally Black Swan events. “In the last two decades there have been a few surprise defaults of what was once considered as high credit quality issuers, such as the bankruptcy of Lehman Brothers in 2008,” says Mabece.
Bringing it closer to home, Gouws of Gradidge Mahura, says: “Remember, your bank can go bankrupt, bank deposits are on-balance-sheet assets and are not risk-free. There have been 15 bank bankruptcies in the last 30 years, including trusted household names.”

Thokan of Investment Solutions by AlexForbes also points to the “handful of negative credit-linked events we have had over the last seven years, including defaults from African Bank, Steinhoff, Ellerines, Bridge Taxi Finance, and even a need for a debt restructure from non-government guaranteed Land Bank debt”.

There are other risks too, adds Segar, who points to liquidity risk, where a borrower is unable to meet payment obligations when these are due, and interest rate risk, where the value of a Fixed Income instrument falls due to fluctuations in interest rates.
Segar says that many investors don’t appreciate that the value of Fixed Income instruments can fluctuate, and capital can be lost as rates and spreads fluctuate and credit quality is re-assessed. He adds that people can get caught by “not demanding enough reward for taking on extra risks…an investor may think they are doing well with a high yield, but they may well be better off with a lower yield that includes significantly less risk