Understanding your fixed interest options
Understanding your fixed interest options
Whether you are reviewing your self-managed super fund (SMSF) asset allocation or saving for a deposit on your first home, fixed interest funds should be considered to help you achieve your investment goals. But what type of fixed interest fund is right for you and what are the risks?
Historically, investors have selected fixed interest strategies due to the consistent income stream and diversification benefits they provide. However, over more recent years some investors have sought out more aggressive strategies that offer higher levels of income and limited diversification benefits.
It is important to understand there are a broad range of fixed interest strategies which offer very different risk and return outcomes and should therefore be used in different ways. We can group these different strategies into broader sectors of bonds; enhanced cash; income; and unconstrained, to then identify the key characteristics to help in selecting a fund that is fit for purpose.
Enhanced cash products generally invest in high quality and short dated securities, and seek to deliver an income level that is comparable to term-deposits while also limiting the level of downside risk and providing a high level of liquidity. These types of strategies may be useful for investments of approximately 12 months or longer, as they provide greater access to the assets than a term deposit and limited tolerance for negative returns. But if an enhanced strategy is generating returns significantly above a term deposit this may be a sign that the fund is taking on an excessive level of risk for this sector.
Bond funds primarily invest in high quality securities issued by governments or large corporations, while also gaining exposure to securities backed by income paying assets such as mortgages. Traditionally these funds have been used for their diversification benefits (as bond prices often increase when equity markets are stressed) and their consistent income streams.
While some argue that bond funds are less attractive given the current low levels of interest rates, there remains a strong argument for the use of bond funds in a long-term investment allocation to provide a more consistent return profile and act as a strong defensive anchor in the event of an equity market panic.
Income focused strategies primarily invest in securities issued by corporations and while these securities rank before common equity in the event of a default, they are exposed to the same forces that drive equity prices up and down. This normally results in fewer diversification benefits – but relative to equities they typically have a more consistent, if somewhat lower, expected return stream due to the income paid on such securities.
It is important for an investor to understand that an income fund that buys only the debt of large blue chip companies (known as ‘investment grade’) is exposed to a lower level of risk relative to that of a fund which invests in securities of smaller, lower quality companies (known as ‘high yield’). So while some income funds may have generated higher returns over time – this return is associated with more risk.
The unconstrained sector is the most challenging for all investors to understand, due to large variances across funds and the latitude such funds are afforded. Some funds within this space retain quite defensive bond -ike characteristics, while some act more like hedge funds taking significant levels of risk in an attempt to achieve very high return targets. Investors need to be aware that high return targets are normally associated with high levels of risk.
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