The Role of Fixed Interest

Traditionally, fixed interest has played three key roles in an asset allocation strategy:

1. to diversify risk;
2. to preserve capital; and
3. to generate income.

Due to the nature of the asset class it has the advantage of achieving each of these roles across a range of economic and financial market conditions that may cause wide fluctuations in the returns of shares and other asset class.

Diversification

Simply put, diversification means not “putting all your eggs in one basket”.
Predicting the future performance of any one asset class is impossible, and a diversified portfolio is the most effective way to minimise risks associated with each type of investment.
A share market investor faces the risk that the share market will decline and take the portfolio along for the ride.
To offset this risk, investors have long turned to the fixed interest market. The performance of bonds and shares is often not correlated, and unlike shares, bonds tend to perform well in periods of economic weakness.

Source:Thompson Financial. Bonds represented by the Lehman Aggregate Bond Index;
Stocks represented by the S&P 500 Composite Index.

Although diversification does not insure against loss, an investor can diversify a portfolio across different asset classes that perform independently in market cycles to reduce the risk of low, or even negative, returns.

Capital Preservation

Fixed interest allocations are typically less volatile than shares, and periods of negative returns tend to be short lived and relatively modest. As the chart – Monthly Rolling Annual Returns to Global Fixed Interest– shows, since 1990 there have been only two brief periods where bonds have posted negative 12 month returns.

Further, despite initial negative capital returns accruing to bond holders as interest rates increase¹ , the benefits of reinvesting at higher yields will eventually more than compensate fixed interest market investors in a higher rate environment.
This effect is compounded by the likelihood of greater capital appreciation accruing to bond holders as central banks near the peak of their tightening cycles.

Income Generation

Traditionally, investors held bonds for income. A bond is a loan; as such the investor can expect to receive a steady stream of interest payments for the life of the loan (assuming the issuer is not in default).
This predictability of payments has always been a central attraction for institutional investors such as superannuation funds, since they can use the income to meet similarly predictable liabilities.
Reinvesting the interest paid in bonds can increase capital over time due to the effect of compounding.

While shares might also provide income through dividend payments, they tend to be much smaller than bond coupon payments and companies make dividend payments at their discretion. Bond issuers are obligated to make coupon payments on a predictable and regular basis.