Why Fixed Interest

One of the keys to good long-term investment returns is ensuring your overall investment portfolio is well diversified (see The Role of Fixed Interest for further explanation).

While some investors with a very long-term view have a high tolerance to volatility, or fluctuations in returns, most investors are more comfortable with a portfolio designed to smooth out those fluctuations.

In this sense, fixed interest provides two essential components of a portfolio: a regular, known and dependable level of income; and the security of knowing that your capital will be returned to you by the time your fixed interest investment matures.

The traditional response to the question of why investors should allocate to fixed interest, is to act as a cushion against losses when there is a downturn in equity markets. This is because the performance of bonds and shares is often not correlated - market factors that are likely to have a negative impact on the performance of shares historically have had little to no impact on bonds and in some cases can actually improve bond performance.

For example, an investor who purchases both a blue-chip share and a government bond, may offset the downward market cycle in one asset class because a drop in a company's share price and a drop in a government's ability to repay a bond are usually unrelated. This diversification of risk and return remains a very important reason for investors to continue to include an allocation to fixed interest in their portfolios.

However, over the years, fixed interest strategies have evolved with innovations in the superannuation industry. Once investors predominantly invested in domestic bonds but there has been a move over the years to global bond benchmarks and also smaller allocations to fixed interest sectors such as emerging markets, high yield, inflation-linked bonds and commodities. These allocations still aim to diversify risk, but fixed interest is now also taking on another role, as a return-seeking asset. In recent years, with a buoyant global economy, a strong bull equities market, a tightening interest rate bias and contracting credit spreads, fixed interest allocations have reduced considerably as investors went searching for higher returns. In response, fixed interest managers have looked for innovative ways to keep fixed interest on their investors' radars.

One of these innovations has come in the form of products that separate the excess return from the benchmark (known as alpha/ beta separation) so the manager can produce alpha from their best fixed interest strategies and then transfer this alpha over any benchmark that meets their needs. Managers are also using strategies such as long/short credit and absolute return strategies (where leverage is generally used to boost returns in order to meet an agreed return target) in an effort to compete with equity returns. While these products are capable of producing greater returns than an allocation to a typical global bond strategy, this additional return comes with a price: greater risk.

In most recent times, the US sub-prime crisis and the consequent credit and liquidity crunch also highlighted that a fixed interest allocation can be opportunistic, with a number of distressed mortgage and structured credit opportunity products on offer.

So the role of fixed income, which in its most traditional sense forms the anchor of any well-diversified investment portfolio by providing regular income and security of capital, has evolved over time to offer additional levels of investment return, albeit with a different level of risk.