Why Fixed Interest

Fixed interest investments offer three essential advantages:

• Diversification: fixed interest investments can reduce risk and smooth out returns across your investment portfolio.
• Income: you can enjoy a regular and predictable income from your investment.
• Security: you can invest with confidence, knowing that your capital will be returned once your fixed-interest investment matures.

Fixed-interest assets can offer these benefits across a range of economic and market conditions, including conditions that can cause wide fluctuations in the returns of assets such as shares.

Recently, fixed interest investments have also taken on a new role, helping investment managers to generate excess returns.

Diversification

Diversification is the key to achieving good long-term returns.

Investors who allocate money to fixed-interest assets, such as bonds, create a cushion against the investment losses that can occur when there is a downturn in equity markets. This is because market factors that have a negative impact on shares, such as slowing economic growth, have historically had little to no impact on bonds or have even boosted their performance. Unlike shares, bonds tend to perform well in periods of economic weakness.

While some long-term investors have a high tolerance to volatility, or fluctuations in returns, most investors prefer a portfolio that includes fixed-interest assets, smoothing out fluctuations and reducing the risk of sudden falls in value.

More Predictable Returns: Global Fixed Interest versus Global Equity

Source: Bloomberg as at 31 October 2010

The Benefits of Diversification: Combining Bonds with Equities

Source: Bloomberg as at 31 October 2010
Bonds are represented by the Barclays Capital Global Aggregate Bond Index. Stocks are represented by the MSCI World Index

Although diversification doesn't insure against investment losses, an investor can diversify their portfolio across different asset classes that perform independently in market cycles to reduce the risk of low, or even negative, investment returns.

Income

Traditionally, investors held bonds for income. A bond is a loan, so the investor can expect to receive a steady stream of interest payments for the life of the loan.

Reinvesting the interest can increase capital appreciation over time, due to the effect of compounding.

While shares might also provide income through dividend payments, companies make dividend payments at their discretion. Bond issuers, however, must make coupon payments on a regular basis.

The predictability of interest income is a central attraction for institutional investors, such as superannuation funds, because they can use the income to meet their liabilities.

Security

Fixed interest assets are typically less volatile than shares. Periods of negative returns tend to be short and modest compared to equities. As the chart below shows, since 1995 there has only been one brief period where bonds posted negative 12-month returns.

Fewer Negative Returns: Rolling Annual Returns for Global Fixed Interest

Source: Bloomberg as at 31 October 2010

Despite losses accruing to bond holders as interest rates rise¹ , the benefits to investors of reinvesting at lower prices and higher yields will eventually more than compensate investors in a higher interest-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.

1 .This is due to the inverse relationship between a bond's price and yield. A bond's price reflects the value of the income that it provides through regular coupon interest payments. When interest rates rise, older bonds may become less valuable as their coupons are relatively low and therefore older bonds trade at a discount which reduces the value of the investor's capital.

Creating Excess Returns

Over the years, fixed-interest strategies have evolved with innovations in the superannuation and funds management industries.  As a result, investment managers now use fixed interest to create excess returns, as well as diversifying risk.

These innovations include investing in global bonds, in addition to domestic bonds, and investing in new fixed-interest sectors, including emerging markets, high yield bonds and inflation-linked bonds (ILBs).

One innovation has come in the form of products that separate excess return from the benchmark return (known as alpha–beta separation). This approach allows the manager to produce alpha from their best fixed-interest strategies, while combining them with any benchmark that meets their needs.

Managers are also using strategies such as long–short credit and absolute return strategies to boost returns through leverage and meet a particular return target. While these products are capable of producing greater returns than a typical global bond strategy, they also come with greater risk.

Most recently, the global financial crisis (GFC) has shown that a fixed interest allocation can be opportunistic, with a number of distressed mortgage and structured credit opportunity products on offer. So the traditionally defensive role of fixed income has evolved over time to offer additional investment returns, though with a different level of risk.