SMSFs have traditionally had low allocations to fixed income investments. But a growing search for capital stability and predictable income is set to increase SMSFs’ use of this asset class to build more defensive portfolios, Richard Murphy explains.
Ask any SMSF trustee what their allocation to fixed income is like, and you’re likely to hear they have a decent cash portion and that’s about as defensive as it gets. The trusty term deposit has proven a household staple for many.
Term deposits have been useful and an important component of many investment portfolios, providing capital security and reasonable returns – at least historically.
Outside of cash, SMSFs’ fixed income exposure is minimal. Estimates from the ATO reveal as at March 2016, SMSFs held 29 per cent of fund assets in listed stocks, around 26 per cent in cash and term deposits and 17 per cent in Australian property. Investments in fixed income securities amounted to a little over 1 per cent of SMSF assets.
But there are signs of change. Global market volatility and a universal search for yield in a low-rate environment are causing investors and advisers to recognise the need for fixed income. Moreover, market innovation is opening up opportunities to invest in this important asset class.
Why the low allocation to fixed income?
The tendency of Australian retail investors to stay away from fixed income is the result of various factors. Most Australian investors were firmly entrenched in equities up to the global financial crisis (GFC), and property has been a well-understood asset class for many years. Following the GFC, bank deposits – themselves a fixed income alternative – were offering very attractive rates, and they carried the security of a government guarantee.
Most importantly, however, was the fact bonds, one of the main fixed income securities, weren’t readily accessible. Institutional investors and banks trading between themselves dominated Australia’s corporate bond market. Top 50 Australian Securities Exchange (ASX) companies issue bonds both locally and in overseas markets. Bonds traded in the professional market in parcel sizes of typically at least $500,000 – far too large a sum for most retail investors and SMSFs.
In short, many Australian retail investors and SMSFs have not had the opportunity to invest in corporate bonds. They were generally not available on the ASX like shares, and bonds were not readily available on wrap platforms.
This is changing, particularly as term deposit rates have tracked down to new all-time lows, with a strong possibility they may fall further.
Various developments over the past few years have made it a lot easier for SMSFs and retail investors to access fixed income securities.
The ASX introduced exchange-traded Australian government bonds (AGB) in 2012. This was closely followed by fixed income exchange-traded funds (ETF), which enable individuals and SMSFs to invest in portfolios of fixed income securities based on an underlying bond index.
In 2015, exchange-traded bond units (XTB) were introduced over individual corporate bonds from top 50 to 100 ASX listed companies. Like AGBs and ETFs, they are traded on the ASX. Unlike the institutional market, there is no minimum investment, so XTBs may be accessed by all investors and SMSFs on the ASX in $100 lots. This enables investors to build diversified portfolios of corporate bond exposures.
Unlike ETFs, a single underlying bond backs each XTB. Their yields are generally above term deposit rates, whereas government bond yields are below term deposits. With XTBs the timing and the coupon rate of the XTB matches the timing and the coupon rate of the underlying bond. When the underlying bond matures, so too does the XTB.
The time is right for better fixed income
We are living in a low interest rate world. And it’s unlikely to change any time soon. It’s becoming increasingly apparent that central banks – and markets – the world over, are expecting low interest rates to prevail for many years to come.
In this environment, every percentage point of investment return really matters. A 1 per cent gain or loss matters less when official interest rates and major government bond yields are about 5 or 6 per cent. When they are 2 per cent or less, as is the case now, a 1 per cent change is far more significant.
It means the capital stability that comes from investment-grade bonds is a much more important element in investing. Relative to equities, hybrids and other growth assets, bonds offer a high degree of capital stability as well as highly predictable income.
With interest rates remaining low in 2016, and volatility concerns heightened, there is a growing need for higher-yielding fixed income options, such as corporate bonds. As of the end of May 2016, Rate City statistics show average two-year term deposits were paying around 2.70 per cent. In contrast, the yields available on investment-grade corporate bonds, via XTBs, ranged from the mid 2 per cent range to high 4 per cent range. An uplift in yields of up to 1.5 percentage points over term deposits is available.
Certainly, the feedback we receive from many advisers is that many SMSFs’ interest in fixed income is growing. Moreover, as more Australians approach retirement, it’s particularly critical to consider ways to de-risk portfolios. Many of these investors are looking for an alternative that provides a step up in yield without a large jump in capital instability. For a retiree, 2.7 per cent to 3.7 per cent is a 30 per cent-plus increase in your income.
Building better fixed income portfolios
SMSF trustees and advisers, in search of yield, but with capital stability and predictability of income, recognise the necessity of this asset class. It is now more pertinent than ever to shine a light on fixed income investing in this extraordinary financial environment.
In our recent white paper, “Lower rates for longer: Implications for Australian fixed income”, we looked at four burning questions we hope will help guide better fixed income investing in Australia. Let’s take a look at a couple of these now.
Are hybrids substitutes for fixed income?
For a long time, advisers and investors used hybrids for fixed income exposure because there were simply no fixed income investment options on the ASX. This is changing, and so fixed income ETFs, government bonds and XTBs come into the picture.
Not all protagonists see hybrids as a proper substitute for fixed income assets. Many treat them as a separate asset class to which there should be a specific allocation. An increasingly common view from advisers is fixed income has a very specific meaning (that is, it refers to pure debt securities) and does not include hybrids.
Thanks in part to the volatile performance of hybrids through the GFC and in 2014, 2015 and early 2016, there is strong evidence to show that hybrids are a very particular security that can go wrong. In particular, hybrids will behave like equities at the exact time that you least want them to – when equities tumble. Fixed income is supposed to be your defence.
Specifically, hybrids can convert into equities or have their call dates deferred – or both. All hybrid income can be deferred by the issuer, or can sometimes not be paid at all. While you are compensated for these risks with a higher coupon rate, the capital instability that comes with these features means you need to monitor the capital price of hybrids as well as the income amount. Total returns could be negative for a hybrid investor if they needed to sell out early and the hybrid capital loss more than offsets any income.
In other words, while hybrids may have a place within a diversified investment portfolio, they should not be viewed as defensive fixed income.
What’s better – direct investment or managed solutions?
Two key developments over the past year or so include the arrival of XTBs and the rising popularity of separately managed accounts (SMA). SMAs have some similarities with managed funds, in that each SMA will have a range of bonds or equities, but where you own the individual underlying securities. Together they mean investors, often with support from financial advisers, can invest directly into a tailored portfolio of fixed income securities. Previously, most investors had to access fixed income securities through a managed fund or an ETF: in neither case could an investor choose the underlying bonds.
An obvious question therefore is: what is better – direct investment or investment through a managed fund or ETF?
There is no single and simple answer. The suitability of a direct approach – as opposed to a managed approach – is determined by the risk preference of the investor, the investor’s time horizon, the size of the portfolio, and whether the investor needs to accurately know the income they will receive. There are benefits for both.
If an SMSF trustee has the need to control their own duration and the specific outcome of their investment in terms of the timing of income and final principal payments, direct investment is probably the best over the long term. Bonds mature and pay income on fixed dates, so direct holdings allow for predictability of exact cash flow and return.
Understanding the capital structure
Fixed income generally provides investors with more secure and capital stable investments than equity, hybrids, property and other growth assets. But not all fixed income investments are equal. It all comes down to the capital structure.The higher in the capital structure, the lower the risk, as you’re higher in the queue if there’s a default. This lower risk means lower returns, but it also means lower capital volatility. The lower in the capital structure, the greater the return and the risk and the volatility of prices.
Figure 1: How the risk levels of different investments compare.
Price performance charts for the year ending March 2016. Source: Australian Corporate Bond Company.
Engaging with SMSF clients on fixed income
- Establish whether clients know much about fixed income – it’s likely their knowledge may be limited.
- Help clients to understand the value of fixed income and explain how it works. There is plenty of educational material available at www.xtbs.com.au.
- For clients rolling over term deposits, this is an ideal time to speak with them about reinvesting that cash into fixed income.
- For clients with hybrids that wish to reallocate these into the growth area of their portfolio, this is an ideal time to talk to them about the broader range of fixed income investments available on ASX.
Education is key
Recent market developments are paving the way for Australian retail investors, including SMSFs, to incorporate better fixed income into their portfolios.
We focus on education and supporting advisers and investors build portfolios that are more defensive. For advisers, it’s time to start educating clients about the significance of fixed income. While it may not be as sexy as shares, it should always form a critical part of a properly balanced portfolio and SMSF trustees should understand its value.
The attractions of fixed income – capital stability and predictable income – are more important now than ever before.
