Fixed income can be a crucial capital preservation component within an SMSF portfolio. Alwyn Hung highlights the asset class’s importance and explains a new way to access bonds now exists.
Fixed income has traditionally been an under-represented asset class in Australian investor portfolios. Viewed as a safe, stable and reliable asset class, fixed income’s less volatile characteristics lend it to not being a hot topic of discussion in the media, unlike shares. This, coupled with the bond market traditionally being accessed exclusively by institutions, has led to lack of interest and understanding about how fixed income works – particularly how it can help to provide a buffer from riskier assets in a portfolio.
Lack of education is one of the key reasons for the under-investment in fixed income. Recent ATO statistics indicate, as at September 2016, SMSFs allocate less than 1.5 per cent of capital towards fixed income and are carrying large amounts of risk in their portfolios, represented by high weightings to equities.
In an environment where persistently low growth and low interest rates are becoming the norm, combined with a global economy where both leverage and asset valuations continue to remain well above historical averages, the importance of fixed income in a balanced portfolio has never been more relevant.
The above factors, that are the direct result of a ‘stressed’ global financial system, prompted one of the largest fixed income managers in the world, Bill Gross, to note in a recent interview with CNBC that “as an investor, you should be more concerned about the return of money than the return on money in 2017 and beyond”. That is, protecting your capital is more important in this environment than chasing returns.
SMSF investors continue to invest with a barbell approach by concentrating their investments in more volatile equity investments at one end of the bar, with high levels of cash balances on the other side. This may not be an appropriate diversified strategy for members who are nearing retirement who typically are more focused on capital preservation instead of wealth accumulation.
Key characteristics of fixed income
Fixed income can provide an anchor point for an SMSF investment portfolio and the necessary capital stability. Fixed income is known as a defensive asset and has structural differences to equities, as outlined below:
- A defined maturity date: fixed income has a fixed term so you know when you are going to get your money back.
- Defined coupon or income: you know what you are going to earn during a period.
- Return yield can be calculated: you can more accurately estimate the return on investment.
- Increased security: you receive full capital repayment at the end of the investment and are first in line in the corporate recovery process in the event of default, resulting in increased probability of recovery of capital.
These defined metrics result in a more stable investment that allows trustees to better manage and forecast financial and investment outcomes, and provide a defensive asset in periods of market volatility.
A case for fixed income: performance of debt vs equity
A good example of how stable a fixed income asset is and how it helps to mitigate risk in a balanced portfolio is displayed in figure 1. We highlight the capital performance (not taking into account dividends or coupons) of three securities from the same issuer/company. A senior bond, a hybrid (which possess characteristics of both debt and equity) and the shares (equity) issued by National Australia Bank (NAB). As you can see, the volatility of the senior bond is significantly lower than that of the NAB hybrid security and NAB shares over the five-year period.
Figure 1: Volatility in performance of NAB – senior bond, hybrid and shares (5 years to 31 March 2017)
Source: Bloomberg and Mason Stevens. Daily change in prices. It does not include reinvestment of dividends or coupons. Past performance is not a reliable indicator of future performance.
In addition, the NAB senior bond pays a semi-annual coupon of 4.75 per cent each year, resulting in guaranteed income that is over and above what is offered if holding this capital in cash and/or term deposits.
The amount of your portfolio you allocate to fixed income will depend on your risk profile and investment time frame. Where you may need to access your superannuation funds in the short term (five years or less), then capital stability will be key. This is where you need to allocate more of your portfolio to less volatile asset classes that provide capital stability and income. Given the ATO reported in September last year that 60 per cent of all SMSF members are aged between 55 and 85, it is alarming to see riskier assets like equities make up the largest portfolio allocation, followed by cash and term deposits. This further supports the case that fixed interest is not well understood.
Accessing suitable investment products: managed funds vs separately managed accounts
Managed funds have traditionally been the primary way for retail and SMSF investors to access fixed income. They can come in the form of unlisted or listed funds and cover various investment strategies across global and domestic bonds and other credit investments. They offer exposure to a diversified portfolio of fixed income securities (as investor capital is pooled) and are professionally and actively managed to add value using various risk management tools, such as derivatives.
However, since the global financial crisis (GFC), investors have demanded more accountability from fund managers and visibility of the underlying investments they make. This has led to investors taking control of their own superannuation investment decisions, and can be seen in the growth of new SMSF establishments since that time. This has also flowed through to the retail investment market for equities. Many equity asset managers have developed separately managed account (SMA) portfolios to give retail and SMSF investors the benefits of a professionally managed investment, but with absolute see-through to the end investments, where the investor is the beneficial owner of each underlying security. With that comes greater tax advantages than having funds pooled together in a managed fund.
In the case of fixed income investment, innovation has somewhat lagged given soft demand for fixed income. What’s more, minimum tradeable bond parcels have traditionally been high, so the average SMSF has not been able to build a sufficiently diversified portfolio of direct fixed income securities. Recent advancements in investment administration and custodial arrangements have allowed investment managers to design appropriately diversified fixed income SMA portfolios.
Today, with a minimum of $100,000, SMSF investors can hold a bond portfolio directly and get exposure to investment-grade fixed income securities. The following case study highlights how a fixed income SMA portfolio works for a couple who are a year away from retirement.
Case study
Current situation Betty and John are in their early sixties and are considering retirement in the next year or so. They have some personal savings and a combined superannuation balance of $1 million. They wish to use their superannuation capital to generate income for their future living expenses.
Risk tolerance
Betty and John are risk averse given their stage of life and nervous about the share market as they experienced equity capital losses during the GFC. They are worried about the increasing uncertainty in the stability of their capital and the potential dividend yields of their current share holdings. They are seeking a strategy that limits capital losses, generates sufficient income to fund their lifestyle and doesn’t materially impact on their capital.
Current strategy – pure cash
Betty and John are currently invested in cash via a rolling six-month term deposit at a rate of 2.60 per cent a year. They receive total annual income of $26,000 or $500 per week. They use the interest earned to fund their day-to-day expenses, however, there is insufficient income to maintain their lifestyle.
New strategy – diversified portfolio
They work with their adviser to create a diversified portfolio that is in line with their risk profile. It has the potential to preserve capital and is income focused. The strategy also generates expected annual income of $46,790 or $899 per week (see Table 1).This strategy results in an 80 per cent uplift in available income and limited erosion of capital.
Table 1
Table 2: Comparison of different investment structures
Fixed income SMAs – comfort through transparency
Fixed income provides a level of capital stability and predictable income to help SMSF members with their income needs in retirement or when transitioning to retirement. While investing in a fixed income managed fund has its benefits, it also has its flaws. This is because a managed fund’s value is expressed through a unit price, which is a reflection of the managed fund’s net asset value (NAV). The NAV of a fund is the total (realised and unrealised) value of its assets minus the total amount of liabilities, divided by the number of units issued. As changes in unrealised values contribute to the value of the fund’s NAV, a fund’s performance can materially vary from reporting period to reporting period. Fund distributions tend to be based on the fund’s performance and therefore can also vary.
Through the ownership of a directly held portfolio of fixed income securities, members can directly benefit from the key attributes of what a fixed income security provides, that is, capital preservation, observable baseline performance and predictable and stable income flows. In the event where a bond issuer cannot honour its legal obligations, the worst possible outcome that a directly held bond portfolio will deliver on is its original yield to investors. For example, if you purchased a portfolio of bonds delivering a yield to maturity of 5 per cent and elected to do nothing with the portfolio over time, your return would be 5 per cent a year.
An SMA portfolio is a structure that allows the investor to directly own a portfolio of securities via a ‘ring fenced’ account. All investments are effectively registered in the name of the investor, that is, the investor retains beneficial ownership, however, it is managed by an institutional investment manager, generally under a model portfolio. This is unlike a managed fund where an investor has indirect ownership and limited visibility of where the capital is being invested. By delivering on what is being demanded by financial planners and their clients, we believe SMAs represent the structure of investing for the future.