Backing yourself with fixed income

Planner allocation to fixed income has declined year-on-year since 2012, but will market volatility and a turbulent share market will force them to re-think their options for the sake of diversification?

Australia is in a unique position compared to the rest of the world: it is perhaps the only market that has not experienced a recession in the last 20 years, which means financial planners may have forgotten what it is like to weather long-term periods of negative returns in risk-on or equity assets.

Fear lingered over investors post-global financial crisis (GFC) due to unstable markets, which led them and planners to seek shelter in defensive assets like fixed income, cash and term deposits.

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However, that fear seems to have well and truly subsided. The love affair with equities has continued in Australia, with investors having a bigger exposure to equities in their portfolios than their overseas counterparts.

The year began on a bumpy note, with the first two months of 2016 seeing a rampant financial market sell-off. Industry pundits have warned of more volatility in equities and bonds throughout the year due to China's economic rebalancing, the energy sector dealing with plummeting oil prices, and lack of confidence in monetary policy.

The last time investors experienced market volatility to this degree was in 2012, and they rushed to products like cash, term deposits, and fixed income.

But it's different this time.

Investment Trends research showed that where there was a flight to safety in the form of increased use of fixed income investments in 2012, clients are demanding growth in their portfolios in 2016.

Investment Trends' head of research, wealth management, Recep Peker, said return expectations were low among clients, and the demand for growth was seeing continued upside for managed investments.

The October 2015 Retirement Planner Report, which was based on an online survey of 676 financial planners, showed that while planners allocated 32 per cent of new client money into bonds, term deposits, and cash products for pre-retirees in 2012, this had halved to only 16 per cent.

It has been a gradual decline: fixed income allocation stood at 22 per cent in 2013, and 19 per cent in 2014.

A third of new client money was going into fixed income investments, down from 39 per cent in 2012 (see chart below).

Chart 1: Overall asset allocation averages among financial planners

p20 fixed income

Source: Investment Trends Adviser Product and Marketing Needs Report 2015

More planners were using diversified and income funds, and even bond funds and infrastructure funds, Peker said.

"Infrastructure funds are quite popular right now to get the yield exposure, and you get exposure to a diversified range of bonds with bond funds, and that's what the advisers have been using."

Part of the reason for the difference in fixed income allocations from 2012 to 2016 was because planners still believed in the equity story.

They expected the share market to grow by 7.8 per cent per annum over the next 20 years, which indicated they were still taking a long-term view of the markets.

Peker emphasised, however, that falling fixed income flows did not necessarily mean planners were not using the fixed income option; rather it meant that they were obtaining it in different ways.

While allocation to fixed income products remained low, advisers said they would like to increase their use of enhanced cash exchange traded funds (ETFs), government bond ETFs, listed corporate bonds, and floating rate bonds.

BT Investment Solutions' head of sector portfolio management, Ron Mehmet, said advisers did not need to consider fixed income investments in recent years as they were comfortable investing clients' money in term deposits when banks offered special rates of five or six per cent.

However, as the Reserve Bank of Australia (RBA) lowered the cash rate to two per cent and overseas bond rates were also very low, advisers moved into fixed interest funds with the aim of generating better rates than those offered in term deposits.

"However, the trend has been that they've gone into areas like credit whether it's investment grade or high yield credit," Mehmet said.

"They've gone into areas of corporate bonds or even into hybrids because they can get maybe two, three, or four per cent higher than cash rates and they see returns of four, five and six per cent, which is better than term deposit rates."

Weighing up the opportunity cost

Mehmet acknowledged that many planners would look at the yields on offer and question why they would invest clients' money in something that was half a per cent, and could hit zero, when they could opt for something more promising like hybrids.

They would also question the benefits of investing in bonds when yields were at the same rate as the cash rate or below on a risk-adjusted basis, and would perhaps prefer staying in cash and term deposits.

"However, they forget the risk that if this volatility continues, the RBA may have no choice but to cut rates even if it doesn't want to," Mehmet said.

"Now, if the RBA is forced to cut and suddenly the cash rate in Australia becomes 1.5 per cent, guess what, you needed to be in bonds because they're rallying again and you'll get a big capital gain. That's the opportunity cost they may miss."

The overriding case for allocating to fixed income, however, was not for the movements of the cash rate, but for diversification benefits.

Aberdeen Asset Management's head of Australian fixed income, Nick Bishop, said that pessimistic global macro developments such as a slowing Chinese economy, drop in commodity prices, and challenging conditions in emerging markets had negatively impacted equity markets as much as it had bond yields.

"The fact that we're at record low bond yields is not only a challenge for a planner from a fixed income perspective, it's also a challenge in thinking about how many risky assets I own, full stop," Bishop said.

Despite the continuing appetite for growth among clients, the onus was on financial planners to prepare clients for a climate of lower returns in a world of low interest rates, slowing economies and no inflation.

"It's wrong to expect bond yields to be heading back to five, six per cent, just as we think it's wrong for global growth to be accelerating aggressively, or Australian growth to be accelerating aggressively within a very slow growth backdrop which will last for quite some time," Bishop said.

Australian Corporate Bond Company (ACBC) chief executive and co-founder, Richard Murphy, warned that clients would not get a truly senior, defensive return at rates like five per cent.

If investors were offered five per cent returns, they would have to wonder if the bond was from a company lower down on the ASX, more risky, and therefore question whether it was truly defensive.

He said senior corporate bonds might offer three to five per cent.

"Beyond that, the bond itself is more risky because the company's more risky; so a senior bond issued by company 850 is not really going to be that much different to equity because the company might collapse in a heap in a week's time," he said.

Other than playing the diversification role in a portfolio, fixed income investments suited those clients who were willing to take a bit more risk than term deposits for a higher return.

"It's those senior bonds, whether they're corporate bonds or government bonds on the Australian Securities Exchange, that are the next cab off the rank from the term deposits in terms of a bit of higher risk. But you get higher returns and what you don't get is the volatility that we're getting now," he said.

Bishop noted that many retail investors were under the impression that owning listed hybrids, which are regular higher income paying instruments, was sufficient enough in terms of a client's fixed income exposure, but warned clients would be disappointed with the returns in the last few quarters.

"Prices have dropped very sharply. Just to pick some names like Santos or Origin, those hybrid prices have dropped 20-30 per cent over the last nine to 12 months. That's not a very defensive fixed income-like outcome because they are more closely correlated to equity risk," he said.

Bishop emphasised that clients were looking for simplicity, and said if investors had stuck to plain and simple products, like ETFs or even passive bond allocations in Australian domestic bonds, they would have seen returns of about 16 per cent against the benchmark.

Factors to consider

Advisers have to consider several factors when allocating to fixed income investments, and must choose quality bonds carefully to mitigate the risk of volatility on a client's portfolio.

Western Asset Management's head of client services and marketing, Michael Dale, said advisers had to decide whether they would prefer to go domestic or global in their fixed income allocations, as well as decide on whether they wanted an active or passive manager.

"Of course working for an active manager, I would highly recommend an active management strategy given such dispersion of central bank monetary policy at the moment and given such an opportunity set to add value; but also to go active rather than passive in the local market," Dale said.

FIIG's head of personal and intermediary clients, Grant McCorquodale, said advisers' biggest role was to help clients who have created capital and were transitioning into retirement, adding that clients would want to move from growth assets to income assets to sustain them through the next 25 years of retirement.

"It goes from pre-retirement and 70 per cent growth focused and 30 per cent income focused into retirement which becomes a 70 per cent income focused and 30 per cent growth," McCorquodale said.

McCorquodale said market volatility was as much an emotional measure as it was a financial measure and planners needed to allocate to fixed income to ensure clients do not lose confidence in their investment strategies.

He also said that while bonds were only accessible to institutional and corporate investors as minimum parcel amounts were $500,000, this could change as FIIG was offering Australian and international bonds in parcels starting from $10,000, with a minimum portfolio balance of $50,000.

"Private investors and advisers have shown that there is an enormous appeal for clients to have direct fixed interest and that's now on the way in transition," he said.

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