High returns can be accessed from fixed interest markets, but it is vital that investors have a portfolio that is properly diversified if they want to keep the returns they have captured, writes Warren Bird.
Many investors have reassessed their allocation to fixed interest in the wake of the heightened volatility of markets.
While term deposits have provided a safe and sometimes attractively yielding option, other fixed interest investments have also been on the radar for many, and the government is pursuing the development of a retail corporate bond market to provide additional options.
As investors consider these possibilities, it’s important they have a clear understanding of the risks that they are taking and how best to manage them.
Corporate bond risk
The most important thing for investors to appreciate is that the portfolio construction principles used when investing in equities are not transferable to a corporate bond (credit) portfolio.
With an equity investment, the investor has downside risk if the company fails. Being last in the capital structure in the event of a windup, equity investors often lose all their capital in that situation.
Offsetting that risk is the potential for very significant upside if the company succeeds.
Credit investments, however, display an asymmetric return profile. The upside is limited to the yield that the investment pays.
Risk is concentrated on the downside – if the issuer defaults, capital and future income can be lost.
Ranking ahead of equity, bond-holders typically enjoy some recovery of capital if that happens, but corporate bond investors should plan on incurring some losses at some point in time.
However, the potential for losses should not scare investors away from investing in corporate bonds.
Fixed interest portfolios that include credit provide a very reliable return if the risk of loss is managed to minimise the impact of portfolio defaults. Diversification is the key, if done properly.
Diversifying fixed interest
Proper diversification in fixed interest requires many more individual investments than in an equity fund. An equity portfolio as small as 30-40 companies can be diversified enough to deliver a strong return even if two or three of the companies fail.
However, a credit portfolio of 40 holdings that is generating, say, an additional 2-3 per cent in yield above the risk-free return, will probably have that excess return wiped out if two or three of the companies fail.
There are two keys to proper diversification in fixed interest.
First, the correlation of defaults within the portfolio needs to be minimised. Default correlation tells us the likelihood that two different borrowers will default at the same time. Often, due to industry factors, defaults can occur in clusters.
Portfolios that hold assets with a high default correlation are not only more exposed if a default occurs, but also are more likely to experience default clustering than those with low default correlations.
Proper diversification requires investments to be held across as many industries as possible and in as many countries as possible.
Second, individual exposures need to be limited to very small levels. Quite simply, if there’s a credit that represents 10 per cent of the portfolio’s value and that’s the holding that fails, then the portfolio wasn’t properly diversified.
Active management
The principles of diversification need also to be supplemented by active management.
At the security selection level, this requires credit research to monitor the financial health of each issuer and detect problems as early as possible so that the exposure can be sold.
Loss minimisation by holding small exposures is one thing, but it is far better to avoid owning a loss-making proposition in the first place if possible.
Relative value analysis needs to be undertaken. Credit spreads can become too tight and investors should reduce their overall credit exposure at such times.
For instance, in 2006 credit spreads were very tight and it was appropriate to hold underweight credit risk, but by 2009 the value proposition for credit had become compelling.
Active management can take advantage of such opportunities as they arise.
Managed funds come into their own
Diversification like this needs an investor to own literally hundreds of individual corporate names.
This is where managed funds come into their own. Proper, thorough credit risk management requires a financial capability, research resources and access to capital markets that is beyond the reach of all but a handful of very wealthy individuals.
Professional fund managers have the resources and market access to do the job, carrying out their fiduciary duty on behalf of investors.
Warren Bird is the co-head of global fixed interest and credit at Colonial First State Global Asset Management.
