We all have slightly different views on portfolio allocation, here we outline five FIIG experts’ views – Elizabeth Moran, Kieran Quaine, Jon Sheridan, Craig Swanger and Leigh Winton
Portfolio allocation is the perennial client question. How much do I allocate to bonds? Which bonds do I use? How much diversification do I need?
We asked five specialists for their thoughts.
Elizabeth Moran, Director of Education and Research
My theory hasn’t changed much over the years. People primarily invest in bonds for their defensive qualities – capital preservation and reliable income. Aside from that, I’m a conservative investor, having worked in the Recovery Department for a major bank and watched as people lost their homes as the consequence of poor financial decisions.
So, in terms of your overall portfolio, I’d work out what you need to live the life you want to lead and allocate that to the defensive part of your portfolio - bonds and cash. More bonds should give you higher returns, but more risk. More cash will reduce risk but also reduce returns. You need to work out a balance between the two.
For the bond part of a portfolio, I’d suggest 70% should be investment grade and 30% high yield. Both of these figures can be scaled up or down. The 70% combined with your cash holdings should be the amount you think you need to live as you would like for the rest of your life.
Don’t risk what you can't afford to lose
So, if you have large holdings, of say $10m in bonds, but think you could live as you would wish on $3m, then you might allocate $3m to investment grade bonds and be happy investing the remaining $7m in high yield.
On the other hand, I once met an investor who as a legacy, wanted to open a museum. He was intent on growing capital conservatively to protect his vision. In that instance a 90 to 100% investment grade portfolio would have been appropriate.
Across the total bond portfolio, I would suggest an allocation to fixed, floating and inflation linked bonds depending on your views of where you think future interest rates might be. Weightings might move between the three. I’ve always liked fixed rate bonds for their absolute certainty and despite the possibility of higher rates in future – I’m not convinced they will increase any time soon or by any significant amount. So, I’d be happy to hold circa 40 - 50% fixed, including some long dated protection, just in case we are in a period of sustained low interest rates.
Then I’d split the difference between floating rate and inflation linked bonds.
Like others have suggested, I’d only hold small amounts for each high yield issuer. One word of caution – watch your allocation per asset class, sector, company and geographical location. So many Australian investors are over-weight in financials.
Kieran Quaine, Chief Investment Officer, FIIG’s Managed Income Portfolio Service
Asset allocation differentials between equities, property and debt sectors will depend on your tolerance for risk, and that is usually a function of age.
Equities and property, to a slightly lower extent, have historically exhibited higher returns than bonds in the long term, but also have experienced significantly higher volatility. Younger people, in a wealth accumulation phase, can afford to suffer the short term implications of that volatility, but older people, in wealth expenditure phase, cannot.
The allocation to bonds, a defensive and more secure asset with reliable forward return projections, should be larger the older you are.
A rule of thumb is difficult to isolate, but given current life expectancy, as a general rule allocating your actual age as a percentage to the sector is a good starting point. So as you approach retirement, a 65 year old might have 65% exposure to bonds.
9The older you are, again, the less risk that should be taken. I favour a simplistic model of allocation of a larger percentage to lower risk profile assets the older you are. But risk is not just associated with credit rating. The average tenor of exposure should be shorter the older you are.
As a fair guide, any corporate debt greater than five years is considered ‘long term’, with three years considered medium term. Simplistically, the longer the investment, the higher the risk associated with the variance of performance in the business model to which the investor is lending.
So that same rule of thumb applied for the age based allocation system between asset classes could be applied to the specific bond allocation. At 65 years of age, the bond allocation could be 65% Investment Grade (IG) and 35% Non-IG (high yield or unrated), and the tenor allocation could be 65% @ 3 year tenor and 35% @ a 5 year (average tenor), delivering a near 3.75 year term to maturity target (or near 3.5 year ‘duration’).
How much (of my investable wealth) should I allocate to bonds?
As much as is possible. Diversity across non correlated industries protects investors during periods of downturns. Apply diversity to all asset allocation sectors, within reason. Direct property is difficult to diversify given minimum entry thresholds, but diversity is easily achieved via listed equities and the bond market, whether investing within a trust, or directly, taking advantage of FIIG’s DirectBond service.
Jon Sheridan, Joint National Head Private Clients
Bonds as part of overall asset allocation
When investing in bonds like every other asset class, you need to assess your risk tolerance and risk appetite.
If you have a large portfolio, which generates more income than you need, then you may have a higher risk tolerance, as any capital losses will not impact your lifestyle, although risk tolerance and appetite are not always aligned!!
Australians generally have a high risk appetite. Historically, equities and property have shown good returns, helped by a growing population and the longest period of developed market economic growth recorded.
However past performance does not guarantee future returns.
With this in mind, I would recommend generally looking at a higher allocation to defensive assets, which would include investment grade bonds and maybe even government bonds. Current super fund models show most portfolios carry up to 90% equity style risk, which is in my opinion far too high. Retirement portfolios should contain 40% defensive assets such as bonds as a minimum.
The lower yields on these investments (particularly government bonds) mean you need to be able to tolerate the opportunity cost of a lower yield as a sort of ‘insurance premium’ against a large fall in risk asset prices (equities, property and high yield bonds).
The ATO tells us that SMSFs have around 1% of assets allocated to bonds and 25% to cash. I would look to rebalance that to almost no cash (as a stand-alone asset – I would have a decent proportion of my equity allocation in cash or short dated AAA rated bonds for liquidity at the moment awaiting opportunity), and the balance in investment grade bonds, with perhaps 1/3 of those being relatively long dated government bonds.
Allocations within the bond portfolio
Diversification is the investor’s best weapon against loss. Aim to diversify your portfolio as much as possible particularly in higher risk, higher yielding positions.
This also applies to sectors, just as it does within an equity portfolio.
The safer the position in terms of credit risk, then the more comfortable I am with a larger position, and would consider a 10% allocation to a very safe bond a maximum allocation.
There are other types of risk, such as interest rate risk, which can be managed depending on your view, but again I think the principle of not having all your eggs in one basket is sound.
This means having a range of maturities so that you get your money back at regular intervals, allowing you to take advantage of the prevailing market conditions to your advantage, regardless of where interest rates are going. Managed funds do not allow you to have control of your maturity schedule in this way, and so while offering diversification, they take away this key attribute of fixed income.
For certain exposures, such as the government bond hedge I mentioned earlier, it is desirable to take interest rate exposure via a longer dated position, as this is what gives you the protection. Remaining exposures particularly in high yield credit should have shorter terms until maturity to compensate.
Finally, I would add US dollar denominated foreign currency bonds. This adds diversification, but also if history is to repeat itself in times of correction, then this should provide an added hedge to the AUD value of the portfolio.
I have preferred to take high yield positions here in recent times, up to around 25-30% of the portfolio, as we have seen a rising rate environment in the US which has made longer dated, higher quality USD bonds underperform.
This may be ending soon, and those longer bonds may well be a good place to place this allocation.
Note: In September 2017, Jon began a sample portfolio to demonstrate how an actively managed bond portfolio performs over time. To view his most recent update click here.
Craig Swanger, Investment Markets Economist
One of the most misunderstood topics in fixed income asset management is the role of currency.
A typical fixed income fund manager hedges out all currency movements because their job is to manage fixed income. They aren’t paid to help your overall portfolio; they are paid to get the best result within their specific mandate, ie bonds. But a fund manager charged with looking after your entire portfolio will use the full breadth of investment markets to best achieve your goals.
And if you are running your own portfolio in an SMSF, then that’s your job. You have the opportunity to use all the tools at your disposal, so if you feel you understand what those tools can do and the risks they bring, you should be using them in the right combinations to get the job done.
The whole point of having some of your portfolio in other currencies is to hedge the risks in your total portfolio
So here are the core principles for using non-AUD bonds in your portfolio, from the perspective of a total portfolio manager (not a fixed income fund manager!):
- The higher your equities allocation, particularly your Australian equities allocation, the more benefit you can get from this hedging strategy
- This strategy is not exclusive to bonds. You can achieve the same hedge by simply holding USD cash, using BetaShares US Dollar ETF, holding your equities in USD, or even holding property in the US
- There is however an additional advantage in using bonds for a non-AUD hedge, and that is that it provides a broader range of available corporate bonds. The US economy is obviously much larger and broader (more industries) than ours
- The logic behind this hedging strategy is simple: in the event of an equities market downturn, there is typically a “risk-off trade”, which typically pushes up the USD and pushes down currencies sensitive to global growth such as Australia. So if markets start to fear a downturn for whatever reason, your equities holdings will probably lose value, your bond holdings will probably gain value, and your non-AUD holdings will probably also gain value. As bond markets aren’t as volatile as equities and currency markets, the gain on the bonds is unlikely to offset the loss on equities, but the non-AUD has a much higher chance of doing so. And even better if the bonds and currency are combined
- For Australians, this logic is further extended by the overweight risk that our economy and sharemarket has in China’s economic health. A downturn in China would impact global equities, but more so our equities. It would also push down the AUD, meaning that the AUD value of any holdings you have in other currencies goes up. If you have an USD property, bond portfolio or share portfolio worth AUD1m today and the value of the AUDUSD falls 10% next month because of fears of a Chinese slowdown, that portfolio is then worth AUD1.1m. This will offset $100,000 worth of losses you have made on your equities portfolio.
Repeating the first principle in a different way, the point of having some of your portfolio in other currencies is NOT to punt on foreign exchange markets. Currency markets are the most heavily traded markets in the world and unlike equities and bonds, they are a zero sum game (for every person winning a dollar, someone lost a dollar). If you think you know better than the average professional in that market, there are currency trading websites (but that would be the last place I’d be putting my money!).
With all that in mind, the last point that you need to decide is USD, EUR, JPY or GBP (these are the “flight to safety” currencies that will work better in this strategy, particularly USD). For us at present, USD is really the only choice. Japan’s economy will also suffer if the Chinese economy slows suddenly, so it doesn’t make as strong a hedge; the UK is subject to high volatility at present due to Brexit; and the EUR still has some structural issues to sort through.
Leigh Winton, Head of Investment Strategy
I head Investment Strategy and therefore construct three model portfolios, which are updated monthly and can be found on the FIIG website. Each of the three DirectBond portfolios has different levels of risk. For the Conservative lower risk portfolio, I aim to have at least 10 securities in a portfolio and to have a mix of fixed, floating and inflation linked securities, with a roughly neutral split across the three security types, acknowledging the inflation allocation is often lower due to product scarcity.
For the two other portfolios (Balanced and High Yield), I aim to have at least 20 securities to reduce the single name concentration risk.
Additionally, the portfolios should have at least four sectors and staggered maturities in line with investor objectives for expected maturity cashflow and their view or appreciation of duration risk which measures the sensitivity of a portfolio to a change in market benchmark interest rates..
It is better and more diverse to have a larger number of names with smaller face values in differing sectors. This way if a single name or sector comes under pressure there is less chance of contagion across the whole portfolio.
This is particularly important since default correlation is complex.
‘Default probability’ and associated correlation is an art not a science
This is especially important as ‘default probability’ and associated correlation is an art not a science. Simply put it’s not obvious for example, if Ford goes under, whether that is a huge positive to GM as it has lost a major competitor or whether Ford is in dire trouble and it shows there is something structurally wrong with the industry.
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