Wednesday 22 January 2014 by Elizabeth Moran Trade opportunities

2014 watchlist for fixed income investors

This article is based on one published earlier this month in the ASX newsletter.

Key points:

  1. We expect low interest rates for the next couple of years based on revised downwards growth projections of the Reserve Bank, the OECD and forward BBSW rates.
  2. Inflation is forecast to stay within the RBA target of 2 to 3%.
  3. This is a good point in the cycle to sell out of higher risk assets and substitute lower risk assets given the differences in income is low.
  4. The new year is a good time to check your portfolio allocations and rebalance if necessary.

The New Year brings with it a natural break to step back and reassess investments for the coming year. Below is a list of five key points worth considering.

1. Interest rate expectations

Unexpected interest rate changes influence markets, as do changes to the Reserve Bank cash rate. Banks project forward interest rates every day and these are reflected through the bank bill swap rate (BBSW). BBSW is forecast to be virtually unchanged in a year’s time, implying that banks expect interest rates to be unchanged through 2014. In fact we expect low interest rates for the next couple of years based on revised downwards growth projections of the Reserve Bank and the OECD and of course forward BBSW rates.

This doesn’t bode well for term deposit investors waiting for higher rates. Next year is unlikely to deliver any material term deposit rate increases. Banks will always have a need for funds in certain maturity buckets, so look out for specials or find a broker that can find the best rates for you. Banks rarely reward loyalty, but suggesting you can find a better rate elsewhere may deliver a better rate from your local branch manager.

BBSW rate expectations are already factored into fixed rate and floating rate bond prices. Often issuers of bonds will issue a fixed rate and a floating rate option at the same time with the same maturity date. Short dated bonds from the same issuer, for example a 2014 fixed and floating bonds in the over-the-counter market, have very similar overall yields but the way in which the income/returns are delivered differs. At the time of writing, the fixed rate bond is trading at a premium over $100, so income throughout the life of the bond is higher and the investor makes a small loss at maturity when the company repays just the $100 face value of the bond. Whereas the floating rate note has lower income throughout the life of the bond, but is trading at a discount, so pays a greater proportion of its income at maturity. In that instance investors need to decide what is most important to them: the higher income on offer from the fixed rate bond during the year or the gain on the capital price of the bond at maturity from the floating rate option.

Given our interest rate expectations we still think there is merit in investing in fixed rate bonds even though there has been recent preference for floating rate bonds. Those concerned that interest rates will rise in the medium to longer term should limit terms to maturity to less than three years. However, if you think interest rates will be lower for even longer, you’ll be rewarded by extending maturities out over five years. A number of corporations have issued bonds in the five to eight year space with good comparative returns; some over 7%.

2. Inflation

Inflation surprised on the upside in the September quarter but still remained within the RBA target 2 to 3% band. We would forecast inflation to remain within the band but with so much money in global markets in an effort to stimulate economies, global commentators are now worried about inflation. An inflation spiral in the US, for example, would be reflected in our own markets and that is why we would recommend all investors have an allocation to inflation linked bonds, the only direct 100% hedge against inflation. Particularly important for those in or near retirement given inflation has the potential to erode purchasing power and retirees spend higher proportions of their income on consumables impacted by inflation. Government inflation indexed bonds are available through the ASX while corporate inflation indexed bonds are available through brokers in the over-the-counter market.

3. Compare alternate investment risks and returns

Returns available from different asset classes have been squeezed with the quest for yield. It’s worth remembering that higher returns are paid as compensation for higher risks (see the traditional risk versus return graph below). The highest risk investment on the chart is shares, while hybrids, senior debt (senior bonds) and government bonds are lower risk and thus should offer lower returns.

In a low rate environment the distinctions between different asset classes in terms of the returns offered is compressed, meaning investors are not always appropriately rewarded for risk. It’s worth reassessing your investments for risk and return. This is a good point in the cycle to sell out of higher risk assets and substitute lower risk assets given the differences in income is low.

If a high return is on offer you need to question what you are being paid for. For example hybrids can have their maturity dates extended or distributions can be stopped and there may be no requirement to make them up or in some scenarios hybrids can be converted to shares. On the other hand there is no requirement for shares to pay dividends and there is no maturity date, meaning investors must decide to sell shares to recoup capital; their return will be unknown until they sell. For these reasons you would expect the highest returns from shares.

This point leads me to the next. Investment in growth assets such as shares has it’s rewards but diversification is key to successful investing.

Risk versus return
risk versus return graph

Source: FIIG Securities

4. Diversification/ asset allocation – do you need to revise the mix?

As the major banks and Telstra shares have had a good run on the sharemarket their higher value may have distorted your asset allocation. For example, assume your SMSF worth $1,000,000 has a pre-determined allocation of 50% shares, 25% fixed income and 25% term deposits or cash. If at the end of 2013 your shares had increased in value by 30%, fixed income by 7% and cash by 4%, you may now need to alter the mix as weighting over the year has changed. That is sell down some shares and reweight to fixed income and term deposits to ensure your original asset allocation remains. Theoretically you take profits when one asset class outperforms the others and redistribute in line with your original determination.

asset allocation example
In terms of diversification you need to diversify between sectors as well as asset classes. A portfolio holding ANZ term deposits, CBA bonds, NAB hybrids and Westpac shares is over exposed to the banking sector and should seek to diversify by adding corporate bonds, hybrids and shares and investigate government bonds for even greater diversification. Given the banks are significant bond issuers and make up a large portion of the market, any corporate bond issuance is often sought after by a wide variety of investors to add diversification to their portfolios.

5. Set aside what you need for your lifestyle/ plans in defensive assets

The sharemarket’s outperformance has been a huge relief to many investors but I’d caution against over allocating to growth assets such as shares and property. These investments are cyclical.

l and while they have been great investments over the last year, there’s no guarantee they will be this year. I think it’s always prudent to determine the minimum income you need to live well and the minimum capital you need to deliver that income and invest those funds in defensive assets. 

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