Wednesday 29 January 2020 by Jonathan Sheridan Education (basics)

Building a diversified bond portfolio with FIIG

Given the unpredictable nature of financial markets, it is a timely reminder that investors should always have a plan that includes protection against unexpected future events. In this article we provide nine considerations for building a diversified, defensive bond portfolio and highlight how FIIG can help investors to tailor a portfolio to their needs. 

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Bonds are a great diversifier. They can help protect your wealth and income throughout different stages of the economic cycle, while providing better returns than term deposits. If you are new to bond investments or simply looking to re-evaluate your existing holdings, this article provides a few ideas to help you determine how much you should allocate to defensive assets.

Over the years, we’ve continually recommended that portfolios should not be 100 percent invested in a single asset class, let alone a single venture. Finding a balance is important – a “no risk” strategy has its own problems; it could mean low returns and may not deliver enough income to live.

A good starting point would be to include proportionate holdings of the three types of bonds being fixed, floating and inflation linked bonds in your portfolio. Each of these serve a specific purpose

Fixed rate bonds improve future income certainty and reduce income risk by locking in future cashflows (typically quarterly or semi annual constant coupon payments)

Floating rate bonds are tied to the benchmark bank bill swap rate (BBSW) indices, and interest paid will rise as interest rates rise. Consequently, they help mitigate the risk of any interest rate rises reducing the value of your fixed rate holdings and/or overall portfolio.

Inflation linked bonds reduce the risk of inflation weakening the purchasing power of your portfolio income by having coupons and/or principal which adjust in line with CPI.

Typically we recommend an allocation of 1/3 of the portfolio to each of fixed rate, floating rate and inflation linked bonds. This is likely to give you the most stable outcome at the portfolio level regardless of the direction of interest rates. However, availability of good value bonds in each category might tilt the allocations towards one or the other type as well as our opinion on the future direction of rates. 

For example, if the prevailing view is that rates are likely to go down, then fixed rate bonds would be favoured in the allocation, and vice versa. 

Regardless of current economic climates and outlooks, investors should always have a plan that protects against unexpected future events. Here are nine questions to consider in building a diversified bond portfolio:

1. How much income do you need to maintain your lifestyle?
Investing in securities that have a known income will help achieve these goals.

2. How much capital do you need to maintain your lifestyle?
Many investors have aspirations to leave a specific amount to children and grandchildren; how do you make sure those funds are preserved?

3. How old are you?
The older you are, the more predictability you should have in your portfolio as you may have less time to recover lost capital. Consequently, most investors increase their allocation to fixed income as they get closer to retirement as this decreases the proportion in high risk assets. 

4. Do you have any known future expenses?
If you know you need funds for an event like a wedding or holiday, these funds should be set aside. Bonds can be acquired with cashflows and maturity dates to suit known future expenses.

5. What is your appetite for risk – more appropriately, how much are you willing to lose?

6. Do you have the capacity to earn income to supplement losses?
If you still work, even on a part time basis, that income will help protect your lifestyle and allow you to take additional risks.

7. Is your portfolio diversified so the investments you hold are across different sectors, have varying maturities and risk profiles?
Diversification is key to running a successful portfolio. To achieve a diversified fixed income portfolio you should hold different types of bonds – such as fixed, floating rate and inflation linked – and of varying credit quality and tenor.

8. How liquid is your portfolio?
If you need to access a large sum quickly, can you do so in an orderly and easy fashion without losing value on the investment? This is becoming ever increasingly important as deposits often now require up to a one month notice period for redemption.

9. What return do you aim to achieve?
This is often the first question investors ask themselves, and while important, should be considered in light of the above. Remember: higher returns often mean higher risk.

Helping investors to build a bespoke corporate bond portfolio

At FIIG, our staff are experts, with extensive experience working in fixed income markets in Australia and overseas. We have a vast range of best-in-class educational material to assist clients as well as a dedicated team of research and strategy professionals on hand.

FIIG works with its clients to put together portfolios that balance yield, maturity and risk to achieve investor requirements in conjunction with available securities. Such diversification reduces the risk of just being exposed to a particular company or sector.

Portfolio risk review
We review client portfolios on a periodic basis and continually educate clients on the very important considerations of portfolio diversification and individual security weightings, amongst other metrics.

These reviews are beneficial to highlight the composition of client portfolios based on certain parameters such as exposure to lower rated (sub investment grade or unrated) bonds or foreign currency bonds.

The output of these measures and risk framework adopted by our Investment Strategy Group is the production of a Portfolio Risk Review scorecard. The scorecard is helpful as it shows if your portfolio exposure still meets your investment requirements and is suitable for your acceptable levels of risk tolerance.

Call us on 1800 01 01 81 and we can show you the potential of a bespoke corporate bond portfolio.