Wednesday 02 December 2020 by Darryl Bruce Portfolio-Construction-800 Company research

Portfolio Construction

2020 has been an incredible year which has thrown many unexpected challenges both at the markets and at us personally. Despite having lived through working from home, including home schooling two children, I am not sure I consider myself to be an expert in that particular area. In regard to the challenges thrown at us by the market it is portfolio construction that often dictates how investors manage to weather the storm.

I have been presenting portfolio construction seminars in our Perth office for many years. One of the things that I have said consistently is that whilst it is usually very hard to predict what will cause the next financial/economic crisis we do know that they arrive periodically.

As such, it is prudent to have a portfolio that is not purely designed for stable or bull markets. It will always be bear markets, not bull markets, that will be the ultimate test of portfolio construction. In 2020 we have seen that some businesses have thrived through COVID and others effectively became zero revenue businesses overnight. Having a well-constructed portfolio can make a huge difference to negotiating the challenging waters of a recessionary environment.

Building a suitable portfolio is almost always about trying to balance competing interests. In most cases the key balance to strike is between risk and return. A portfolio that has very little risk is unlikely to offer much by way of return. A much higher yielding portfolio might offer an eye-catching return but the risk is unlikely to appeal.

There are numerous considerations to take into account when constructing a fixed income portfolio. I like to think of it as part art and part science. There are broad guidelines that deserve close attention but there are also areas that allow investors to express their personal views more freely. In this article I cover a number of the areas that require close consideration and offer a few thoughts on each.

A logical starting point is looking at the exposure to the three different types of bonds.

  • 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.

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Often investors look to start with a portfolio that has a 1/3 allocation to each type of 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 your 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 over floating rate bonds, and vice versa.

Given that the future is always uncertain here are nine other areas to consider when putting together a fixed income portfolio.

  1. How much income do you need to maintain your lifestyle?
    Investing in securities that have a known income can give you more certainty around your income stream.
  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?
    The market is not necessarily efficient at all times, however if a bond is offering a higher yield it is safe to assume that it is coming with higher risks.
  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.
    Looking at position sizes, a broad rule of thumb that I like to follow is holding up to 10% of a portfolio in an individual investment grade bond and up to 5% in individual high yield or unrated bonds.
  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, it should be considered in light of the above. For investors targeting higher returns I think portfolio construction is even more important. I am very comfortable with high yield bonds, however I think exposure is best achieved through a large number of bonds with a relatively small exposure to each individual issuer.

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 being excessively 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.