Monday 17 March 2014 by FIIG Securities FIIG Securities Legacy

A three way split will protect your portfolio no matter what happens

Weighing up the good news and the bad news and trying to decipher the implications for markets is the cause of many sleepless nights for investors

A few years ago I had a meeting with a 70 year old client, who had a funny story to tell. Overnight the US stock market had suffered a big drop and early morning indications were that the Australian market would follow and lose a similarly high percentage. He had been woken by a surprise call from his distressed 92 year old mother. Initially he thought she must have had an accident, but she was worried about the implications for her share portfolio. He told me he’d said “Mum, you know I’ve got bonds and I’m not worried about the share market”, and returned to bed.

I think if you’ve worked hard and saved for your retirement, you deserve a bit of peace and to be able to sleep well without that constant concern. Diversification will quell your nervousness as holding a range of investments across different asset classes that outperform in different economic conditions means losses in any one class will be offset by gains in another. But, if you are worried and can’t sleep at night, then your allocation probably needs adjusting. 

Too few investors hold bonds and their combined protections give investors confidence. For example if you hold bonds to maturity, you know when interest will be paid to you and that capital will be repaid at maturity. There are many strategies you can employ but if you are uncertain about the direction of financial markets, a good start up strategy is to divide an allocation evenly between the three types of bonds: fixed, floating and inflation linked.

Fixed rate bonds outperform as interest rates come down. They have an inverse relationship between yield and price, which should offset losses in other parts of your portfolio such as property and equities in a slowing economy. If income is important to you, fixed rate bonds will also protect your income stream as they pay defined half yearly interest.

Conversely, if interest rates start to rise, higher interest will be captured by having an allocation to floating rate bonds whose interest payments are linked to an underlying benchmark – usually the bank bill swap (BBSW) rate in Australia. Interest payments are set at BBSW plus a margin. Quarterly interest payments will rise with higher interest rates.

Run-away growth can lead to an inflation spiral. In slowing, or bottoming economy, governments are under pressure to stimulate economic activity through direct or monetary policy intervention. If the government gets this wrong, overstimulates, or stimulates for too long, upward inflationary pressures can result. Holding an allocation to inflation linked bonds (ILBs) makes sense before the risk of inflation heightens.  ILBs can also be an excellent investment in a low growth economy. Their known set margin above the Consumer Price Index (CPI) can be attractive when interest rates are low for long periods.

No matter what happens with conflict in Syria and the Ukraine, US tapering, the US debt ceiling or sequester, the Coalition’s first budget, domestic interest rates, unemployment and inflation;  diversifying your portfolio and holding a range of bonds should help protect your income and capital and alleviate the worry about your investments.