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Smart Investing
Fixed interest a safe haven in stormy times
 September 24, 2007
Robin Bowerman
The market shakeout in recent weeks affects people in different ways.
For some it has been a buying opportunity – with money streaming into super because of the June 30 deadline many investors and advisers were happy to get money in through the super door before it shut and parked it in cash.
The market drops clearly prompted some people to allocate the money into growth investments. But for others the sudden dips and rebounds cause severe indigestion.
One investor recently spoke of his frustration. After several years of heavy salary sacrificing – he was a dogmatic super sceptic until his mid-50s – he had just got his super to the point where he was comfortable with his financial planner’s projections for how long he could fund his lifestyle in retirement.
But his concern was that the portfolio was market-linked – and he knew only too well that that means it can go up and down. So what he was looking for as he got older was a little more certainty – something more guaranteed.
Now you can buy guaranteed income stream annuities. But they are not popular for a couple of good reasons – the returns are not that attractive because these are expensive products for a life company to provide a guarantee for but most importantly these products involve handing over a lot of capital – with a subsequent loss of control.
That is a real show stopper for most people.
Now financial planners tend to divide into two camps on this issue. One group will wind back exposure to growth assets fairly dramatically – capital preservation being the dominant aim. Others argue that when you retire you still have an expectation of 20-30 years to live so you have plenty of time to stay invested in growth markets and let the economic cycles run their course. That is terrific but one thing changes when you retire – the ability to replenish the savings from earnings if investments go bad. So the aversion to loss of capital logically increases at the time of retirement.
This is where asset allocation is a powerful risk management tool. Fixed interest returns in recent years have been low but the volatility of recent weeks underlines the importance of fixed interest investments in a portfolio. Investing in high grade corporate or government bonds can lower a portfolio’s overall volatility – and therefore the risk of nasty negative return surprises. It does not provide a capital guarantee because bond valuations fluctuate based on the yield or coupon rate and the term the bond has to run.
To illustrate the point look at the returns (after fees) in July for Vanguard’s Australian share fund – it was down 2.1% for the month in line with the sharemarket in a volatile month. Compare that to the diversified bond fund that invests in a blend of government, semi-government and semi-corporate bonds both in Australia and internationally. In July the fund’s value increased almost 1%.
Another way of looking at the power of fixed interest in portfolio protection is to look at the returns from Vanguard’s range of diversified funds which have varying levels of fixed interest exposure. The growth portfolio with 30% in cash and fixed interest lost 1.6% in July; the balanced fund with 50% in cash and fixed interest lost 1.05% while the conservative fund which has 70% in cash and fixed interest saw the portfolio dipped a modest 0.45%.
The message from these fund allocations is that as the amount of fixed interest increases in the portfolio the volatility – at demonstrated in July this year – dropped. One month is a very short window and the trade-off is the longer-term return. Past performance is not necessarily and indicator of future performance but over 5 years the diversified bond fund has delivered 5.6% a year; the growth portfolio in the same time has returned 11.5% a year.
There is no escaping the trade-off between risk and return but fixed interest has a real role to play as a defensive asset and as investors in some hedge funds have found out recently the thing you need to be really confident of is that when markets are bouncing around your safe haven assets are just that.
More articles from this week's CompareShares newsletter:
Stocks: Five stocks not exposed to US downturn
CS stock lab: Guide to analysing stocks
Managed Funds: Smart funds for hardened share punters
Resident Trader: Low-risk forex trading
Smart investing: A safe haven in stormy times
Analyst report: Beaten down stocks to watch
Commodities: Gold set to continue its run
Stock of the week: Swick Mining
Options: Become a better share trader by understanding options
Whatever your views, you can discuss this article - or any of Robin's articles - on our message board Your 2 Cents.
Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia and the former managing editor of Shares and Personal Investor magazines. To receive this column by email each week go to http://www.vanguard.com.au/ and register with smart investing.
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