Fixed interest: Are bonds the key to portfolios again?

By Jayson Forrest

With the market predicting a fall in the cash rate to around 3 per cent by the end of next year, bonds are again looking attractive as part of a diversified portfolio. Chris West (Context Capital), Michael Frearson (Real Asset Management), Chris Lioutas (Insight Investment Consultants), and Tim Hext (Pendal Group) provide their outlook for fixed interest over the next 12 months.

IMAP Independent Thought Conference Fixed Interest

Bonds are back.” That was the key message from Tim Hext — Head Government Bond Strategies at Pendal Group — who backed up his statement by referring to Australian Prudential Regulation Authority (APRA) data that shows that investors are allocating heavily to this sector.

“APRA recently released industry fund data which shows that in the last 12 months, industry funds have increased their allocation to bonds from 15 to 20 per cent. Industry funds manage over $1 trillion, which means that over $50 billion has been allocated to fixed interest over the last 12 months,” says Tim. “So, we are seeing significant flows into the fixed interest sector.”

As moderator of a fixed interest session at the 2023 IMAP Independent Thought Conference in Sydney, Tim says as a defensive asset, the focus on bonds reflects the concerns of investors about the economy. However, it also demonstrates the appetite they have for an allocation to an asset class that provides good income. “At 4 per cent plus, fixed interest has again become very attractive for investors,” says Tim.

Chris Lioutas is Chief Executive Officer at Insight Investment Consultants;
Chris Lioutas - Insight Investment Consultants
Chris West is Co-founder and Principal Consultant at Context Capital;
Chris West - Context Capital
Michael Frearson, CFA is Director, Head of Fixed Income at Real Asset Management Group.
Michael Frearson, CFA - Real Asset Management Group.
Tim Hext - Head Government Bond Strategies at Pendal Group.
Tim Hext - Pendal Group.

APRA recently released industry fund data which shows that in the last 12 months, industry funds have increased their allocation to bonds from 15 to 20 per cent. Industry funds manage over $1 trillion, which means that over $50 billion has been allocated to fixed interest over the last 12 months. So, we are seeing significant flows into the fixed interest sector

Tim Hext

Engaging investors with fixed interest

With bonds back in vogue, following a lacklustre period when both equities and fixed interest failed to perform in 2022, Chris West — Co-founder and Principal Consultant at Context Capital — believes it’s important for advisers to re-engage their clients with fixed interest.

“When discussing the role of fixed interest in a portfolio with clients, you first need to think about the overall objective of the portfolio,” says Chris. “The actual role of fixed interest in different risk-adjusted portfolios — like conservative, balanced, growth and high growth — needs to be thought of differently.

“For example, a conservative investor is most likely wanting capital stability and income. However, as you go up the risk spectrum, the more risk investors take on. Therefore, the role of fixed interest changes. So, from capital stability and income for a conservative investor, we go to downside protection for a high growth portfolio.”

According to Chris Lioutas — Chief Executive Officer at Insight Investment Consultants — when framing the conversation about fixed interest to clients, he believes it’s important to consider fixed interest from a client sub-sector perspective.

“Bonds are a misunderstood asset class,” says Chris. “The level of education and understanding of bonds is very different amongst clients. The way we approach fixed interest is from a number of angles. It can be from the client’s risk tolerance perspective, or their experiences with investing, or it can be based on the type of clients we have, like retirees.

“If an adviser’s client subset are all pensioners, that’s a very different portfolio to a client subset of accumulators. So, we spend a lot of time with clients as part of the onboarding process to determine what they’re trying to achieve. We then match their needs and objectives to appropriate investment strategies — like risk profile-based, goals-based, and outcomes-based strategies.”

Chris says it’s critical to properly understand the investment objectives and risk appetite of clients. This generally means different fixed income types for different clients.


Bonds are a misunderstood asset class. The level of education and understanding of bonds is very different amongst clients. The way we approach fixed interest is from a number of angles. It can be from the client’s risk tolerance perspective, or their experiences with investing, or it can be based on the type of clients we have, like retirees.

Chris Lioutas

An income-focused approach

Real Asset Management’s approach to fixed interest is a little different to other managers. It has an income-focused managed account, with its investment universe restricted to ASX-listed securities and ETFs. It uses ETFs to keep the underlying cost down for investors, while also providing RAM with a large range of sub-sector exposures, particularly in fixed interest.  

According to Michael Frearson, CFA — Director, Head of Fixed Income at Real Asset Management (RAM) — the way in which RAM builds a portfolio to generate income is by taking a diversified approach, where it blends ASX-listed hybrids with some high-quality government bonds and floating rate exposure.

“This approach provides a diversified solution for clients, and it also provides them with regular income,” says Michael. “In the current environment, with the cash rate at 4.1 per cent, you’re at a 10-year high with income from high quality investment grade assets,” says Michael.

With the current high cash rate, Michael believes there are signs there is a slowdown in the economy, pointing to weakening consumer spending. And with the market widely forecasting the cash rate to fall to 3 per cent by the end of next year, he believes this will be the type of environment where bonds look particularly attractive as part of a diversified portfolio.

“We still think a return of around 6 per cent for investment grade diversified portfolios is the figure that will make fixed interest generally more attractive to investors. There are more speculative exposures that will return 8-10 per cent, but investors need to ensure they understand the risks involved. Given the point in the cycle that we’re currently at, and the outlook for a potential slowdown, it might be a good time for investors to move back up the quality curve,” says Michael.

We still think a return of around 6 per cent for investment grade diversified portfolios is the figure that will make fixed interest generally more attractive to investors. There are more speculative exposures that will return 8-10 per cent, but investors need to ensure they understand the risks involved. Given the point in the cycle that we’re currently at, and the outlook for a potential slowdown, it might be a good time for investors to move back up the quality curve.

Michael Frearson, CFA

Retirement planning

With more Australians now in the decumulation phase of their retirement, fixed interest is a key component of many retirement strategies and products. There is a broad spectrum of retirement products available in the market, ranging from term deposits, annuities, through to structured products.

“Compared to where bond investing was 15-20 years ago, there is a considerable range of investments that advisers can use today as part of their fixed interest toolkit — like unlisted managed funds and ETFs,” says Chris Lioutas.

When considering the value of retirement products, Insight Investment Consultants thinks about them from the perspective of how they fit in an adviser’s toolkit. This includes: can they be used in a core model portfolio; does an advice firm actually appreciate the use of them; or is it best just to stick with traditional fixed interest investing to achieve the outcomes that have been set?

Tim says it helps that long rates are now providing investors with a decent return. “Even in the state government space, you can get over 5 per cent for a 20-year investment, which is attractive compared to cash rates at 4.1 per cent. Again, the defensiveness of fixed interest provides protection against an economic downturn, whilst also rewarding investors.” 

Chris West believes that when it comes to retirement planning, the complexity of strategies needs to be properly priced, and not just at a portfolio level but also at a client interaction level. He adds the same applies for any retirement product.

“In relation to retirement products, beginning with a term deposit is probably a great starting point for many investors,” he says. “Why overcomplicate things and create anxiety and confusion for clients, when the real value of an adviser is delivering trust and understanding, while helping to simplify the financial planning process and provide clients with peace of mind.”

Having the simplicity of segmenting the capital in the client’s head helps them to stay invested in the market, while cushioning them from market volatility, which is critical in relation to longevity risk — the risk of investors outliving their savings – which is one of the biggest risks facing retirees today.

Chris West

Longevity risk

However, Chris concedes that when it comes to investing, too many retirees tend to underinvest in risk, and go completely defensive with their investments by cashing out their capital and investing in a term deposit upon reaching their preservation age.

But by using life/longevity tables, advisers are able to demonstrate the likelihood of a client’s life expectancy — based on a range of factors — and the expected drawdown of their capital over time. This illustrates the need for clients to remain invested in the market.

“One of the benefits of retirement planning is for advisers to help their clients through their retirement journey by staying invested in the market. The advice firms we partner with use a bucket strategy, which separately contain cash and growth allocations.”

Essentially, the bucket strategy involves segmenting a client’s capital into two or more pools or buckets. For example: a ‘cash bucket’ with safe investments for pension payments expected over the short-term (three to five years); and an ‘investment bucket’ invested in growth assets, like equities and property, for the intermediate or long-term.  

“It’s a simple retirement strategy,” says Chris. “Having the simplicity of segmenting the capital in the client’s head helps them to stay invested in the market, while cushioning them from market volatility, which is critical in relation to longevity risk — the risk of investors outliving their savings – which is one of the biggest risks facing retirees today.”

Tim agrees, adding the lack of focus on inflation by both advisers and investors is a cause for concern. He says most people don’t focus on ‘after-inflation’ impacts.

“One of the reasons consumer spending is so weak at the moment is because wages and investments haven’t kept pace with inflation, and people have actually gone backwards financially,” says Tim.

“Instead, there needs to be a conversation with clients about hedging their inflation liabilities, so their purchasing power today will remain intact tomorrow. Just knowing that your money is going to buy what you need going forward in retirement is a great starting point for most retirement planning discussions.

“It’s the defensive qualities of capital stability, coupled with income generation, that makes fixed interest such a key part of any diversified portfolio.”    

About

Chris West is Co-founder and Principal Consultant at Context Capital;

Chris Lioutas is Chief Executive Officer at Insight Investment Consultants; and

Michael Frearson, CFA is Director, Head of Fixed Income at Real Asset Management Group.

They spoke on ‘Fixed Interest: Are bonds the key to portfolios again?’ at the 2023 IMAP Independent Thought Conference in Sydney.

The session was moderated by Tim Hext — Head Government Bond Strategies at Pendal Group.

 

 

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