Fixed Income is a crucially important topic because in every generation someone inevitably messes it up and when they mess it up, they mess it up royally. And to mess this up almost certainly means catastrophic (meaning non-recoverable) damage.
The basic premise of fixed income is this: you let some entity borrow your money in exchange for the promise to pay you back with interest. If everything goes right you get that money back with interest. If something goes wrong, you could end up with nothing.
The interest payment could be generous, maybe even 10%. The potential downside is horrific – minus 100%.
Essentially, there are two options when someone borrows your money:
- Option 1: Receive money back + interest
- Option 2: Nada
Of course there are some negotiated in-betweens, but it’s generally pretty ugly.
Why do I stress this point so much? It’s certainly not to scare you. It’s to point out how small investors often get this wrong. They focus, at times, almost exclusively on one number… the interest rate.
This is how they come to the conclusion a bond yielding 8% is better than one yielding 6%, or a fund yielding 7% is better than one yielding 6%.
Not necessarily.
But yet, it’s these types of simple comparisons which induce investors to reach for yield and make horrible investment decisions.
The best two recent examples are Collateralised Debt Obligations (CDOs) and Finance Company Debentures.
CDOs are the instrument that nearly brought down the financial world. They are basically a pool of loans. That pool is then divided up into tranches (or slices). Senior tranches get paid back first as each month borrowers pay back their loans. Junior tranches only get paid back once senior tranches are paid up in full. To compensate investors, junior tranches offer a high coupon (interest) payment.
These instruments were incredibly popular because they magically paid higher interest. Essentially brokers knew there were huge swaths of money available through these instruments that could be used to finance almost any mortgage. It was really just a matter of finding a willing buyer. So they did find willing buyers… that were less and less and less credit worthy.
I guess someone forgot to tell the investors that they were holding an asset backed mostly by subprime mortgage backed-bonds.
But the point is that CDOs paid higher interest then other similarly rated securities. And based on that alone, investors poured in billions.
We’re probably more familiar with Finance Companies. Yet it was much the same issue. A finance company is offering you a 9% return on your money. The boring diversified low duration fixed interest fund is offering you 6%. Hello! That’s like 50% more interest. Why wouldn’t you go for the finance company? …Because finance companies are around 100 times more likely to default than a high grade bond, perhaps?
But when the going is good no one notices and based on simple comparisons, many piled in.
Beware positively reinforced bad decisions. To be honest, many had invested with such finance companies for years and got their returns year after year. Such experience simply reinforced the idea that concentrating their portfolios in finance companies was a good idea. Coupled with this, many advisers were paid generous commissions to place their clients in such risky investments. I’m sure these debentures were easy to sell. The paid salespeople (that called themselves advisers) would simply show their clients the difference in estimated yield and BAM! A sale was sure to come.
In both situations this logic of reaching for yield proved disastrous.
Yes, it’s possible to get higher yields but to get it you generally need to accept greater risk that you won’t get paid back. The chart below explains:
In other words, yield increases with the risk of default… well we should all hope so!
But investors often just seem to ignore that inconvenient truth.
The role of fixed interest in your portfolios is to be there as a bedrock to your portfolio during the bad times. When times are good and the equity portion of your portfolio is soaring then you’re not worried about fixed interest. Those 20% to 30% returns on equities seem to lift all boats.
But when markets are bad and equities fall, as most volatile assets do during bad times, you need the fixed income portion of your portfolio to keep its value so that you can more comfortably ride out these patches in markets.
To accomplish this you must do three basic things (before the bad market hits):
- Own bonds of predominantly good credit quality (we’re talking all above BBB and mostly AAA, AA, and A)
- Own a portfolio with a relatively low average maturity. The closer the bond is to maturity the more likely the borrower is to pay you back; the more investors will want those bonds during bad times; the more you’ll get paid as someone who already owns those bonds
- Own bonds from a lot of different issuers. Think beyond New Zealand here. You want to own bonds from around the world from both businesses and governments, and certainly not concentrate on only a few issuers or types of fixed interest.
If you do those simple things then, when times are tough, your bond portfolio will shine through. 2008 was a horrible year for equity investors, yet a diversified portfolio of low risk fixed interest shined through. To illustrate our point we show you below how the Bradley Nuttall International Fixed Interest and Bradley Nuttall Global Equity Portfolios did in 2008.
Right when equity was having an horrific year, fixed interest held strong. How would the above illustration have looked if your fixed income portfolio was in Bridgecorp?
So what is the role of fixed interest in your portfolio? Simply this: to be the bedrock during bad times and provide stability. Secondary to that, it provides income for reinvestment or to fund your lifestyle.
Fixed interest is not (or perhaps should never be) a tool for speculation, reaching for yield and generating high income at any cost…. Because it could come at any cost and that cost is far too high.
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