'Fixed income' is a broad asset class that includes government bonds, corporate bonds, and asset-backed securities. It is called 'fixed income' because these assets provide a return in the form of fixed periodic payments.
Fixed income investments are defensive in nature, and generally less volatile than equities. They have the potential to provide investors with benefits such as capital preservation, income generation and diversification.
Fixed income comes in many forms
The types of fixed income investments and their relative risk levels are summarised below.
Why invest in fixed income?
An allocation to fixed income assets can play a vital role in managing total portfolio risk. It can be used to provide diversification from equity risk, a potential source of liquidity, potential regular income or even as a potential source of total return.
1. Potential regular income: Fixed income can provide a regular and reliable source of income
Coupon income is the key source of returns for fixed income securities, or bonds. Coupons are regular, contractual payments, paid throughout the lifetime of a bond. As a result, fixed income generally contains an explicit income obligation, providing more predictable income streams.
In comparison, dividends from equities are highly reliant on company profit and ultimately are discretionary, so they can fluctuate significantly. As such while not guaranteed, an allocation to fixed income has the potential to provide more predictable and reliable sources of income.
2. Diversification: Fixed income can offer diversification benefits against equity risk; potentially with benefits greater than what could be sourced from cash
Economist and Nobel Prize winner Harry Markowitz coined the phrase “diversification is the only free lunch” in investing. This refers to the concept of diversifying risk across multiple asset classes in order to maximise risk adjusted returns and smooth the overall investment journey.
An allocation to more defensive assets, such as fixed income, has the potential to help to protect portfolios against equity market volatility. Bonds generally exhibit a lower risk, or variation in returns, and over the long term are negatively correlated to equity returns, with the ability to provide a buffer to a diversified portfolio during times of stress.
For example, a simplified balanced portfolio of 60% equities* and 40% bonds* would have recovered its losses during the Global Financial Crisis in almost half the time of a 100% holding in equities*.
Months to recover from a crisis
Source: Macquarie and Bloomberg. For Japan, calculation based on the *Tokyo Stock Exchange Price Index and *10-year Japanese government bonds. For Australia, calculation based on *Australian All Ordinaries index and *10-year Australian Commonwealth Government Bond. 1987 period begins October 1987, 2007, period begins November 2007, 1986, period begins December 1986.
3. Liquidity: Fixed income can provide a source of liquidity
Liquidity is the ability to convert an asset into cash quickly and efficiently, when needed. The liquidity profile of an asset is a significant consideration when investors seek to access the wealth they have built. As the COVID-19 pandemic has demonstrated, liquidity remains an important requirement for investors. Even though the COVID impacts on markets were transient, some investors were left with illiquid assets and forced to sell in weak market conditions.
Fixed income provides access to a large, global market of securities, more than double the size of global equity markets and almost 80% larger than Australian equity markets. As such, an allocation to daily liquid, fixed income assets have the potential to provide an important source of liquidity for investors, enabling access to investments quickly and efficiently. Examples of more liquid fixed income investments include government bonds, semi-government bonds and some corporate bonds.
4. Return potential: The fixed income universe is wide and diverse, and can offer opportunities for compelling returns
Fixed income markets are the largest capital markets in the world, providing a range of attractive opportunities for investors across the risk / return spectrum over the long term.
Importantly, actively managed solutions can help to provide additional potential returns derived from fixed income markets. Professional fixed income managers seek out active investment opportunities whilst managing downside risks with the aim of delivering a smoother return profile for investors.
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