Interest rates have increased over 4% in the past couple of years following the dramatic inflation spike in the US on 15 June 2022 (9.1%), causing cash flow pain and much uncertainty in certain areas of the market and economy affecting individuals, households and small business. However, a certain asset class has returned to significance and relevance, that is fixed interest. Fixed interest is around 10 times the size of the equity market so is meaningful, although widely misunderstood.
This is a defensive asset sector suitable for inclusion within traditional and tactical diversified portfolios, its role usually reduces volatility and provides income returns. Within fixed interest there are bonds (government, semi-government and corporate bonds), credit income (including income, private credit and debt), hybrids and convertible notes (less understood), term deposits and cash that are well known. This update excludes other income sources from growth risk assets like dividends and option income. Carries or income returns on short-dated investments have been very attractive given the risk has been so low. Good term deposit rates are around 4.65-5% for 12 months, compared to every day savings accounts that offer almost 0%. Shop around and it is easy.
Talking about defensives - bonds and credit - they are two different securities whose yields have recovered and are currently generous on a risk adjusted basis. You will usually find them in a balanced or other diversified portfolio with a meaningful allocation. In a traditional growth portfolio, defensives account for around 30% of the allocation.
Firstly, bonds have struggled of late as stubborn CPI and mixed economic data has affected sentiment, with the bond face value disguising the actual income component. Income from defensives are in fact good. As official interest rates around the world start the gradual fall to a neutral setting, sentiment will recover because the fixed interest coupon of recently issued bonds will be higher and worth more and the value of the bond will rise. Trading in bonds will become wider and diversified portfolios should stand to benefit, via potential capital gains. This risk of duration however applies if interest rate settings rise unexpectedly.
Secondly, with growth in private credit and debt (lending) investments, income can start from ~6% and above (depending on your risk and choice). Changes in traditional bank lending and new demand factors have led to a boom in alternative lending via residential and commercial origination purposes. Private debt can provide regular income even during periods of extreme volatility.
Interest and fee payments are received from borrowers at specified intervals under the binding terms of their debt contract. A floating base rate, with additional credit margin, ensures total interest income rises in line with market interest rates to combat inflation. Very attractive returns for a commensurate level of risk (should be secured lending), has proven popular for investors undertaking actual reduction of portfolio risk in preparation for or during retirement phase. Again, they are less volatile than equities and comes with a different earnings source.
Of course, there are many risks. There are two worth mentioning – liquidity risk and duration risk – however this is not an exhaustive list. Shrinking money supply (e.g. from inflation) and mismanaged liabilities or cash flows may push a borrower’s capacity or ability to meet their loan repayment obligations, loan defaults can add to fractures within an investment such as private credit and bonds affecting investor capital. Economic conditions can certainly add to this pressure, that is why quality and prudent management is a must.
Duration risk is the potential loss that an investor faces when interest rate changes, and for large upward shifts in interest rates bonds can be adversely affected. Interest rate volatility, macro factors like inflation and economic growth and credit ratings can all cause duration risk.
As defensive investors, we are better prepared for risk these days: there is better screening of borrowers, more appropriate loan agreements, well prepared managers cognisant of cash buffers and better leverage discipline ; banks are well buffered above Basel 3 capital requirements ; and regulators perform regular stress testing of both large and small credit issuers.
For these reasons we think defensives like fixed interest and credit are an attractive destination for investor money and fit well within a quality diversified portfolio where they can help reduce volatility and offer a different source of income, along with growth risk assets like equities and property.
For More Information
For assistance or more information, please contact James Cavanough at Lantern Advisory on (07) 3002 2690 or via jamesc@lanternadvisory.com.au.
