Fix your returns

PORTFOLIO POINT: Looking around for less volatile alternatives to equities in your SMSF? Your solution could be fixed interest. But how do you get yourself some?

Have equities been providing you with less joy than a naked romp in a prickle field?

Are you suffering from volatility fatigue? Are you one bad day from selling up and leaving the market forever?

Unlikely. As you are readers of this column, you’re made of sterner stuff. And I’m guessing, far from being panic merchants too fearful of making a wrong step, you’re actually wondering how to make the most of the opportunities presented by current conditions.

But the volatility can be tiring and stressful. And with the risks for interest rates on the negative side – banks have already begun slashing term deposit rates – there’s unlikely to be too much joy found in cash.

The alternatives

There are four asset classes. In generally accepted order of risk and return, they run cash, fixed interest (or bonds), property and shares.

Interest in fixed interest is on the rise. And, arguably, it is an asset class that the vast majority of super funds, including self-managed super funds, should be in. But, as a result of a very long period of poor performance until about 2008, it has been a somewhat neglected asset class.

If you’ve had enough of the volatility of equities and don’t believe there’s much in the immediate future for cash, then it’s time you got yourself at least an understanding of fixed interest as an asset class for your SMSF.

The absolute basics

Cash is you giving your money to a bank and them then taking the risk on lending the money out to borrowers, including governments, businesses and individuals.

Fixed interest is, at its core, you lending the money directly yourself, predominantly to governments and corporations. You’re taking a bigger risk, including that the borrower won’t repay the debt when it falls due. For that, you deserve a higher return, which fixed interest/bonds usually do, over longer periods of time.

Bonds pays coupons (while cash pays interest) and they sit well above dividends in the priority for repayment by the borrower. If a company/business/government doesn’t pay their coupon, they are in default, which is far more disastrous for confidence than not paying a dividend.

Fixed interest is a regular source of income, usually six-monthly or quarterly.

A major difference is that the value of the “loan” can fluctuate, based on interest rates, the health of the company, when the bond was issued and how long until maturity, when capital will be repaid.

Fixed interest is, by no means, homogenous. As an asset class, it is almost as broad and complex as shares and property, with similar abilities to out- and under-perform.

How do I get some?

If you are in managed fund super (industry, government, corporate or retail funds), then there’s a good chance that you have some money in fixed interest. Call your super fund and ask for a breakdown of the asset allocation.

When it comes to diversified managers, all but pure growth funds (all shares and property) will have some money invested in fixed interest. How much you have in fixed interest will depend on your election over how much risk you are prepared to take.

But those who start up SMSFs often do so because they have a specific interest in equities or property. And outside of that, cash is a fairly easy asset class to understand.

Access to investments in fixed interest for SMSFs is not particularly difficult. The major decision is one of scale.

Managed funds versus direct

Like everything, you have a broader choice with your investment options when it comes to SMSFs and fixed interest.

It is reasonably easy to gain access to fixed interest investments through managed funds. However you will find a similarly confusing array of managers and styles when it comes to fixed interest/bonds as there is in equity funds.

The downside of all managed funds is one of cost. You will incur management expense ratios (MERs), which will impact on returns. Those costs are typically between 0.3 and 1.2%, depending on whether you’re invested through wholesale or retail funds. But for that, you will get instant diversification, which is difficult in the direct bond market.

Through most retail investment platforms (for SMSFs) or retail super platforms (for non-SMSFs), you will be able to get an array of fixed interest investment choices.

And that’s where your research skills will have to kick in, if you’re fond of doing that sort of thing yourself (or speak to a quality financial adviser).

International versus domestic, what sort of fixed interest is being invested in, management expense ratios, platform fees … all have to be considered.

Personally, I’m a fan of index funds for this sector (such as Vanguard and Blackrock), unless you have particularly large amounts to invest in the sector, when it can make sense to purchase bonds directly.

Almost more so than any other asset class, index funds seem to outperform peers in this sector, in that they are usually top quartile. (The performance of most managers, given the opportunities, is incongruous.)

Managed funds – be wary

Because the asset class is so broad, make sure that you know exactly what your fund is invested in. (And it should go without saying that you shouldn’t simply chase historical returns.)

A lot of the “frozen funds” from 2008 – when the rush from risk to government-guaranteed banks caused liquidity problems for managers – occurred in the fixed interest/mortgage and illiquid property sectors. The pain of frozen funds is still being felt three years later.

While you can’t make the mistake of buying into currently frozen funds, make sure you research any fund you’re considering carefully so that you know what it is invested in.

The major advantage over directly purchasing bonds (next) is that you can do it with as little as a few thousand dollars through a platform.

Buying bonds direct

Investors can buy bonds directly. While retail offers of fixed interest investments do exist, they can be a little thin on the ground.

Some stockbrokers are knowledgeable enough to aid with the purchase of fixed interest securities, as are many financial advisers, who may be prepared to do so for a fee-for-service.

The problem is size. While generally the rate of minimum parcel sizes has fallen, getting a properly diversified portfolio is still going to require a minimum of $400,000 to $500,000 (unless you take up direct offers through institutions to retail investors).

How much do I allocate to fixed interest?

If you have never “sat” a risk profile test, then I do recommend doing one. A very basic one can be found on my website (click here), which will give you a rough idea of your risk tolerance and how much of your portfolio should be weighted to fixed interest.

Table 1: Risk Profile Asset Allocations

According to investment theory, a balanced investor should have around 30-35% in fixed interest. More conservative investors should have more in fixed interest than that. And all but the most aggressive investors should have some part of their money in fixed interest.

Never forget, however, the risk versus return trade-off. If you are purchasing inside your SMSF, then you might be tempted by returns to maturity of 9-10% from bonds, which are on offer.

Higher yields are offered for a reason. They generally equate to risk, such as the risk of the company defaulting, or falling over, even if that risk is small.

Australian Government bond yields, for example, will almost always be at the lowest end of the return spectrum. Everything above that base will come with a higher risk and the higher the yield, the higher the risk you’re taking.

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The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are advised to consult your financial adviser.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking.