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Going with fixed income

Published: 
Wednesday, March 26, 2014
Managing Your Money

Last week we started to look at asset allocation, evaluating the importance of equities even in a conservative portfolio. We put forward then what might be considered a representative target portfolio for a conservative investor. While this would have constituted 25 per cent in equities, the main component of the portfolio would be fixed income. In this case, we would target 40 per cent in TT dollars and a further 33 per cent in hard currency or currencies other than the TT$.

 

What then would constitute this fixed income of which we speak? As defined by investment information Web site Investopedia, fixed income refers to: “An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. Unlike a variable-income security, where payments change based on some underlying measure such as short-term interest rates, the payments of a fixed-income security are known in advance.”

 

The main form of fixed income would be government and corporate bonds. These could be medium to long-term in nature, spanning generally between five years and up to 30 years, from issuance to maturity. In T&T, government bonds far overshadow the corporate bond market in terms of total issuance and trading activity. When you consider investing in bonds—in this case local bonds—there are some critical questions which must be addressed. 

 

As an investor, you must ensure that yield received on your bond investment is higher than the expected rate of inflation. For example, the recent yield on a ten-year Government of T&T (GORTT) bond was around 2.50 per cent, while recent inflation figures have been hovering around 5.60 per cent, it does not make much sense, then, for you to invest in such a bond since the real value (purchasing power) of your money will be eroded by the effects of inflation. 

 

You must achieve positive real returns on your investment. If not available in T&T, you may have to consider looking internationally. With US Dollar inflation around 2.00 per cent, USD-denominated bonds are providing generally positive real returns. Even at five to seven-year maturities, an investor can earn bond yields ranging between 4.5 per cent-5.5 per cent on bonds of investment grade quality (more on this later).  

 

Going the fixed income route tends to be a bit less-rewarding in the long-run—it is a fact that equities tend to outperform bonds over long periods. However, the benefits of fixed income are not measured merely in percentage returns. The stability, relative peace of mind and reasonably “low maintenance” nature of bonds make them an integral part of any portfolio. 

 

 

Comfortably predictable income
Fixed income is, in most cases, exactly as stated. While there are bonds which offer floating/non-constant coupon payments, you as a conservative/moderate investor should favour bonds with known and fixed interest payments. It is this very predictability which makes these investments attractive to investors with periodic cash needs, as well as individuals who are willing to accept lower investment returns in exchange for greater certainty. The vast majority of bonds pay interest on a semi-annual basis (every six months).

 

Avoid market risk, hold to maturity
Apart from gaining interest payments on an annual or semi-annual basis, from the bond that you buy into, based on interest rate movements, you could potentially benefit from capital gains on the bond. Several factors, including changing interest rates, investor demand and credit worthiness, influence the prices of fixed income holdings. 

 

You as a conservative investor, however, can insulate yourself from the changing value of bonds. You can utilise a strategy of holding your bonds to maturity. In doing so, any risks (and benefits) from selling the bond at the open market price is forgone. In adopting this approach, you choose to earn what is known as the Yield to Maturity, an annualised return on the bond known at the time of purchase. In other words, barring any defaults or other events related to the bond issuer, you have essentially locked in a return for your portfolio.

 

 

Quality is key
While we may all have different appetites for risk, most who venture more enthusiastically into bond investments do so because of the higher level of certainty these assets afford us. It makes sense then, that we would be willing to sacrifice some level of return for more certainty and stability.

 

 

The key here is that we should be focusing on quality bonds, rather than bonds that offer the highest returns. You may have come across terms such as ‘credit rating’ or ‘investment grade’ at some point in time. The jargon, in a nutshell, refers to the level of credit quality of a bond. Simply put, it gives an idea of how likely a bond issuer can make payments of interest and/or principal. 

 

Naturally, higher credit quality bonds (investment grade bonds) have greater ability to pay. Conversely, lower credit quality bonds bear more uncertainty in their ability to make timely payments of interest and principal. Logically, for the conservative investor who is focused on certainty of returns, higher credit quality bonds should be favoured.

 

Next week, we compare some bond versus equity returns to help you determine what should be included in your portfolio, both locally and internationally.

 

(Subhas Ramkhelawan is the managing director of Bourse Securities Limited.)

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