CPD: A spotlight on fixed income investments

Although we pronounced that ‘bonds are back’ six months ago the journey for fixed income in 2024 has not been a linear one. Sticky inflation and varied labour force numbers have held up the anticipated rate cuts in the world’s major economies, which in turn has kept the bond market subdued.

And, while debate continues to rage about whether or not the 60/40 portfolio is ‘broken’, there continues to be good reasons for investor portfolios to have an exposure to fixed income investments. In the earlier days of the 60/40 portfolio, most investors’ fixed income investments would have come in the form of traditional bonds funds, either passive (index) funds or funds actively managed versus a benchmark.

Today, however, there’s a much broader range of funds available, including ETFs and a range of actively managed funds. The latter includes more conservative funds focused on government and semi-government bonds right through to the higher risk/higher return high yield funds. In between, there are a range of diversified products that invest in a broader set of fixed income investments, some of which are constrained by a benchmark and others that are not.

Fixed income basics

A fixed income investment is a loan made by an investor to a government or corporate borrower. In return, the investor receives a fixed rate of interest for a fixed amount of time. Whether government or corporate bonds, shorter-dated bank bills or securitised assets, fixed income is an important source of income and diversification for investors.

A key benefit of fixed income securities is that each has a natural buyer in the issuer. The issuer is required to repay the loan at par value – i.e. the maturity value of a bond – when it reaches its stated maturity date. This gives fixed income securities greater predictability of returns.

A powerful consequence of this ‘natural buyer’ is that securities that have sold off in the marketplace due to technical reasons, such as reacting to interest rate or stock market movements, will naturally ‘pull back’ to their par value as the time to maturity draws nearer. Active investment managers can take advantage of this phenomenon.

Those securities where there is a greater risk of default (i.e. not receiving the principal at maturity) need to pay investors a higher yield to compensate for the increased risk.

Types of fixed income securities

Different securities – and classes of securities within a specific fixed income subsector – will be subject to ratings by one or more independent rating services; these may include Standard & Poor’s, Moody’s or Fitch Ratings Inc.

These ratings agencies evaluate the issuer’s financial strength and importantly, its ability to repay a bond’s principal and interest. The ratings agency typically assigns a letter grade to lenders and individual fixed income securities that indicates their credit quality (figure one shows Standard & Poor’s ratings hierarchy).

Ratings

There are two broad classes of fixed income securities: investment grade and non-investment grade, also referred to as high yield.

Investment grade bonds are assigned:

• AAA to BBB ratings from Standard & Poor’s
• Aaa to Baa3 ratings from Moody’s

Non-investment grade issues carry lower ratings:

• BB+ and lower from Standard & Poor’s
• Ba1 and lower from Moody’s

Generally, the higher a security’s rating, the lower the interest rate; this is why government bonds typically pay a lower rate of interest than corporate bonds or non-investment grade issues.

Government bonds

Government bonds – referred to as ‘Treasuries’ in the US and ‘Sovereign bonds’ in other markets – are debt securities issued by a government to raise funds for public projects, such as infrastructure development, social programs, or to manage budget deficits. When an investor buys a government bond, they are lending money to the government in exchange for periodic interest payments and the return of the bond’s face value when it matures. Governments may issue a range of fixed income securities with different maturity profiles. By way of example, US bonds come as the following:

• Treasury Bonds (T-Bonds): long-term bonds issued by the US Treasury with maturities of 10 to 30 years.
• Treasury Notes (T-Notes): medium-term bonds with maturities ranging from 2 to 10 years.
• Treasury Bills (T-Bills): short-term bonds with maturities of one year or less.
• Municipal Bonds: Bonds issued by local or regional governments.

Semi-government bonds

Semi-government bonds are debt securities issued by government-related entities. This could include state or regional governments, government-owned corporations or public sector institutions. Considered a step below national government bonds in terms of risk, semi-government bonds generally offer stable returns.

Semi-government bonds are typically issued to fund projects or operations that serve public interests: infrastructure development, education, health services and utilities. As with government bonds, semi-government bonds usually pay a fixed or floating interest rate, typically semi-annually or annually. The interest payments are funded by the revenues generated by the entity issuing the bond.

The credit risk of semi-government bonds is generally higher than that of national government bonds because they are backed by a government-related entity rather than the central government itself. Accordingly, semi-government bonds usually offer higher yields compared to government bonds to compensate for the slightly higher risk associated with them.

Corporate bonds

Corporate bonds are debt securities issued by companies to raise capital for purposes such as expansion, to finance mergers and acquisitions, to refinance existing debt or fund new projects. This is a significant sub-sector of fixed income and offers a range of risk and return profiles based on the issuing company’s creditworthiness and financial health, as well as market conditions.

As with bonds issued by government and semi-government, corporate bonds can be issued with different maturity profiles. They generally offer higher yields than government bonds to compensate for the higher risk. The yield depends on factors like the bond’s credit rating, maturity, market interest rates, and the issuer’s financial condition.

Bonds from companies with high credit ratings (investment-grade) are considered less risky, while bonds with lower ratings (non-investment grade) are riskier but typically offer higher yields.

Companies may also issue different types of bonds. One example is the convertible bond, those which can be converted into a predetermined number of shares of the issuing company’s stock. They offer lower coupon rates compared to regular corporate bonds but provide the potential for equity upside. Another example is debentures, an unsecured corporate bond not backed by specific assets; instead, they rely on the general creditworthiness of the issuer.

High yield debt

Sometimes referred to as junk bonds, high yield debt consists of bonds that are rated below investment grade by credit rating agencies and offer higher interest rates (or yields) to compensate investors for the increased credit risk associated with issuers that have a greater likelihood of default.

High yield debt may be issued by companies with weaker credit profiles or those in financial distress. It may also be issued by ‘fallen angels’, companies that were once rated as investment grade but have been downgraded to high yield status due to deteriorating financial conditions.

High yield debt may be included in fixed income portfolios for several reasons: higher yields make it attractive to income focused investors, diversification through exposure to different sectors and companies that may not be available through investment-grade bonds and, in cases where the issuer’s credit rating improves, high yield bonds may offer potential capital gains in addition to interest income.

Emerging market debt (EMD)

EMD refers to fixed income securities issued by countries or corporations located in emerging or developing economies. In the context of fixed income investing, EMD provides investors with exposure to the growth potential and higher yields associated with emerging markets, but it also involves additional risks, such as political instability, currency fluctuations and credit risk.

EMD can help enhance overall portfolio yield by providing higher income compared to bonds issued in developed markets. It can also add geographical and economic diversification to a portfolio, helping to spread risk across different regions and sectors. Finally, EMD allows investors to gain exposure to the growth potential of emerging economies, which may outperform developed economies over the long term.

Asset backed securities (ABS)

A type of fixed income security that represents a pool of underlying assets, such as:

• auto loans
• credit card receivables
• student loans
• home loans
• leases, including equipment or vehicle leases.

These assets are typically bundled together and sold to investors. In essence, ABS allows lenders to convert illiquid assets, such as loans, into tradable securities; it provides the lender with immediate capital and transfers the risk to investors.

The process of creating ABS involves securitisation, where a lender bundles a group of similar loans or receivables into a pool. These assets are then transferred to a legally separate entity called a Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) and are sold in tranches.

The SPV issues securities to investors that are backed by the cash flows generated from the underlying assets. This structure isolates the ABS from the financial risk of the original lender or institution. Investors in ABS receive periodic interest payments funded by the cash flows from the underlying assets (for example, loan or lease repayments). The coupon rate can be fixed or floating, depending on the terms of the ABS.

Asset backed securities may be included in a fixed income portfolio for several reasons: a predictable income stream, diversification and the different tranches allow investors to choose the level of risk and potential return they are comfortable with.

Credit risk transfer (CRT)

CRTs refers to financial strategies and instruments used by lenders to transfer the risk of borrower defaults on loans or other credit obligations to third parties. In the context of fixed income investing, CRT securities enable institutions to mitigate potential losses associated with credit risk, while allowing investors to gain exposure to those risks in exchange for a potential return in the form of interest payments or premiums.

There are different types of CRT strategies available to investors, including:

Credit-linked notes (CLNs): debt securities where the repayment of principal and interest is linked to the credit performance of a specific reference asset or portfolio (such as corporate loans or bonds).

Credit default swaps (CDS): a type of derivative contract where one party (the protection buyer) pays a periodic fee to another party (the protection seller) in exchange for protection against the default of a reference entity (such as a corporation or government). If the reference entity defaults, the protection seller compensates the protection buyer, effectively transferring the credit risk from the buyer to the seller.

Collateralised loan obligations (CLOs): a security that pools together a portfolio of loans (typically corporate loans) and issues securities with varying levels of risk and return (tranches) to investors. The lower tranches bear more of the credit risk (and provide a higher return), while the senior tranches are generally considered safer.

CRTs may be included in a fixed income portfolio for several reasons: higher yields than traditional fixed income securities due to credit risk exposure, diversification across credit markets, sectors or regions, as well as being able to select a specific tranche to match a portfolio’s specific risk tolerance and return objectives.

Mortgage backed securities (MBS)

There are two main categories of MBS – commercial mortgage backed securities (CMBS) and agency mortgage backed securities (AMBS).

CMBS

Commercial MBS are a type of asset-backed security specifically backed by a pool of commercial real estate loans such as office buildings, retail properties, industrial properties and hotels or hospitality properties. These securities offer investors exposure to the performance of the commercial real estate market and provide a regular stream of interest payments and the return of principal, depending on the performance of the underlying loans.

CMBS may be included in a fixed income portfolio for several reasons: higher yields than traditional fixed income securities, diversification across different asset pools, and customisable risk profiling through tranches that allow investors to choose the risk and return profile that aligns with their investment goals and risk tolerance.

AMBS

Agency MBS are a security that represents an interest in a pool of residential mortgages that are issued or guaranteed by US government-sponsored enterprises such as Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation), or a government agency such as Ginnie Mae (Government National Mortgage Association). Agency MBS are considered to be relatively safe and provide a stable income stream, making them attractive to many investors.

AMBS may be included in a fixed income portfolio for several reasons: a steady stream of income with relatively low credit risk, diversification across different asset pools, as well as liquidity and flexibility, suitable for investors who need the flexibility to buy or sell securities as needed.

Fixed income strategies

To be a direct investor into fixed income securities has generally been the realm of institutional or other large investors, as minimum transactions require substantial investment dollars. Accordingly, the majority of investors get exposure to fixed income through a listed or unlisted fund.

Passive fixed income

Passive fixed income is generally comprised of fixed income index funds and ETFs, both of which generally mirror a particular bond index. However, most funds tend to focus on government and corporate bonds and provide limited exposure to fixed income securities such as mortgage backed securities, asset backed securities or emerging market debt.

There are several potential drawbacks with passive fixed income investments:

1. Investors have to passively accept the characteristics of the index with respect to duration and credit quality.
2. Generally more apposite to corporate bond indices, benchmarks they are issuer weighted. This means that the biggest issuer (or the most indebted corporate) has the highest index weight. While not necessarily bad if that big issuer is matched by its size or ‘market-cap’, it is also counter-intuitive that the investor has the biggest exposure to biggest debtor where one might expect ‘ability-to-pay’ concerns to emerge.
3. If a client is invested in a credit ETF and a big issuer defaults (for example, Enron in the early 2000s), there is the potential for big drawdowns compared to an active investor who is better placed to avoid credit ‘accidents’. Through to July 2024, there were 87 defaults, the highest number since 2009^[1]
4. Investors locks in underperformance of the specific index by the amount of the fees charged.

Passive fixed income, whether listed or unlisted, can often play an important role in a diversified portfolio; however, there are potential shortcomings that advisers and investors should be aware of.

Traditional bond funds

Traditional fixed income funds tend to employ a relative return investment strategy, one which aims to beat a benchmark index, such as the Bloomberg AusBond Composite Bond Index. When a fund is managed with reference to a benchmark, it is typically more constrained, owning similar securities in similar proportions to that benchmark.

A market cap weighted index is an interesting snapshot of the bond market, but from an investor’s perspective, does it make sense to use a strategy that largely replicates the index? As with passive funds, relative return funds are generally exposed to fixed income securities that have the highest benchmark weighting…or, in other words, those that are the most indebted. And, as with passive funds, exposure to long duration assets is not always the best positioning for investors.

Any strategy that mimics an index will share the characteristics of that index. In an environment with interest rate uncertainty, ‘sticky’ inflation, market volatility and a high degree of geopolitical uncertainty, traditional benchmark-based approaches to fixed income investment may be less effective.

Absolute return funds

The increased number of absolute return (or unconstrained) fixed income funds illustrates that investment managers are thinking about how to best position a fixed income portfolio to generate positive returns for investors.

Unlike traditional bond funds where the majority of return is driven by the performance of the benchmark (figure two), returns from absolute return strategies are driven by the investment approach adopted by the manager.

An absolute return investment strategy is not beholden to a benchmark; instead it’s a strategy generally designed to better navigate the complexities of the evolving fixed income landscape than traditional bond funds that are constrained to managing a fund to a specific benchmark.

Absolute return strategies are typically managed to beat a cash or equivalent benchmark rather than a bond index, thus removing constraints around duration and sector positioning, and it’s able to manage its risk and return profile by utilising all fixed income sectors.

Consequently, absolute return funds typically have lower duration (i.e. are less sensitive to changes in interest rates), a good thing when the interest rate environment is changeable. At such times, it can be more challenging for managers of traditional funds to make quick changes to allow for a changing economic environment or market circumstances. Absolute return fixed income managers can do that much more quickly.

Investing in fixed income offers a range of benefits, from providing a steady stream of income to reducing overall portfolio risk. With predictable interest payments and principal repayment, fixed income securities can offer stability and preserve capital in uncertain market conditions, while providing diversification benefits to an investment portfolio. It’s important to determine the type of fixed income exposure most appropriate to your client’s needs.

 

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Notes:
[1] https://www.spglobal.com/ratings/en/research/articles/240905-creditweek-will-a-decline-in-corporate-defaults-come-as-quickly-as-their-recent-rise-13240141

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