Fixed Interest: Investment Portfolio

Gilts, corporate bonds and other fixed interest investments are often overlooked as ’boring’ when it comes to building an investment portfolio, but, as James Norton argues, sensible investing is not about excitement, it is about reducing volatility and enhancing long term returns.

He proves the value of fixed interest investments and points out why every portfolio should hold them.

When we talk about constructing investment portfolios with clients, we find many are reluctant to hold fixed interest (i.e. gilts and corporate bonds). They think that these are ‘boring’ and will add no value to the portfolio. This is not the case. It is our belief that all portfolios should hold an element of fixed interest, with most clients holding upwards of 25% in this asset class.

The table below illustrates simply the benefits of this type of diversification. It shows the risk and return on portfolios invested in the FTSE All Share and UK Gilt indices in different proportions from 1956 to the end of 2004. As one would expect, it shows that although the historic return is lower when the equity component of the portfolio is reduced, the volatility or risk is also dramatically reduced.

Fixed Interest: Risk and Return on Equity and Gilt Portfolios from Jan 1956 – Dec 2005

Standard deviation is a statistical measurement of risk. The table above shows that as the gilt proportion of the portfolios is increased, so the standard deviation falls – i.e. the risk is getting lower. What is particularly interesting is that when a 100% equity portfolio has as little as 25% exposure to gilts added, the return only suffers marginally, however, there is a dramatic reduction in risk.

Fixed Interest: Gilts, Corporate Bonds and Your Investment Portfolio

We therefore believe that the primary role of fixed interest in portfolios is to reduce risk. However, fixed interest does also play an important part in increasing the yield of portfolios, and can also provide short term liquidity to investors with cash needs over a two to four year period.

So how should investors obtain their fixed income exposure? As its main role is to reduce risk, it is important to consider the two main factors that explain bond returns. The first is that of default – ie the risk that the company that issues the bond will not be able to pay the interest on it. The second risk is duration. Whilst many people may be vaguely aware that long dated bonds carry higher risks than short dated bonds, they often do not realise that this risk tends not to be compensated for by higher returns, once the maturity of the bond exceeds five years. For this reason, most of our bond exposure for clients is made up of short dated (less than five years) investment grade corporate and government bonds.

What funds should private clients actually buy? In his book Common Sense on Mutual Funds, John Bogle the founder of Vanguard wrote “As a group, bond funds have failed to provide investors with adequate returns relative to those achieved by the bond market itself”.

When the charges of these funds are looked at it is hardly surprising. For example, an actively managed bond fund may deliver a market average return of 6% and charge 1% in fees reducing the return by a staggering 16.7%. In reality few UK bond funds have expenses as low as this. Part of the reason for these high charges is that they often pay up to 0.5% to IFAs or stockbrokers in the form of trail commission which many investors are not aware of.

The result is that the fund manager has to significantly outperform the market average, just to provide investors with the market return. Few people are able to do this on a consistent basis without taking a higher level of risk. Given that we have already established that the main reason for holding fixed income is to reduce risk, this does not seem to be a sensible strategy.

It strikes us that as with equity funds, the sensible way to manage bonds is in index funds. The current shape of the UK fund industry does not make this easy, but this is one area where exchange traded funds (ETFs) have helped private clients enormously.

In simple terms, an ETF is a fund that can be bought and sold on the London Stock Exchange through a broker in real time. Because the funds track an index, they are low cost to run and consequently have low annual management charges. The main provider of these funds in the UK is Barclays through their iShares range. They have launched a number of fixed interest ETFs with charges of only 0.2% per annum. This cost is 80% lower than the average actively managed bond fund.

Fixed Interest: Creating a Balanced Investment Portfolio

Traditionally, fixed interest is an area where private clients have been underweight. While we would not recommend that all clients go out and start selling equities to buy fixed interest, we would caution against those who hold back from this asset class saying it is boring. Sensible investing is not about excitement, it is about reducing volatility and enhancing long term returns.

About the Author: James Norton (pictured) ACA, FSI, APFS, CFP, is a Director at Evolve Financial Planning, winners of the Scottish Widows Award for IFA newcomer 2006. For more information visit www.evolvefp.com.

James Norton is writing a series of articles exclusively for FinanceDaily.co.uk on the subject of investing. Sign-up to the newsletter (enter your email address in the box above - where it says ’Newsletter Sign-up’) to be sure to receive next-month’s exclusive investment instalment.

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