It's a challenge for advisers too, as they look for ways to help clients maximise income, while being mindful of capital protection, longevity risk and the need to manage volatility.
In this context, the conversation that advisers have with clients often ends with weighing up cash/traditional fixed income (i.e. government bonds) versus shares. But this approach isn't the only solution.
The new environment of record low interest rates globally and locally means that historical returns achieved from cash/fixed income are unlikely to be achieved in the future. Dividends from shares are proving to be no magic bullet either, and come with the increased capital volatility associated with the equity asset class. Recently, decisions by the likes of BHP Billiton and ANZ to cut their dividend was a wake-up call for equities investors - a reminder that income from shares is discretionary.
So what options do we have in this new world? One of these is the global fixed interest/credit market. This sub asset sector sits between the higher volatility/higher risk of shares, and the lower risk/lower returns of cash and government bonds. It’s been proven historically to deliver good income with an attractive, “intermediate” risk profile. It can also provide diversification away from the domestic market, more security than equities, and the potential for more income than cash or bonds.
What do we find attractive with this sub asset sector?
1. Income generation – fixed interest/credit which includes corporate bonds, loans, asset backed securities and high-yield securities - tend to pay investors regular coupons with a higher yield than cash or traditional fixed interest. A diversified portfolio of such coupon-paying investments allows for the smoothing out of all those cashflows, which can be paid out as regular, high-yielding income (i.e. through monthly or quarterly fund distributions).
2. Liquidity – global fixed interest/credit is a large and deep market and significantly larger than global share markets and much larger than the ASX. It has many different investor types, including asset managers, banks, insurance companies, pension funds and sovereign wealth funds. This diversity of investors means credit investments are traded in high volume between buyers and sellers even during challenging times.
3. Diversification – global fixed interest/credit allows Australian investors to diversify away from Australian shares and achieve a broader spread of exposures across issuers and economic/geographic areas. Industry diversification is particularly important, because corporate failures may occur in clusters – for example, the technology crash in the early 2000s, or financial institutions during the GFC.
4. Industry diversification is difficult to achieve in the Australian market. Australia is a small economy with a heavy concentration to financials and miners (~60 per cent of ASX 200 market capitalisation is in those two sectors). Far greater diversification is available by investing in global asset classes.
5. Interest rate risk – unlike traditional government bond oriented fixed interest investments, it is possible to select funds of credit investments that have low levels of interest rate risk. Investments that have interest rates fixed for long periods of time (i.e. long duration) are at risk of falling in value should interest rates rise. Given our current outlook for interest rates, Cardena’s Model Portfolios are avoiding large exposures to investments carrying material levels of interest rate risk. As such, shorter duration investments in the credit sub asset sector are relatively attractive now.
One such fund that we use in the Cardena Model Portfolios to take advantage of these opportunities is the Kapstream Absolute Return Income Fund. This fund is designed to deliver capital stability through an actively managed portfolio of fixed income investments and is diversified across countries and fixed income sectors. Kapstream Capital manages their global fixed income portfolio by carefully selecting the bonds of quality well-structured companies who have proven track records in conducting business through varying economic cycles, commonly referred to as “investment grade” companies.
Companies that have manageable levels of debt, good earnings potential and a good debt-paying record will have a good credit rating. A company is considered investment grade when it is rated BBB or higher by ratings agencies such as Standard and Poor’s and Moody’s. Kapstream Capital usually invests in A+ rated companies.
Keep an eye out for our next boardroom lunch event on 27 July 2017 where we will invite members of the investment team from Kapstream to share their insights on markets and how they invest in fixed income opportunities, on behalf of our clients invested via the Cardena Model Portfolios. A separate invitation will be sent shortly.
