Why do some advisers overlook bonds when constructing portfolios

The market environment has changed dramatically in the past few years. Previously, yields were relatively low at 2% to 3%, which is well below what most clients want from their defensive portfolios and made them reluctant to build bigger allocations to bonds.

But now may be an appropriate time to rethink that mindset. High-quality liquid bonds can generate income of 5% to 6% today. This creates a much stronger role for those sorts of assets in a portfolio due to their capacity to provide a regular return and capital protection. 

There are two main risks associated with every fixed income portfolio. One is credit risk, which is the risk that you won't be repaid by an issuer. The second is interest rate risk – whether rates go up or down can impact the income generated for clients.

Advisers need to manage both risks to optimise risk-adjusted returns, and active management of a diversified portfolio is a good way to achieve that objective.

Should advisers opt for bond funds or buy direct bonds?

There may be a place for both in portfolios. Either way, it’s important to understand the characteristics of any investment before purchasing it.

The general outlook for interest rates is mixed, with some countries cutting, some raising, and others holding rates steady. It may be worthwhile engaging a fixed income specialist who is in the market every day to gain a better grasp of the impact on bond selection.

The factors to consider when selecting a bond includes its credit rating – an investment grade rating indicates that a bond is among the highest quality. For example, these bonds tend to come from big brand-name businesses or large banks. It is also important to consider if a bond’s yield meets your target and is appropriate for the risk attached to the investment.

If you’re considering a fixed income fund, it’s worthwhile looking at the underlying assets. An ETF that tracks an index that invests in government bonds will, by definition, be mostly fixed rate. If a client’s preference is for floating rate securities, particularly when rates are rising , then that ETF may not meet their needs.

For active funds, it’s important to read the mandate and general terms. Some funds can restrict redemptions in a disordered market, and advisers should understand that in advance, and whether it matches a client’s expectations of capital stability.

What’s the best way to evaluate the income from a bond?

Firstly, consider the headline yield, which is what the bond would pay if held to maturity. High-quality liquid investment-grade bonds in the public market are currently paying 5% to 6%.

But the performance of a bond over its life is not a flat, say, 6%, from start to finish. It typically performs stronger in the first couple of years – for example, investors might receive an 8% return in the peak years. 

FIIG aims to actively capture that 8% return in the first years for its direct bond clients – and then move into a different bond, offering a premium at the start of its term. This active management is key to maximising returns from fixed income. For the past two financial years, FIIG clients averaged 9% per year* due to active trading, new issue premium, currency diversification, and some allocation to high yield securities. They also benefited from tightening credit spreads.

Is there still a case to hold bank hybrids?

If advisers still find value in hybrids, versus other fixed income instruments that are somewhat equivalent, they should retain them.

However, many advisers are already transitioning clients to bonds with more attractive yields today. They appear to be opting for investments such as tier 2 bank bonds, listed fixed income vehicles, and global fixed income funds.

The listed fixed income market is also expanding as more issuers seek to tap demand for listed alternatives to bank hybrids. FIIG was recently Joint Lead Manager for the oversubscribed issue of RAM Secured Income Notes (ASX: RAMHA), which exceeded a $300 million target and closed almost a week early due to demand.

What is the OTC bond market?

The over-the-counter (OTC) bond market is where most bonds are traded. It allows investors to buy bonds through a fixed income dealer or broker. The OTC market can appeal to advisers and sophisticated investors due to the potential returns, transparency and liquidity. Investors can also track the performance of each bond and their portfolio on a daily basis.

FIIG offers services that provide access to the OTC market including breaking down institutional parcels into smaller amounts for eligible investors.

*Note that past performance isn't a guarantee of future returns. The median return for FIIG clients over the five-year period (FY20-25) and three-year period (FY23-25) was 6.62% and 8.09% respectively.

AUSIEX provides tools and expertise to help you construct and manage fixed income portfolios. Contact us for more information.