While it is crucial to maintain a diversified investment portfolio at all times, it is understandable that in the current market there has been a renewed interest in defensive assets.
Defensive assets generally act as a counter to market volatility by offering greater certainty compared to other investment options, although the trade-off may be lower returns and reduced flexibility.
The main type of defensive asset classes are cash (savings accounts and term deposits) and fixed interest investments such as bonds, and it is the latter category which is the focus of this blog.
Investing in bonds
One of the ways governments and companies raise capital to fund various projects and activities is by issuing bonds.
So, when you invest in these bonds, you lend money to the government or organisation, usually at an agreed interest rate and for a specified period of time. Generally, interest payments are paid at regular intervals during the life of the bond (usually quarterly or half-yearly) and once the bond matures the amount you invested (your capital) is returned to you.
Exchange Traded Bonds
Some investors express concerns about being locked into a bond until it matures. One way to increase your flexibility while still investing in bonds is to trade them in secondary markets such as the ASX. Bonds that can be traded in this way are called ‘listed’ or ‘exchange-traded’ bonds (ETBs).
Similar to bonds, ETBs offer the benefit of a regular income stream via your interest payments while offering the additional benefit of greater flexibility. It is important to note that ETBs can be subject to variations in the amount and type of interest they pay.
Bond funds
As the name suggests, a bond fund invests primarily in bonds, as opposed to say, stock funds or money funds.
As with other types of bond investments, bond funds pay periodic distributions (income) being the interest payments (also called coupons) of the underlying bonds. Bonds are issued by governments of all types and the corporate sector, so a bond fund investor gains access to a diversified range of issuers. The advantage of joining a bond fund is access to types of investments which may not be open to the individual investor.
Credit funds
If follows that credit funds invest in credit raisings which can be more simply described as proving loans to government or corporate borrowers, these may be Australian or international, in fact offshore credit markets are substantially larger than in Australia.
Credit funds receive interest payments from their borrowers and pay regular income distributions to investors. The rate of interest paid by each borrower is determined by their credit rating, it is the role of the fund manager to manage the credit risk and protect the capital of the fund. Typically credit funds have a higher risk profile than bond funds, but still fall within the defensive asset classes.
Diversified fixed interest funds
Diversified fixed interest funds are well worthwhile considering as an alternative to traditional bond funds. While they share many of the traits of bond funds such as a focus on defensive investing and capital preservation, they have a greater focus on diversified investment within the fund. The fund manager will aim to acheive a total return with an acceptable level of overall risk through diversification.
This type of fund is best suited to investors who seek to diversify their fixed income exposure through investment in a mix of Australian and international securities across the fixed income asset class.
Hybrid securities
Similar to bonds, hybrid securities (often known simply as ‘hybrids’) allow banks and companies to borrow money from investors in return for interest payments.
Hybrids are a far more complex type of investment than ‘normal’ bonds and while they can offer greater returns, they undoubtedly carry greater risk. For example, similar to company shares, the value of hybrids can be subject to market place volatility. They are also generally unsecured, meaning that in the case of the company issuing the hybrid becoming insolvent, hybrid investors are not first in the line of creditors.
However, the attractiveness of hybrids to investors who are more comfortable with a higher level of uncertainty include the fact that they can offer significantly higher rates of return.
In some cases hybrids also offer the holder the option to convert the hybrid securities into equity securities (such as shares) upon maturity, thereby allowing the investor to diversify their portfolio.
To find out more about the defensive asset types covered in this blog and their place in an overall well-balanced financial plan please call me on 03 6234 2233 or email me on glynn@falconeradvisers.com.au.