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Fixed Income And How You Can Diversify
Tradeable | 12 March 2013
By: Simeon Ang
Articles (125) Profile

Equities are exciting, aren’t they? The ups and downs of equity markets in the past year alone have left many investors dizzied due to the heights and downright hopeless when at its lows. We often hear from experts that we should try to diversify our investment portfolios. Given the headache of looking around for investment products that are not correlated to each other (that’s the whole idea of diversifying right?), what is this pronouncement really rooted in?

From the scholarly point of view, the idea of diversification stems from a theory on modern portfolios. Basically, the theory espouses the wisdom that putting all your eggs in one basket bears the risk of you not having any eggs at the end of the day. While it would be nice to go through this entire theory, my purpose for today is not to share the merits of said theory. Instead, I want to focus on fixed income.

Fixed… What?
Yes, fixed income otherwise known as debt instruments or bonds. But why fixed income? Fixed income by itself is usually seen as a less attractive brother when compared to equities. But fixed income can actually be a boon for investors who want a source of regular income or want to diversify their portfolio of investment assets. In fact, historically speaking, during a massive stock market crash, the flight to “safety” usually includes the buying of fixed income instruments.

However, ever since the Great Recession of 2008/09, uncertainties around the bond market and the interest rate environment have become top concerns amongst fixed income investors. Why so? This is because many investors have become unsettled by low current yields (low interest rates = lower coupons payments = lower yields) and are anxious to know how they might be affected if and when interest rates start to rise. When interest rates rise, the fixed income instruments they currently hold will fall in terms of price, because new fixed income instruments that are issued at higher interest rates will have higher yield and thus be priced at a premium.

Outlook for Fixed Income in 2013
In its 2013 economic and investment outlook, American investment management firm, Vanguard opined that the Federal Reserve will likely keep interest rates low at least till 2015. However, better than expected economic results (for example if unemployment in the US falls below its stated target of 6.5 percent), or higher than expected inflation, could push the Federal Reserve to adjust rates.

Given the likelihood of interest rates remaining low, what then is the role of fixed income in a diversified portfolio?

The Role of Bonds in Diversified Portfolio
While the outlook for fixed income investments remains cloudy (then again, a lot of things are cloudy these days), these investments can still have an important role to play in investors’ portfolios. After all, they can provide two very important benefits.

These include:

  • Provision of stability and diversification. As mentioned earlier, bonds have weathered economic downturns far better than their equity counterparts. Based on this historical evidence, fixed income instruments have been known be less volatile than stocks at the same time providing some protection to investors’ capital.

 

Source: FactSet, graph comparing a fixed income index, the iBoxx ABF Singapore (blue) with the Straits Times Index (yellow)

  • Income provision. Despite the low interest rate environment, fixed income investors can benefit from rising interest rates (rates are so low now, the only way they can go is up!) because maturing bonds and new assets can be reinvested into higher-yielding bonds.

Investing in Fixed Income
Investing in fixed income or bonds have been made much easier ever since the Monetary Authority of Singapore allowed bonds to be traded on the Singapore Exchange. However, investing in fixed income funds is usually more effective than investing directly in the same bonds that are in these funds. This is due to two main reasons. The first being, that as a retail investor, you would not need a large capital outlay to purchase all the fixed income instruments that are in the funds. Second, the task of managing these holdings can be passed on to someone else who, hopefully, is a professional who is good at what he/she does.

But with so many fixed income funds out there, how does one tell the difference between a good fund and the lemons? Enter the global independent research providers such as Morningstar, which provide analyst reports on individual funds (much like how the research houses issue research reports on individual stocks). In fact, besides coming up with research reports on the individual funds, Morningstar has recognised fund houses who have done particularly well on a yearly basis. This award has both a quantitative and qualitative basis. The two pronged approach ensures that awards are given to funds that have outstanding one-year performance as well as the ability to post strong long-term results without undue risk.

Just how did the fixed income fund houses fare last year? Make a date with us on 19th March 2013 as Tradeable extends exclusive LIVE coverage of the Morningstar Singapore Fund Awards 2013 on Twitter!

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Simeon, an LSE graduate, is currently the editor of Aspire. He specialises on topics surrounding trading psychology, politics and macroeconomics.

Please click here for more information about this author.


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The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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