Fixed income is often described as the defensive part of an investment portfolio. For many investors, it is expected to provide regular income, reduce reliance on share market returns and help smooth the overall investment journey. That description is broadly right. But it can also create an unrealistic expectation that fixed income investing is simple, safe and always stable.
Most fixed income investors are trying to balance three objectives.
The first is return. This might come through interest payments, distributions or capital gains from changes in bond prices or credit spreads. In a higher rate environment, the potential return from fixed income can be materially better than it was during the ultra-low interest rate period post covid.
The second is liquidity. Liquidity refers to how quickly an investor can access their capital and how reliably the investment can be sold or redeemed at a fair price. Cash and term deposits are usually highly liquid or have a known maturity date. Listed bond funds may be traded daily. Some private credit, direct lending or real estate debt investments may only offer monthly, quarterly or even less frequent access.
The third is volatility. Volatility is the extent to which the value of an investment moves around over time. Some fixed income assets have very stable values. Others can move significantly, particularly when interest rates change, credit markets reprice or investors become more cautious.
The problem is that these three objectives compete with each other.
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If an investor wants high liquidity and low volatility, the obvious examples are cash, short-term deposits and very short duration, high quality fixed income. These investments can be very useful. They provide flexibility and stability. The trade-off is that returns are usually lower than more complex or less liquid alternatives.
If an investor wants higher returns and high liquidity, they may look to listed hybrids, high yield bonds, liquid credit funds or bond exchange traded funds. These investments can offer better return potential and usually allow reasonably quick access to capital. The trade-off is that market pricing can move around. In periods of stress, the value of these investments may fall, sometimes at exactly the time investors most want stability.
If an investor wants higher returns and lower volatility, the answer is often found in less liquid parts of the market. Private credit, direct lending, real estate debt and some securitised credit investments may offer attractive income and relatively stable valuations. The trade-off is that investors may need to accept less frequent withdrawals, longer notice periods, or the possibility that liquidity could be delayed in difficult market conditions.
This is the central fixed income bargain. Investors can target higher returns, better liquidity or lower volatility, but should be realistic about which two they are prioritising.
Cash is the simplest example. It provides high liquidity and very low volatility. It is ideal for short-term needs, emergency reserves and capital that may be required soon. But cash is unlikely to be the best long-term return option, particularly after inflation and tax.
Term deposits may offer slightly better returns than cash, with low visible volatility. However, investors often give up some flexibility, especially if capital is locked away for a fixed period or early withdrawal comes with a penalty. The return is known, but so is the limitation.
Government bonds are generally high quality and can be liquid, particularly in major markets. But they can still be volatile, particularly for longer term fixed rate bonds. When interest rates rise, the price of existing bonds can fall. This surprised many investors during recent years, when assets traditionally viewed as defensive produced negative returns for periods of time.
Investment grade corporate bonds add credit exposure. They can offer higher yields than government bonds. But they are exposed to both interest rate risk and credit spread risk, which increases volatility. Liquidity is usually reasonable, but not guaranteed during market stress.
High yield bonds and hybrids may provide even higher income. They are often accessible through listed markets or managed funds, which helps liquidity. But their prices can behave more like risk assets (stock markets) when economic conditions deteriorate. The investor gets higher return potential and liquidity, but must accept more volatility and credit risk.
Private credit and real estate debt can offer attractive income, particularly where lenders are being paid for complexity, illiquidity or specialist origination. These investments may have lower visible volatility than listed credit, partly because they are not traded every day. But investors must be comfortable with lower liquidity and the importance of careful manager selection, credit assessment and diversification.
Diversified income funds can sit between these categories. A well-managed income fund can combine cash, public credit, private credit, securitised assets and other fixed income opportunities. The objective is not to maximise any single feature, but to build a portfolio that balances return, liquidity and volatility in a sensible way.
One of the biggest mistakes in fixed income is simply chasing the highest yield. A high yield can be attractive, but it is also a signal. It may reflect higher credit risk, weaker security, more leverage, lower liquidity, complexity or a less favourable position in the capital structure.
That does not automatically make it bad. Some higher yielding opportunities are excellent. But the return should be considered alongside the risks being taken to achieve it.
For most investors, the better question is not “what has the highest return?” The better question is: “what is the best balance of return, liquidity and volatility for the role this investment is meant to play in my portfolio?”
For capital needed in the next few months, cash or short-term deposits may be the right answer, even if the return is lower. For long-term capital where some variation in value is acceptable, more liquid credit funds may make sense. For investors seeking higher income and who do not need daily access, less liquid credit strategies may be appropriate.
The right answer depends on purpose.
In reality, fixed income involves trade-offs. Investors usually want three things: attractive returns, access to their money when they need it, and low volatility of returns. The challenge is that in most fixed income investments, you can usually optimise for two of these outcomes, but rarely all three at once.
Put another way, there is no free lunch. If an investment offers a higher return, the investor usually has to accept either lower liquidity, more volatility, or some combination of these two. If an investment offers daily liquidity and very low volatility, the return will usually be more modest. And if an investment promises high returns, daily access and very stable unit prices, investors should ask carefully how that is being achieved (if something sounds too good to be true…).
This does not mean fixed income is unattractive. Quite the opposite. Higher interest rates have created one of the more interesting environments for income investors in many years. But it does mean investors should think clearly about what they are trying to achieve, and what trade-offs they are prepared to accept.
A highly diversified portfolio of fixed income assets that aims to provide investors with a minimum distribution equal to the RBA Cash Rate plus 3% per annum paid monthly over rolling 3 year periods after payment of distributions.
AIF aims to deliver above average results but in a very different way to a traditional investment fund. We seek to invest with 20-35 underlying managers across all asset classes, in a way in which we believe balances maximum returns with low volatility.
Through the ALF we seek to take advantage of opportunities available in the LIC sector, with a focus on LICs trading at attractive discounts to NTA. Through LICs, the Fund provides access to a broad range of investment styles, strategies and geographies.
The ASF aims to provide Eligible Investors with access to a portfolio of ASX listed equity securities outside the S&P/ASX 100 Index. The portfolio may also have some exposure to ASX listed securities and global companies. (Wholesale Investors Only)
Disclaimer: This sponsored article is prepared by Affluence Funds. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.
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