Financial advisers and private client advisers at banks and broking firms have a long history of buying fixed interest securities as direct holdings for their clients. However, over recent years there has been a shift in behaviour, with fixed interest funds increasingly becoming the solution of choice.

So, what are the pros and cons of each option, and what criteria should matter most to investors?

In this article we discuss a range of criteria, and provide some insights gained from our activities in the domestic fixed interest market.

Does the investment provide the risk and return exposure that is sought, given the investor’s risk appetite and investment objectives?

Investors tend to seek fixed interest as an asset class for its traditional characteristics of income, as well as capital stability. They do this because fixed interest tends to offset the volatility experienced by shares. To offset share volatility effectively, fixed interest investments should be made up exclusively of investment grade bonds (rated between AAA and BBB- on the S&P scale). When share prices fall investors tend to flock to Investment grade securities, pushing up their price. Their price rise offsets the price fall in shares. This cannot be relied on with high yield securities, as investors discovered with the New Zealand finance company collapses.

Here’s the important point – to raise the likelihood of fixed interest investments providing capital stability, diversification is required. An investor who utilises individual securities rather than a fund will likely be limited to only a small number of issuers. In a concentrated portfolio, default, or a significant downgrade by a single issuer, can severely undermine returns at the time the portfolio needs those returns the most.

Again, the failure of finance companies in New Zealand from 2007 – 2010 is a reminder of both the pitfalls of sub-investment grade securities and, in many cases, poor diversification.

For example, below we show the returns of our New Zealand equity strategy in 2007 and 2008 (the heart of the Global Financial Crisis) and a blended portfolio of 50% equities and 50% fixed interest. Note that all returns listed below are after relevant investment management fees.

2007	-4.26%	2.54%	-0.99%
2008	-27.73%	15.51%	-7.92%
Total return	-16.98%	9.83%	-4.52%

 

All returns are net of investment management fees but gross of advice, custodial and transaction costs. Past performance is not indicative of future results. For details on our NZ equity and fixed interest strategy please see consiliumnz.co.nz/disclosure-statement. This clearly shows the potential of a properly diversified investment grade portfolio of fixed interest to offset the volatility of shares at exactly the right time.

Can investors achieve diversification in New Zealand fixed income?

While global fixed interest markets offer significantly greater scope for diversification, it is also possible to achieve a reasonable degree of diversification in New Zealand. It is easier to do this with a fund rather than by selecting direct securities. This is because there are some corporate issuers that only issue to the wholesale market, meaning retail investors cannot buy these securities. If we exclude small local authorities, there are over 90 different issuers available to wholesale investors in New Zealand. Of these, only around 30 can be bought by retail investors directly.

Another challenge for buying New Zealand fixed interest directly is opportunities to invest in new issues. As the number of securities in New Zealand is limited, new issues are very important. A fund can more flexibly and easily add new issues into a broadly diversified portfolio because it can accommodate varying maturity dates and credit qualities. Those buying direct will naturally have more specific maturity, issuer and credit quality requirements, meaning that new issues cannot be easily incorporated into their portfolio.

What costs are involved?

Of course, there is a management fee cost to owning a fund. We pay less than 0.40% for our direct New Zealand fixed interest funds. It’s worth noting that investing in fixed interest via a managed fund actually lowers costs in two important (but often unaccounted for) ways. Firstly, funds pay lower brokerage costs to transact on the exchange, and secondly, funds simply pay less for the same bond via a narrower bid/offer spread for trades not dealt on the exchange. We estimate that these savings are around 0.25% at the time of purchase.

Are there other benefits from professional management?

Fund managers may also be able to add some additional value to help offset their costs. This will vary across funds, depending on the capabilities of the fund manager and the design and investment approach of the fund. As an example, for the three years to June 2015 the Harbour NZ Corporate Bond Fund has generated about 0.12% p.a. of added value over the ANZ Corporate Investment Grade Bond Index, before costs. The relevant issue is perhaps not the 0.12% cost offset, but that no investor buying bonds directly could ever hope to achieve the diversification of the ANZ Corporate Investment Grade Bond Index without incurring very high transaction and monitoring costs. The fact that Harbour can do so, and add a little something back, is a great benefit to investors.

Even if you don’t believe that managers can add value through professional management, their research resources may help avoid the accidents that can occur in small, poorly researched portfolios.

Can term deposits be a solution?

Term deposits (TDs) often provide a higher running yield than a bond fund (after fees) or direct securities (after costs). There is a good argument for holding some exposure to TDs, but they also have different characteristics. Investors typically choose short maturity TDs, of less than one year, because of the severe penalties that occur with early withdrawal. The short length of the TDs may offset the potential added return. To underline this issue, the Reserve Bank and APRA, the Australian regulator, have required Australian banks, and their New Zealand branches or subsidiaries, to tighten up the conditions under which investors can break a TD before maturity. This lack of liquidity may be a problem at times for investors.

Secondly, since TDs have no price mechanism, they do not increase in capital value at times when shares fall, meaning we lose some of the diversification benefit we are seeking through fixed interest securities.

What am I paying my adviser to be an expert in – financial planning or bond markets?

The Code of Professional Conduct requires an authorised financial adviser (AFA) to “make recommendations only in relation to financial products that have been analysed by the AFA to a level that provides a reasonable basis for any such recommendation, or analysed by another person upon whose analysis it is reasonable, in all circumstances, for the AFA to rely.” In our experience, it is a challenge for most advisers to bring together the expertise and resources required to satisfy this requirement in relation to directly held securities. In our view advisers are, and should be, experts in financial planning rather than experts in fixed interest markets. Those who try to be both risk doing both to a lesser standard.

There are several factors to consider when choosing between funds or direct investments in New Zealand fixed interest. Financial planners are accustomed to using funds for investing in equities and overseas asset classes. We believe the underlying investment characteristics of an appropriate fund can be a better proposition than direct securities, due to a fund’s ability to achieve diversification, liquidity and benefit from professional management.

We’d like to thank Harbour Asset Management’s Mark Brown for his assistance with this article.

Important notice and disclaimer

This commentary is given in good faith and has been prepared from published information and other sources believed to be reliable, accurate and complete at the time of preparation but its accuracy and completeness is not guaranteed. Information and any analysis, opinions or views contained herein reflect a judgement at the date of preparation and are subject to change without notice. The information and any analysis, opinions or views made or referred to is for general information purposes only. To the extent that any such content constitutes advice, it does not take into account any person’s particular financial situation or goals, and accordingly, does not constitute personalised financial advice under the Financial Advisers Act 2008, nor does it constitute advice of a legal, tax, accounting or other nature to any person. The bond market is volatile. The price, value and income derived from investments may fluctuate in that values can go down as well as up, and investors may get back less than originally invested. Past performance is not indicative of future results, and no representation or warranty, express or implied, is made regarding future performance. Bonds and bond funds carry interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), inflation risk and issuer credit and default risks. To the maximum extent permitted by law, no liability or responsibility is accepted for any loss or damage, direct or consequential, arising from or in connection with this document or its contents. No person guarantees the performance of funds monitored by Consilium NZ Limited.