When deciding which asset classes to invest in, it is important to consider the varying benefits, costs and risks associated which your available options. The following article will outline some areas which need to be taken into account by all investors when investing in fixed income assets.
What are fixed-income assets?
Fixed-income assets refer to those investments which provide a return in the form of fixed periodic interest payments and the eventual return of the principal at maturity. The borrower or issuer of the security is obliged to make payments of a fixed amount on a specified schedule. They are generally issued by companies or governments in the form of debt securities that raise money to fund their day-to-day operations or finance large projects.
How do they work?
When individuals invest their money in fixed income assets, they will receive a set interest rate which is fixed in exchange for the money they have provided to the issuer of the investment. These payments are known as coupon payments and will be received at specific dates until the bond matures.
The benefit of investing in these types of assets is that investors are provided with certainty around how much interest they will earn over the bond’s life. Therefore, investors may be able to predict more easily what their return on investment may be.
The Australian bond market (government and corporate issues) is worth $958 billion, however, JP Morgan Asset Management has recently released data to suggest that fixed-income assets will return just 3.7% over the next decade, which begs the question of whether fixed-income assets are a valuable investment.
To ascertain whether this asset class is a valuable investment, it is important to consider the following points
- Fixed interest provides diversification when investing in equity – bonds have the potential to reduce overall portfolio volatility when they are held in conjunction to growth assets such as domestic and international equity
- Fixed interest may be more suitable for a ‘risk averse’ investor whose primary goal is capital preservation and does not wish to be exposed to high risk or growth assets
- Fixed interest provides investors with a steady and regular income stream which could be more suitable for retirees or those who do not wish to be fully invested in the market
- Priority at the time of liquidation means that if a company goes into liquidation, investors with fixed income securities will be given priority over other securities issued by the company including shareholders with shares in the company’s equity
However, it is also important to consider the potential risks of investing in fixed income assets. This form of investment is also subject to interest rate risk which refers to the potential for losses to be incurred as a result of changing interest rates. This means that if interest rates rise, the value of a bond or other fixed income will decline as the investor will continue to receive the same rate or return despite the potential to receive more interest at the same level of investment.
Another risk that must be considered is credit risk. This involves the position of the company that has issued the fixed interest asset to decline due to some internal or external factors. This then reduces the value of the bond or instrument when sold in the secondary market. Therefore, when the investor tries to sell the instrument before its maturity, they may realise a loss or find it difficult to sell. Another source of risk for investors is inflation risk which may occur where the rate of inflation surpasses the amount of fixed-income being received. There is an inverse relationship between interest rates and fixed income asset prices and therefore inflation can have a negative impact on fixed income assets when it results in higher interest rates. To read more about inflation, click here.
Prior to making any investment decisions, it is important to consider all the benefits, costs and risks associates with the choices available to you. If you require assistance in determining the right mix of asset classes for your financial needs and objectives, please click the link to organise a complimentary 20-minute phone call with an EPG Wealth adviser.