What do you get when you make a substantial investment that rewards with a reliable income you can depend on every quarter? Fixed income (FI) of course. But which classes of this asset are best for you and why?
What are fixed-income assets?
As the name implies, fixed-income assets generate a preset amount of income at regular intervals. Just like a bank deposit you pay in a certain amount for a predetermined period at an agreed rate. The bank then credits the equivalent interest every month.
Broadly speaking, fixed income usually refers to debt assets (i.e. investor lending capital) as opposed to equity assets (i.e. investor exchanging capital for ownership). Investors become creditors to the entity that they invest in. In exchange, they are compensated by regular coupon/interest payments at an agreed rate.
Below is a list of common fixed-income assets:
|Fixed income asset||Description|
|Bank deposit||Savers lend money to banks (deposit) in exchange for interest payment. The capital is usually protected up to a certain amount (i.e. CHF 100,000 in Switzerland), guaranteed by government-backed insurance schemes.|
Investors lend money to another entity (be it national governments, municipal governments or corporate entities), in exchange for coupon payment.
|Property bonds||Investors lend money to a corporate entity that owns properties, in exchange for coupon payment. The loan is often secured against the underlying property (collateral).|
|Mini-bonds||Investors lend money to SMEs (small and medium enterprises) in exchange for coupon payments. It’s similar to corporate bonds however the debtor in question tends to be smaller and higher risk. The coupon rate is usually significantly higher than corporate bonds.|
Why invest in fixed-income assets?
Most investors dedicate a significant portion of their portfolio to fixed-income assets, especially pensioners and those close to retirement age. There are 3 key reasons behind such a move:
1. Income regularity – investors receive a fixed level of income at a regular interval (hence the name!)
2. Lower capital volatility – as a fixed income investor, you are a creditor to the investee (rather the owner of). Consequently, in the event of bankruptcy, you will recover your capital before shareholders (although as we’ll see later, this can be deceptive).
3. Securitisation and diversification – fixed-income assets can be securitised and be traded like stocks, achieving liquidity and help to increase diversification (through lower transaction costs).
How to choose profitable fixed-income opportunities?
Like any other investment, the core of a profitable FI asset is the balance between the risk taken on and the reward it generates (risk-reward profile).
There are 2 principles ways to reap the return from FI assets:
- Yield: the fixed coupon/interest payment as stipulated under the terms of the asset.
- Capital price movement: when the underlying par value of the asset changes from the original issuance value. This only really happens with publicly traded bonds.
Equally, there are several intrinsic and extrinsic risks associated with these assets:
- Credit risk: where the issuer defaults and fails to return interest and/or capital.
- Pricing risk: where the selling price of the security is lower than the purchase price.
- Interest risk: where a rise in the central bank base rate renders the security a less attractive investment option, reducing the price.
- Inflation risk: where the rate of inflation outpaces the coupon rate, decreasing the purchasing power of the capital.
- Liquidity risk: how easily an asset can be sold and turned into cash.
The key is, therefore, to ensure for a given level of risk taken on, you are maximising the return.
A glimpse into the most profitable fixed-income assets in Switzerland today
The most common fixed-income assets available to retail investors these days are:
- Government bonds
- Corporate bonds
- Property bonds
Each asset has different characteristics and understanding their risk-reward profile is critical in deciding how to deploy them in the portfolio.
|Asset||Government bonds||Corporate bonds||Property bonds||Mini-bonds|
|Description||Debt instruments issued by local/national governments to fund their spendings.||Debt instruments issued by companies (usually large and public ones) to fund their operations and growth.||Debt instruments issued by an SPV (usually a limited company) to fund the purchase of properties.||Debt instruments issued by small private companies (or even individuals) to fund their business operations and growth.|
|Yield||Usually between 0.5-2% for Gilts and Treasury Bills, -0.3% for Swiss government bonds||2-4% for investment-grade bonds||3-7%||8%+|
|Capital appreciation||Limited to 1-2% per year for AAA-rated countries. None if bought at issuance and held to maturity.||2-3% per year. None if bought at issuance and held to maturity.||Not publicly traded. Full repayment if held to maturity.||Not publicly traded. Full repayment if held to maturity.|
|Credit risk||Low – if a default occurs, governments can always just print more money.||Medium – default can happen and bondholders need to go through lengthy legal processes to liquidate assets (if any) and recoup losses.||Low – bond is secured against the property, which can be liquidated relatively quickly (compared to corporate bonds).||High – default will go through a similar process as corporate bonds. However, these companies tend to be smaller and less stable.|
|Pricing risk||Low to medium – short term fluctuation is inevitable.||Low to high – depending on the trading performance of the specific company in question.||None, the instrument is not publicly traded.||None, the instrument is not publicly traded|
|Interest risk||High – any interest rate increase will dampen the par value.||High – any interest rate increase will dampen the par value.||None, the instrument is not publicly traded||None, the instrument is not publicly traded|
|Inflation risk||High – due to the low yield.||Medium to high||Low – as yield is above the historical average CPI.||Low – as yield is above the historical average CPI.|
|Liquidity risk||Low – the government bond is vibrant and highly liquid.||Low – unless a company Is undergoing financial distress.||High – instrument not publicly traded.||High – instrument not publicly traded.|
|Examples||CH government 10-year bonds||Novartis bonds||Le Bijou property bonds (certain issues)||UK Renewable Energy Bonds|
It is evident from the above comparison that at one end of the risk-reward spectrum, we have government bonds that are extremely stable and yet delivering below-inflation returns. On the other hand, we have minibonds issued by SMEs that provide a superior return, but investors might not recoup their capital!
Corporate and property bonds rest somewhere in the middle of the two ends. They both have a similar overall return profile (5-6% per annum). The question, therefore, boils down to liquidity versus credit risk:
- Corporate bonds are highly liquid instruments and can be easily sold over the counter. However, it requires investors to understand the underlying performance of the business in order to gauge the credit risk. Equally, when a default occurs, the process of recouping the capital can be lengthy, onerous and uncertain.
- Property bonds are highly illiquid instruments (since not publicly traded) and require holding until maturity. However, their principal risk lies in the valuation trend of the specific property it is collateralised against, which is easier to understand. Equally, once default occurs, bondholders can simply sell the property and be compensated, which is a simpler and faster process than corporate debt restructuring.
There’s a huge array of different fixed-income assets to choose from, so choosing the one that suits your potential outlay and profile is key. Corporate and property bonds are the most profitable assets. The key trade-off between them lies between the liquidity risk versus liquidation risk. The bottom line though is that property bonds tend to deliver higher returns in the long run. As well as offering better protection against default. However, one must accept the lower liquidity inherent to the asset.