What is fixed income – and why does it matter?

When you think about what Australian Ethical is invested in, your first thought might be shares in companies that are helping transform the planet for the better. But the chances are that some of your money is invested in the debt of these companies as well. Australian Ethical portfolio manager Tim Kelly explains our approach to fixed income.

If you’ve ever watched the business bulletin at the end of the evening news, you’d be familiar with a few major share prices and exchange rates. You might even see a comment about the Reserve Bank’s official interest rate decision, but you’d be less likely to hear about another important aspect of Australia’s financial landscape: fixed income.

A fixed income investment is effectively a loan made by you to another party. For the period of the loan you receive a regular payment (the ‘income’) and at the end of the loan you are repaid your original investment. That’s it! A term deposit is the most basic form of fixed income, but it can come in many other (increasingly complex) forms: bonds, bank bills, and mortgage-backed securities are just a few examples. There’s a good chance that some of your superannuation is invested in fixed income, particularly if you have investments in balanced, conservative or defensive superannuation strategies.

It’s important to realise that fixed income is starkly contrasted with shares (also known as ‘equities’). Whereas a bondholder lends money to a company, a shareholder owns part of the company and may be eligible to receive a share of its profit. And unlike fixed income, shares do not come with an agreement to return the capital (ie, the money originally invested). The uncertainty of shares also demands a higher return than fixed income, which can create higher volatility in price movements. Investors who are looking for more certainty in their returns or more stability in the value of their investments tend to increase their allocation to fixed income relative to equities.

None of this is to suggest that fixed income investing is without its risks. There are four main risks for fixed income investors outlined below:

  • Credit risk – The risk that an interest payment is not made (either partly or in full) at the agreed date or that capital is not returned as promised.
  • Interest rate risk – The risk that interest rate movements will affect the value of an existing contract for payment.
  • Duration risk – Risks that relate to the term of the fixed income contract. The longer the duration, the greater the sensitivity to interest rate changes.
  • Liquidity risk – The risk that the investment cannot be easily converted back into cash.

Australian Ethical’s fixed income products seek to manage these risks in different ways while at the same time adhering to our Ethical Charter.

Australian Ethical Income Fund

The Australian Ethical Income Fund is our most defensive fund. This fund seeks to deliver an income stream that reflects short-term interest rates while minimising the risk of capital loss. This focus on short-term rates allows the Income Fund to manage its duration and interest rate risk by allowing only a short time until either the original capital is returned or the interest rate paid on the investment resets. The fund also seeks to allocate some funds to issues from Commonwealth and State Government securities, since government borrowers tend to have higher liquidity and lower credit risk relative to other companies and banks. The Income Fund also attempts to balance the credit risks represented by individual companies by limiting the size of our investment in any individual entity. By taking this approach, the fund aims to deliver the prevailing short-term interest rates while aiming to deliver capital stability.

Australian Ethical Fixed Interest Fund

The Australian Ethical Fixed Interest Fund is less defensive than its short-term focused cousin. This fund instead seeks to generate income while also having the potential to see some movement in capital values. This potential movement comes from interest rate and duration risk taken by the fund, with the investments here typically taken at fixed rates and with longer maturities than those in the income fund.  The value of an investment can change as market interest rates (known as ‘yields’) move closer to or further away from the agreed interest rate (or ‘coupon’) of each investment. Typically, increases in yields will drive the value of fixed interest investments lower, while decreases in yields will drive the value of fixed interest investments higher. The longer the term to the maturity of the investment (ie, its duration) the greater the movement.

The Australian Ethical Fixed Interest Fund positions its duration relative to its benchmark, the Bloomberg Ausbond Composite Bond Index 0+, which sits at a little over 5 years. Depending on our view of the future direction of interest rates, we may adjust this position around the benchmark level to be slightly higher (when we expect rates to fall and thus values to rise) or lower (when we expect rates to rise, and thus values to fall).

Credit risk for the fund is managed close to that of the benchmark also, with approximately half of all funds invested in Commonwealth Government Securities, a quarter in State Government Securities, and the remaining quarter split between development banks and other corporate issuers (including banks) that meet the our Ethical Charter.

Green bonds

Some of the investments in each fund are in green bonds. These are investments where the issuing entity has identified certain assets on their balance sheet as having environmental characteristics, and then issues a bond whose ‘green’ credentials are backed by these assets (while typically sharing the credit risk of the issuer). Typical examples of characteristics used for green bonds are loans to renewable energy projects, consumer receivables including household solar panels, or energy-efficient office space.

Not all of our fixed income investments are green bonds, but all of our holdings are assessed against the 23 principles of our Ethical Charter which has been unchanged for over 30 years.

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