Fixed Income  

Finding the right risk/reward balance

This article is part of
Fixed income: Back to Bond Basics - March 2014

Bond managers and investors are faced with the challenge of finding fixed income investments that have the right balance of risk and reward to warrant buying into.

Looking outside the traditional fixed income space could offer benefits for investors. Whether this is the protection of short duration, floating rate notes or a bond that has the benefit of being correlated with equity.

Asset-backed securities do not conjure positive thoughts in every investor’s mind, as they are linked with the financial crisis, but the asset class cannot be generalised. These securities’ income payments, and so their value, are derived from and backed by a specified pool of underlying assets.

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The TwentyFour Monument Bond fund is made up of residential mortgage backed securities (RMBS) and is investment-grade only, with 90 per cent of the fund AAA or AA-rated. TwentyFour Asset Management head of distribution John Magrath says the fund is the firm’s alternative to a gilt or investment-grade corporate bond fund, but without the same duration risk, as it is all floating rate.

He adds: “Asset-backed securities will benefit from a rate rise environment, especially RMBS, because you get a tick-for-tick uptick in the yield inline with base rates. This removes interest rate risk. The refinancing market has picked up with more people refinancing, which means we get paid back from the mortgage bonds early, which means our returns go up.”

Brewin Dolphin fund analyst Victoria Hasler says that the firm holds both secured loans and asset-backed securities, which have similar properties. “Income is in high demand and so most things that pay a decent income are fairly fully valued.”

Ms Hasler says the loans are floating rate and have no duration, but look fairly valued now and investors don’t necessarily want to be buying at these levels. She adds: “There is more value in asset backed securities, as they have not rallied as hard as the loans have.”

Another alternative way to access fixed income is through convertible bonds, which are bonds that can be converted into equities at a later date.

Justin Craib-Cox, who runs the Aviva Investors Global Convertibles fund, says that convertibles offer the downside protection of a bond, but equity sensitivity. He explains: “If the underlying equity were to rise or fall by an equal amount, the convertible bond price would increase with the rising price of equity, but would fall by less due to the presence of the bond floor.”

He notes that convertibles are shorter duration than other bonds, at roughly five years, so they are not hit as hard when rates rise. Mr Craib-Cox adds: “The embedded equity element helps improve returns and this works well when there is higher inflation resulting from a better economic growth environment.”

The final benefit is that convertibles offer diversification, as this equity element of the bond means it is uncorrelated to other fixed income.