This was the reason behind the popularity of finance company debentures and the same theme continues today with higher risk bonds.
Retail fixed interest portfolios of today aren't ideal but don't however expect much in the way of improvement in behavior in the future. Under the new rules advisers have to do the best thing for their clients but this can be interpreted in lots of ways particularly if those doing the interpreting themselves don't have a great idea of what constitutes best practice.
One independent expert testified to a court not so long ago that a "good" fixed interest portfolio would have exposure to two finance company debentures. Ridiculous. If you are going to have a portfolio which includes shares then your bond portfolio needs to be very low risk. But unfortunately this independent expert financial adviser doesn't have a monopoly on bad advice.
Another AFA qualified financial adviser made the ridiculous comment in a newspaper recently that "investors would be crazy to lock their money into any bonds for more than two or three years at the moment" and that it was better left in the bank.
Whether keeping your money on call or investing it for 10 years actually turns out to be the best strategy or not is irrelevant - the point is that investing all your money in short term bonds is a risky strategy. What if interest rates fall and call rates are down to 2.0 per cent in two years time? What is that going to do to your income? Besides the volatility of income introduced by just focusing on short term fixed interest investments this was a dumb comment for four reasons:
• If managing a bond portfolio was as simple as picking whichever duration looks most appropriate given the economic outlook then 90 per cent of US bond fund managers would not underperform the index (stats as per recent Lipper study).
• Government stock is much less risky than bank deposits and thus can be expected to far better diversify a portfolio in a negative economic environment, not to mention a Cyprus scenario where bank depositors are invited to bail out a bank. Some experts reckon the new environment for addressing banking crises will involve more "bail ins" and less "bail outs".
• The economic theory "the term structure of interest rates" says that long rates just reflect the market's forecast of short rates over the period of the long rate so what a 4.0 per cent 10 year government bond yield suggests is that short rates are going to be lower than this over the next 10 years.
• The maturity profile of the "index" is much longer than "call" and the portfolios of most fund managers approximate the maturity profile of the "index". Any fund manager who was silly enough to put all his funds on call would be instantly dismissed and wouldn't ever work in the industry again, except perhaps as an Authorised Financial Advisor.
Advisers now have to undertake Continued Professional Development (CPD) to address any weaknesses in their advice but from what I have seen of the CPD courses on fixed interest they are, to be charitable, not ideal.
Some concentrate on the mechanics of how to value a bond which is completely irrelevant for 99.9 per cent of financial advisers and a forthcoming webcast which offers AFA's structured credits talks about "exploring strategies using credit volatility and curve rolldown to your advantage". Goodness knows what that's about but I strongly suspect no clients are going to understand it and very few AFA's will be able to implement it profitably especially when transaction costs are considered.
There seems to be no practical advice on how to put together and manage a fixed interest portfolio. This isn't altogether surprising because a sensible bond portfolio couldn't sustain a high annual fee structure and few people involved seem to know or care what best practice looks like.
So in light of this situation what follows is an interpretation of how the "buy side" puts together a NZ bond portfolio as opposed to the "sell side". Pension funds, Kiwisaver providers and Endowment funds are generally known as the "buy side" because they buy financial products and stockbrokers, financial advisers etc are known as the "sell side" because they sell financial products.
Because the "sell side" is frequently remunerated with commission and high risk bonds pay higher commission than low risk bonds (most of which pay no commission at all) it is no surprise that "junk" features so predominantly in retail investors' portfolios.
So here we go; it is not rocket science - all you need to do is copy the strategy of the big pension funds and concentrate most of your bond portfolio in high quality bonds issued by SOE's, city councils and banks with the latter limited perhaps to a maximum of 30 per cent of your bond portfolio. You need to have some short, medium and long bonds.
Fund managers make a big deal about managing the maturity profiles of their portfolios on the basis of their forecasts of where interest rates are going but the reality is they don't stray too far from the index. If you don't need the income you could also include an allocation of inflation indexed bonds.
Note this is just some thoughts on putting together a local bond portfolio and the average pension fund typically has half its bond exposure outside of NZ. That's a topic for another day.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.
