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Factors to consider when constructing a fixed income portfolio

by Elizabeth Moran | Jul 06, 2011

By Elizabeth Moran

For investors new to fixed income, there are many factors to consider when choosing assets for your portfolio. While analysts focus on the credit worthiness of the issuers and identify the risks involved, investors need to ask themselves a number of questions:

  1. What is your current portfolio allocation? You’ll need to assess your current investment allocation between the major asset classes of equities, property and fixed income. Does this meet your long term objectives? Do you have enough ‘protective’ fixed income investments? Remember that even though cash, including term deposits is included in fixed income, those assets don’t offer counter-cyclical benefits that bonds offer so that when higher risk asset classes underperform, bonds usually outperform smoothing portfolio volatility.
  2. The capital you need to maintain your current lifestyle Assuming the very worst possible scenario and you lose capital, what is the minimum capital you’d need to protect your current lifestyle?
  3. The income you need to maintain your lifestyle
  4. Known liabilities Bonds can be acquired with cash flows and maturity dates to suit known future expenses.
  5. Risk appetite
  6. Age The older you are the less time you have to recover lost capital. Also as you age, your earning potential may decline, again you may not be able to work to recover lost capital. Investors should consider that they generally need to be more protective of capital as they age and if you don’t have enough capital to support your lifestyle when you retire, then it’s not a good time to invest in high risk assets. One rule of thumb is that the maximum equities you hold should be 100 minus your age, so that if you are 70 years old then the maximum equity allocation should be 30%.
  7. Capacity to earn income to supplement losses
  8. Diversification Part of a building a balanced portfolio is making sure the investments you hold are across different industrial sectors, have varying maturities and risk profiles and in terms of a fixed income portfolio you should hold a different types of bonds, such as fixed and floating rate notes, inflation linked and government bonds.
  9. Liquidity
  10. Return This is often the first consideration of investors and while important should be considered in light of the above. Remember higher returns often mean higher risk.

By considering these factors and discussing them with your FIIG dealer or financial advisor, you’ll be better prepared when making decisions about which investments to include in your portfolio.

One final point, if you have proportionally large term deposit holdings one easy way to start investing in bonds is by assessing securities those banks or financial institutions have that are lower in their capital structure, so theoretically should provide greater returns. For example if you hold a Commonwealth Bank term deposit, then you have confidence in the ability of the Commonwealth Bank to continue to trade (it’s credit quality), then you could investigate other fixed income securities the Commonwealth Bank offer further down in its capital structure for a theoretical higher return.