There’s one golden rule that savvy investors follow – don’t put all your eggs in one basket.
Although investing is usually associated with the ups and downs of stock markets, in reality there’s a lot more to it than that. Multi-asset investment funds, for example, typically feature a range of asset classes – shares, cash and fixed income. It may also include other assets like property. A diversified approach can lead to smoother returns, compared to relying on only one source for returns.
Fixed income is one of the more complex asset classes, yet over recent years has provided solid returns. And with rising expectations that interest rates will start to increase over the long-term, the future prospects for fixed income could have a further impact on your investments.
What is fixed income?
Fixed income involves lending your capital to a business or government (such as a UK gilt), which is used to fund their activities. In return, the organisation agrees to pay you back, usually at a pre-determined rate of interest. These investments are often referred to as bonds.
If the company or government was to go bankrupt, or default on the loan, you could lose money. However, you would have a higher claim to receive what you’re owed compared to shareholders (if a company). This means fixed income can be a less risky asset class compared to shares.
Please note, however, fixed income is a diverse asset class. Not all types of fixed income will perform in the same way, and they can vary in risk.
Where’s the value of fixed income?
First of all, the value lies in the returns you could achieve. Investors receive a yield return from a fixed income, the amount affected by fluctuations in the value of the bond. Prices and yields move in opposite directions – when prices go down, yields go up.
There can be some similarities in how fixed income assets and stock markets perform. However, inflation and interest rate movements are more significant to the fortunes of fixed income compared to shares. If shares tumble, fixed income assets typically fall by a lesser extent, if at all. So your portfolio has more protection from volatility in markets.
Why has fixed income benefited investors?
Back in the 80s, the financial world was very different. According to Bank of England, 10-year government gilt bonds (which as the name suggests, have a 10-year investment term) were typically around 15%, which was very much in line with interest rates and inflation at the time.
However, over the last three decades, interest rates and inflation has fallen. Meanwhile, following the global financial crisis that began in 2007, central banks have been printing new money with the aim of stimulating economic growth – an approach known as quantitative easing (QE).
Against this backdrop, fixed income yields also fell significantly – greatly benefiting investors with fixed income holdings. By 2016, UK government gilt bonds had fallen to 0.5%. If you held 10-year gilts over this period, you will have enjoyed very strong returns from these assets.
Will this trend continue?
Past performance is not a guide to future returns and it would appear the strong run for fixed income won’t continue indefinitely. Since the EU Referendum in June 2016, yields have begun to edge back upwards. This could prove to be the start of a long-term trend – and that is something for investors to keep in mind.
Scott Ashworth, Skipton’s Senior Technical Research Adviser, explains
With fixed income yields at such historic low levels, there isn’t really much further for them to significantly fall. And what’s more, the changing economic backdrop could prove less favourable to the prospects of this asset class, if growth continues to remain buoyant.
In the UK, there is the spectre of interest rate and inflation rises over the next few years, and the further scaling back of QE making it more expensive to borrow money. The US appears to be further along this economic cycle, given they have already seen several interest rate rises over the past two years. But inflation is starting to pick up there too. It all points to a growing likelihood that bond yields will go up further.
If your investment portfolio features exposure to fixed income, the possibility of yields rising could be significant on future returns. It could prove to be a challenging few years for fixed income – which your fund manager is likely to be considering, as part of their overall investment strategy.
Scott adds, “The long-term outlook for fixed income feels uncertain. Some fund managers we speak to believe that inflation will rise and as a result bonds are more likely to struggle. But other fund managers argue the factors that have caused yields to fall in recent years remain prevalent, and as such the prospects for fixed income are still favourable.
“Ultimately, the uncertainty in the fixed income market underlines the value of having a diversified portfolio of investments – so you’re not fully exposed to the potential downsides of under-performing assets.”
In a future edition of Skipton Insight we will examine in more detail the potential fixed income challenges facing fund managers, and what they’re doing to prepare.