Bonds pay the bills, shares fund the retirement experience

Patience and education are key to building a strong investment portfolio for retirement. In this article we explore the options for building a portfolio which grows with you and adapts as your goals change.

 The importance of education

Education is key to building a sound investment strategy. The more time spent on educating and building your knowledge, the greater the likelihood of aligned goals and outcomes.

Prior to investing, you should clearly understand any asset class you are considering. Try this simple test: can you explain the asset class and reasons for investing to your young child and elderly grandmother? If not, take the time to reflect on whether it’s the best investment choice.

The next step is to decide what role that asset will play in your portfolio. Portfolio construction is the reverse of opportunity cost investing.

 Portfolio construction and  the challenge of balance

A well-constructed portfolio will meet investment goals, volatility expectations and longevity outcomes. The share market had traditionally inherited the role of growth engine for portfolios. However, more recently, there has been a greater move by investors towards consistent dividend-paying companies – that is, “bond-like” shares.

This demand from investors for dividend shares has resulted in a change in behaviour by corporate Australia, which ultimately has the potential to destabilise the goals of portfolio construction. If corporate Australia constantly pays out profits, where will the asset growth necessary for a well-constructed portfolio come from?

For a comfortable retirement, you need a portfolio that grows with you and adapts as your goals change. This means you need a balanced portfolio that provides income as well as assets that grow at inflation-plus levels.

Investment goals and the benefits of fixed income

While the primary role of fixed income is to provide income, the beauty of the fixed income component of a portfolio is the potential for straightforward investment. Your financial planner can opt for fund manager engagement or embrace the direct investment route, so the questions to ask are, “Will I get my money back?” and, “What is the risk return I am deriving from this asset?”

The benefit of fixed income is the consistent revenue outcomes based on a predetermined series of cash flows. Interest rate volatility is managed by balancing the fund between fixed and floating bonds. In the current investment climate, a portfolio combining inflation, fixed and floating rate bonds should target a return of six per cent. However, in the chase for yield, this is becoming increasingly challenged by crowding out from investors searching for low-volatility assets performing on a relative value- basis comparison.

By supporting investors’ liabilities with consistent income results, the risk of the portfolio is naturally reduced. This is not to assume that the portfolio won’t be without risk, but the goals of the portfolio have altered – moving from a trading basis to a balance sheet basis. 

When the objective of the investor is to manage cash flows, monies arriving from fixed income are set aside to cover pending costs.

A winning strategy

Generating income isn’t the only purpose of the bond component of a portfolio. Inflation-linked bonds can help mitigate the onerous impact of inflation. It’s important for investors to appreciate that inflation has different impacts within different demographics – older investors don’t buy as many appliances like flat- screen TVs, for example, but they do buy energy, healthcare and retirement options. As such, although inflation may average 2.5 per cent, the true cost to some segments is significantly higher and needs to be managed. One way to manage the cost of inflation is to buy investment-grade inflation bonds. The goal should be to buy inflation protection at a real rate of anything above three per cent. (The real rate is the interest rate before inflation that has been added to the total return.)

A combination of fixed rate, floating rate and inflation-linked bonds can be constructed to mitigate the high costs of retirement. To enhance the performance of the portfolio, investors need to manage the portfolio from both a credit and duration perspective. Credit spreads are the implied cost of funding– recent bank hybrids have been issued at the bank bill swap rate of +3.20 per cent so the credit spread is then 3.20 per cent. If investors invest at elevated credit spreads they can carry the higher returns, but if credits rally, they should look to bank profits and reinvest at higher spreads. Duration also works in favour of the investor – when yield curves are normal, the longer you invest, the higher the return. Investors then rotate the investment as it moves down the yield curve and reinvest for longer, picking up the improved return.

This strategy works best in a rallying or static market. If investors are concerned that rates are going up, they should weight their investments towards floating rate notes.

Embracing the right kind of change

Since portfolio construction is constantly evolving, the challenge is to be consistent. By chasing the latest investment advice, investors run the risk of exchanging alpha for performance. And by chasing trades, they are overrun by the ‘what if’ rear-view world of investment management. This challenge should be met with a combination of patience and education.

To find out more about building a strong investment portfolio, speak to Wynyard Park Private Wealth today.

Source: NAB, August 2014