We have been in a period where financial market volatility has been abnormally low and as such, the focus in fixed income has become overly skewed to how much interest income can be generated, at the expense of ignoring downside risks.
For this reason, the price component of bond returns hasn't received much attention. As we are now shifting to a higher interest rate and credit spread volatility regime, price movements become more important as they can be a far larger driver of total returns than interest income.
This is especially relevant for retirees seeking stable income generating portfolios.
Additionally, what we see in Australia is that some of the most popular income sources - equities for dividends (particularly bank stocks), bank hybrid bonds, investment properties - are closely linked to each other and can therefore become highly correlated in a downside scenario. This means they can all end up incurring losses at the same time.
So, when thinking about income sources, it's important to consider how they will behave in different scenarios. To think about how much and what types of risks you're taking to get that income and to consider how those risks will interact with other parts of your investment portfolio.
None of the various income options available is inherently better or worse. Rather, the focus should be on diversifying income sources to achieve a balance of risks that can navigate a range of possible scenarios - whilst still providing a stable income.
Fixed income is generally labelled as a 'defensive' income source. However, the conventional approach to buying and holding bonds to harvest yield (or income) may not be as defensive as assumed.
This is because there are actually two sources of return from a bond. There is the interest payment and there is also the capital gain or loss from bond price movements. The interest component of a bond, assuming the bond issuer doesn't default, is known with certainty, but what is not known is how the bond price will behave over time until it reaches maturity.
These intermediate price movements can actually be far larger than any interest received from holding the bond. This is particularly true in the current environment where bond yields are low but price volatility is rising.
For example, the chart on the next page shows the price of the current 10-year Australian government bond, which pays an annual interest rate of just 2.25%.