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Fixed Income Investing

Adding fixed income, particularly short-term bonds, to an equities portfolio will reduce volatility. Dimensional seeks to maximize expected return by minimizing the unrewarded risk of long-term instruments and by diversifying globally.

Fixed Interest

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Overview

Because bonds behave independently from equities, adding fixed interest investments to a portfolio can improve its overall diversification. Fixed interest securities expand the opportunity of investors to participate in the performance of capital markets and provide a more reliable source of income than other asset classes.

Relative performance in fixed interest is largely driven by two dimensions: bond maturity and credit quality. Bonds that mature farther in the future are subject to the risk of unexpected changes in interest rates. Bonds with lower credit quality are subject to the risk of default. Extending bond maturities and reducing credit quality increases potential returns.

Since it is impossible to predict what will happen with interest rates in the future, we diversify broadly and use a "variable maturity" approach in most of our portfolios. This approach, which was developed by Professor Eugene Fama, uses the current yield curve to determine optimal maturities and holding periods. To maximise expected returns, we choose shorter maturities in flat or inverted yield curve environments and longer maturities in upwardly sloped curves. Maturities are shifted in response to changes in the current yield curve.

Short Term Strategy

DFA Australia launched the Short Term Fixed Interest Trust in 1999. It is designed to provide liquidity and dampen overall portfolio volatility.

The Short Term Fixed Interest Trust invests in high credit quality, Australian dollar denominated domestic securities with a maximum maturity of 2 years. The Trust's weighted average maturity target is 1 year.

Diversified Strategy

DFA Australia launched the Five-Year Diversified Fixed Interest Trust¹ AUD class in 2001 and the Five-Year Diversified Fixed Interest Trust¹ NZD class in 2004. The Two-Year Diversified Fixed Interest Trust was launched in 2005. These strategies are designed to provide liquidity and dampen overall portfolio volatility. The Two-Year and Five-Year Diversified Fixed Interest Trusts invest in high credit quality domestic and global fixed interest securities hedged to the Australian dollar with a maximum maturity of 2 years and 5 years respectively. The Five-Year Diversified Fixed Interest Trust¹ NZD class is hedged to the New Zealand Dollar with a maximum maturity of 5 years.

Country allocation decisions are based on expected returns given current local yield curves. The objective is to provide a fixed interest investment that dampens portfolio volatility, we maximise the country diversification through the equal weighting of country allocations (subject to some country limits). Allocation shifts away from equal weighting are regarded as a reduction in diversification and require an expected return premium to compensate for this reduction. The exception to equal weighting arises when yield curves are inverted and cash offers the highest returns. In this instance, there is no benefit from holding cash in multiple countries and so the allocation might be invested 100% in Australia.

The Diversified Fixed Interest Trusts provide greater risk and a higher expected return than the Short Term Fixed Interest Trust.

  ¹ Formerly known as Diversified Fixed Interest Trust.