The Chinese calendar says this is the year of the dragon.

Less auspicious perhaps but for Australian investors this is shaping up as the year of fixed income.

There are a number of reasons why fixed income as an asset class is likely to be front and centre in debates about investment strategies this year.

For a start there is the ongoing focus on official cash rates and the impacts - direct and otherwise - that flow into other parts of the economy.

The Reserve Bank has already given us an early reminder that even confident predictions from market experts can be wide of the mark.

More broadly on the superannuation front is the wide-ranging debate about the right asset allocation mix for default super funds. Super trustees are asking themselves the hard question about whether Australian investors have been too heavily invested in shares rather than more defensive fixed income assets in their super funds.

Meanwhile nervous eyes are on the Europe and the Greek debt situation where the threat of default hangs over global bond markets.

For superannuation fund members the asset allocation debate is the long-term story.

Regardless of whether you have your own self-managed super fund or are a member of a large public offer fund this is a discussion worth tuning into simply because the asset allocation decision has been found to be the most pre-eminent decision for what drives your portfolio's behavior.

For members of large funds understanding what the mix is between growth and fixed income assets - be it 50/50; 60/40; 70/30 - is to understand how much risk you are taking. And if you are not comfortable with the risk that the portfolio is targeting you can exercise your choice to switch into a more defensive portfolio.

But for SMSFs the challenge around fixed income investing is more fundamental. For a start accessing the fixed income markets directly - be they government or corporate issues - is difficult for individuals as it is largely a wholesale or institutional marketplace.

But in 2012 that is likely to change because on 9 January the Australian Securities Exchange had changes to its operating rules for the AQUA market which is a trading platform for exchange traded funds (ETFs) ratified.

What the rule amendments allow is for fixed income exchange traded funds (ETFs) to be quoted on the ASX for the first time. While equity ETFs have been around for more than 10 years the ASX operating rules effectively blocked fixed income securities (also known as bonds) as the underlying investment for ETFs. That has now changed so investors can expect to see a range of fixed income ETFs from product issuers launched on the market in the coming months and years.

Why should that be of interest to investors? Simply because it will give individual investors and advisers a new set of defensive tools to manage their portfolio's risk.

But it does raise the question of the role of fixed income in a well-diversified, balanced portfolio. The use of fixed income as an asset class within major super funds and other institutional investors is much more prevalent than among individual investor portfolios.

That can partly be explained by the lack of direct accessibility to the bond market - albeit fixed income managed funds have long been offered through financial advisers.

The other big influence has been the interest rates that are on offer via bank term deposits. Investors have clearly voted with their wallets judging by the amount of money flowing into term deposits in recent times.

Term deposits and short-term cash holdings certainly have a role to play in a portfolio so why would you consider investing in bonds?

Going back to basics a bond is a commitment from a borrower to an investor to pay a coupon rate at certain times and repay the principal on maturity.
The coupon rate will vary depending on the prevailing rates of the time, the length of the term and the borrower's creditworthiness.

The federal government is clearly a better credit risk than a second tier industrial company so government-backed bonds will typically pay lower coupon rates than corporate bonds.

Bond investing is primarily defensive and when blended with growth investments like shares it has the effect of reducing the variability of the portfolio, provides a source of income and capital preservation.

And looking back to 2008 and again in 2011 high quality defensive bonds did the job for investors by providing a safe harbor against the equity market storms.
The Australian fixed income market - as measured by the UBS composite index that represents the Australian bond market in a similar way to the S&P/ASX 300 share index - returned 11.4 per cent in 2011 and 14.9 per cent in 2008.

Those types of annual return figures are abnormal for bond funds and people investing in them based on last year's returns need to heed the warnings about past performance not being a reliable predictor of future outcomes.

Investing in fixed income is about lowering and managing risk - something well illustrated when you look back over 20 years of the UBS composite bond index from September 1991 to September 2011 you see that over that period there has only been one year of negative return.

The benefits of investing in bonds are the income paid, the diversification benefit compared with equities and the capital stability that high quality bonds deliver. Bonds also offer liquidity - a key difference when comparing with term deposits where penalty exit fees often apply.

But like any investment there are risks that investors need to be aware of.

When you lend someone money there is always the risk they will not be able to repay it so default risk needs to be understood. This is also where bond funds or ETFs have the advantage of holding a diversified portfolio so the risk of an individual name defaulting is much lower than if you held an individual bond.

Interest rate rises and falls can also affect the value of bonds. The value of a bond is inversely proportional to the interest rate. So as rates fall, all other things being equal, the value of a fixed coupon bond increases and vice versa.

While the development of fixed income ETFs is likely to be positive for individual investors the usual cautions apply in terms of understanding what you are investing in and keeping a weather eye on the costs.

Author:  Robin Bowerman, Vanguard Investments Australia