There's nothing like a stockmarket collapse to remind people how useful defensive investments such as bonds can be. Investors with a decent allocation to these types of investments enjoyed a buffer from the financial crisis and, while it may have seemed a drag during the market rebound of the past nine months, that's more than compensated for by the insulation it provided on the way down.

Terms such as "income" or "defensive" cover a multitude of products, styles and ideas. They go from tedious, plodding cash and bond funds through mortgage funds to high-risk, high-reward credit products and even into high-yielding stocks. The boxes on this page highlight the different types of products available and how to tell them apart.

As a rule of thumb, though, this type of investment has become a lot simpler since the global financial crisis as the things that looked clever and lucrative a few years ago were often the ones that came unstuck. "The last two years have seen an incredible turnaround in the types of investment people have been considering for the income component of their portfolio," says the head of Australian retail at fixed-income experts Pimco, Peter Dorrian.

"If you think back to 2006, bond funds struggled to gain a lot of traction because the income investment class was dominated by things like mortgage funds, highly geared property funds and even hedge fund of funds." But all those areas ran into trouble for one reason or another and the trend today is towards the straightforward. "The little old bond market, long forgotten by investors, has suddenly got increased interest," Dorrian says.

Australian Unity Investments' general manager for retail, Adam Coughlan, agrees. "Where investors got themselves into trouble in the financial crisis was with some of the very high-yielding types of products available," he says. "I would say this: if it seems too good to be true, it is. Now we're starting to see people using bond funds more for their traditional, defensive purposes."

Data from fund researcher Morningstar shows that of the 116 new income funds launched in 2009, 82 were at the straightforward end of things: Australian cash, Aussie bonds, global bonds or a combination of the two. Just three mortgage funds appeared.

So what should investors think about when looking for income products? "There are two related but different roles a defensive asset can play in your portfolio," Dorrian says. "Firstly, as a buffer against the volatility of the equity markets and global asset markets and, secondly, as a provider of income to a portfolio on a very dependable and reliable basis.

"When you go into any bond fund there are two risks you need to think about. One is the risk of not getting income; the other is the risk of not getting 100 cents in the dollar back when it matures." That risk varies depending on who issued the bond. A government, for example, can raise taxes to ensure it repays its debts; a company can't do that and has to rely on its own balance sheet.

So just as with stocks, an important decision to make is what level of risk you want to take. Government bonds won't generate much money but they're unlikely to fall over. Corporate bonds pay out more, for more risk. Globally, professional investors have spent much of the past year trying to work out how best to take advantage of opportunities in what is called credit: higher-yielding, riskier bonds from companies.

"One trend I've noticed in the last 12 months is an interest in credit funds, born out of an incredible spike in the yields and returns available," Dorrian says. Two Pimco funds sold in Australia have some credit exposure and he says "both have had good inflows from investors in the last 12 months".

But in an area such as this it is essential to have professional management involved. It can be difficult for investors to access and tricky to understand. "We think it is very important for people to understand the systemic risk in any part of the market they invest in," says a Russell Investments portfolio manager, Kathy Cave, says. "When you buy equity there is a list of shares - the ASX 300, for example - but in fixed income that's not the case."

International or local

Another decision to make is whether you want international exposure. "When you're buying an offshore bond, you are taking on a whole different level and style of risk," Coughlan says. "The first one investors need to be conscious of is the exchange rate: the Australian dollar is at historically high levels but if it continues to go up then income will naturally go down in Australian dollar terms. That's probably the biggest risk those investors will face."

The risk Coughlan refers to - that gains on your overseas investments will be wiped out by a rising Aussie dollar - can be mitigated: many products offer a hedged and an unhedged version, giving you a choice about whether you want to be exposed to movements in currencies.

A separate point, though, is where the best prospects are. Australia is a high-interest country; the Reserve Bank of Australia has for many years set interest rates higher than is common in other major economies such as the US or Japan and the gap is getting wider now as the bank raises rates while other countries are still keeping them low as they emerge from the financial crisis.

"We're a big believer in diversifying your portfolio, so you need to have exposure outside Australia," Dorrian says. "But the other side of the argument is that Australia has traditionally been a higher interest rate country than many around the world; the US cash rate is virtually zero and it doesn't look like changing until early 2011. Australia has come through in better shape and investment returns from the bond markets look pretty promising in the next 12 to 18 months."

Not everyone agrees about where the opportunities are. "We actually think international might be more attractive than domestic bonds at this point," says Cave at Russell, which recently changed the strategic asset allocation in its multimanager products to increase the allocation towards international bonds. ING Investment Management, where Greg Michel is director of fixed income, has a bias for interest rate exposure in Australia versus Britain, the US and Japan. In any case, as he points out: "The fixed-income market is already a global market when you consider the range of issuers in Australian dollars - a multitude of foreign financial institutions and supranationals whose businesses are operated, in the main, well outside Australia. At the same time, most of the larger iconic Australian companies are active borrowers in foreign capital markets."

Worth another look

A third question is when is it time to return to unloved assets - and in particular, mortgage funds? Many of these ran into serious liquidity problems during the global financial crisis and investors have not been quick to forgive them, but Coughlan at Australian Unity argues that many were perhaps misusing them in the first place.

"The typical mortgage fund was used by two types of investor," he says. "The first type was using it as, in effect, a high-returning bank account. The other type was a pension-style client who saw a rate of interest better than the banks.

"When the financial crisis hit, the first group were the ones that didn't want to be trapped in there - they were really using them not in the way they had been designed." Their attempts to exit swiftly led to problems such as redemption freezes. But, Coughlan says, "the lesson has been learnt, removing these investors from the funds and leaving in place the pension-style client who the product is best suited for. Most mortgage fund providers by the end of this quarter will be through that process and we'll see a really good level of stability from those funds. Things are definitely looking up for the mortgage fund sector in 2010."

All providers agree that the push towards income products is driven by a broader change in Australian society. "We are seeing a demographic shift," the head of retail at Tyndall Investment Management, Craig Hobart, says. "More baby boomers are approaching retirement and demand for quality income streams is something we have identified as a gap." Cave at Russell speaks of "a focus on people who are in the post-accumulation, decumulation phase of their lives". She says: "They are no longer accumulating super but are starting to use it."

Michel says people wanting a fund for income should weigh up the following key considerations in choosing a fund: the stability of the income stream; the creditworthiness of what that fund holds; any use of derivatives by the fund; entry and exit charges; the fund's size; and the experience of the fund's managers.

Australians today have a greater range of choice in this field than ever before but, for the moment, it seems they're exercising that choice with greater caution than was the case before the financial crisis. And that's no bad thing. "It would be very disappointing if we didn't learn from our mistakes," Coughlan says.

What's an income fund?

You get a sense of the diversity of this style of investment by looking at fund researcher Morningstar's classification of income products. It considers them to fall into 10 different camps, roughly along these lines:

Australian cash: Invest mainly in very liquid market securities like bank deposits and bank bills. They usually mature in less than 12 months.

Australian cash enhanced: Similar to Australian cash but can also have exposure to bonds, corporate debt and asset-backed securities and may use derivatives. Usually have about a 12-month duration.

Mortgage funds: Mainly invest in registered first mortgages secured over Australian property but sometimes in fixed interest, money market securities or cash.

Mortgage funds — aggressive: Like mortgage funds but may invest 20 per cent or more in mezzanine debt, development and construction loans, pre-developed land or specialty loans such as to hotels and retirement villages.

Australian bonds: Invest in traditional Australian fixed-interest securities such as government or Australian corporate bonds with a maturity of more than one year.

Global bonds: Invest in foreign government and corporate debt with a maturity of more than one year.

Global-Australian bonds: Combine global and Australian bonds, with at least 25 per cent of the total in Australian.

Diversified credit funds: Invest in credit securities in Australia and-or worldwide. This involves active selection to try to get better returns than government bonds. Usually they invest in securities rated BBB or above (the definition of investment grade) but not always.

High yield: Invest in credit securities where the average credit quality is below BBB or sub-investment grade (sometimes called junk). Typically invest heavily in emerging market debt, junk bonds, structured credit and unrated issues.

Multi-strategy income: Combine different sectors to improve yield, which might include domestic and international government bonds, corporate debt, private debt and hybrid securities.

Even this impressive list does not include several other styles investors might consider as sources of income, such as high-yielding equity funds or listed property funds.

Note: Fixed income or fixed interest? Bankers and investors in most of the world use the term fixed income (even sometimes for bond products where the income isn't actually fixed). In Australia, the term fixed interest tends to be used instead. They mean the same thing.

Income products and the financial crisis

Although income products are usually painted as defensive investments that protect you in bad times, it's worth remembering that bond-related products kicked off the sub-prime crisis, which led to the global financial crisis.

Five years ago, it had become common for investors to put money into products such as collateralised debt obligations (CDOs), which packaged together dozens of debt instruments in order to make a return, usually combining leverage to boost that return. "But the leverage was not always appropriate and because you were investing in assets that were similar, it didn't provide you with diversification," says a portfolio manager at Russell Investments, Kathy Cave. "They could go badly wrong and that's what happened."

Usually, if something goes wrong in an asset, it doesn't affect the rest of the market. "The recent experience was dramatically different," says the director of fixed income at ING Investment Management, Greg Michel (pictured). "The freezing of markets for these assets was not a specific credit event but rather a market-wide liquidity event, with many income-based assets being impacted."

The problem spiralled as investors tried to pull out of funds that were never intended to face sudden redemptions from so many people simultaneously; it was in this environment that managers such as Basis Capital had to suspend redemptions and in some cases shut them down.

It wasn't just CDOs. Peter Dorrian at Pimco says investors had moved their income allocation out of safe bonds and into things such as mortgage funds, property trusts and fund-of-hedge funds. In each asset class, something went wrong.

"In the case of mortgage funds it was for structural reasons, where there was a mismatch between the ability to provide liquidity and the underlying assets they invested in," he says. "In hedge funds it was a similar problem: the liquidity of what the funds were invested in, versus the weight of redemptions seeking to get out. And while most property trusts survived the crisis, they are engrossed in massive capital raisings, which do nothing positive for investors other than reduce gearing levels."

The financial crisis also gave guaranteed funds a bad name, for two reasons: in the worst cases, the bank that provided the guarantee went under, rendering it useless; and in others, while investors didn't lose their money, they found themselves locked into an unproductive fund for up to seven years.

While there's still plenty of life in guaranteed products (provided you trust the guarantor), there is still suspicion.

"We have seen a few products launched that have some kind of guarantee attached to them," Cave says. "It's a different profile — some of them are fixed terms and are not necessarily simple investments. You are giving up the flexibility to get out of products for a guarantee over a period of time."

Nevertheless, the general manager for retail at Australian Unity Investments, Adam Coughlan, argues "there are still good products out there that do what they're meant to do but have a fixed rate of return".

Australian Unity offers a fixed-term product (called an income note) secured on income from retirement villages. "Retirement income is very stable," he says. "Something underpinned by real property is a safer way of getting income."