Fixed income: a repeat of ‘94?

Mike Taylor, managing editor, Money Management: Welcome lady and gentlemen to the Money Management Fixed Interest Round Table – and I will start with the key question: is the situation a repeat of ‘94 and bond yields and bubbles? I’m going to throw that straight to the author of the question, and that’s Jeff. 

Jeff Brunton, head of credit markets, AMP Capital: Thank you. Look, we don’t think it’s 1994. There’s no doubt that globally bond yields are very low, but unlike ‘94 we’ve got a lot of spare capacity in the labour markets and capital markets, particularly in the US. US bond yields in next 12 months will rise from 2.5 per cent to possibly the 3/3.5 per cent range, but that’s not the 3 or 4 per cent rise that we saw in ‘94. 

Meanwhile in Australia we’ve got the mining sector coming off the boil, we’ve got the Australian dollar, which up until recently has been quite high. We’ve got the case for the RBA to continue to be cutting interest rates here. 

So even though one or two cuts are priced into the forward curve in Australia, which might suggest bond yields have fallen as far as they go, there’s a case that the Australian interest rate markets don’t match the rise that we expect to see in the US.

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So bond yields are low – and low by historical standards. Total returns are going to be lower than what we’ve experienced, but we’re not about to go into a ‘94 style meltdown of significantly negative fixed income returns from selling bonds. 

Mike Taylor, Money Management: Jason Blumberg? 

Jason Blumberg, senior investment analyst, van Eyk Research: Yes, I agree with that analysis. I think in ‘94 the Fed didn’t realise the impact that they would have by raising rates unexpectedly. 

I think Ben Bernanke’s very cumbersome to that effect – just looking at how he’s reacted since he’s taken comment, and it’s been despite bond yields. I think he’s realised that he’s not going to be able pull back on what he’s had so far. So it’s a difficult way to spot the true value of US Australian bond yields. 

We’re in the same category as Jeff with Australian bond yields; definitely still got a lot of room to move down on the short end. On the long end, a little bit more sceptical, because with the slowing down of China and how that affects the local economy, we could start to see some credit-type assets in Australian long bond yield.   

Mike Taylor, Money Management: Stephen Nash? 

Stephen Nash, director, strategy and market development, FIIG: I think it’s a very interesting question. We get asked a lot about bubbles in various markets. I could say that QE [quantitative easing] is affecting world markets and clearly the equity market. Comparing ‘94 to now, things are very different in a lot of ways.

The developed world has most central banks extending very unusual measures at the moment, indicating low rates for an extended period of time. In this case we’ve got the US Fed quite concerned about really low inflation and the possibility of deflation. Bernanke did mention that in his recent address. I think this is an ongoing issue for the US, given the labour market. 

Bond yields typically reflect economic fundamentals – and we’re not typically strong at this point. Obviously there’s good growth in the US. When you think about it there’s a lot of constraints in the US growth: there’s the strong US dollar, higher rates now, a higher oil price and also ongoing fiscal drag. So there’s a lot of issues out there which could see bond yields a little bit lower than where they are right now. 

Mike Taylor, Money Management: Stephen van Eyk? 

Stephen van Eyk, managing director, Stephen van Eyk Consulting: To answer the question – could I go back and set the scene the way I’ve been thinking about markets, because I certainly agree with the other speakers. Imagine a world where the output of the real economy is about, say, four trillion.  But then you’ve got the financial economy at 16 trillion, that big – hovering above it.   

But the only place you can make any real money is in the real economy. So you’ve got all this money swirling around, the majority of which is on the balance sheet of central banks, all up there looking for a home down here.   

At first, after 2008, I thought that with all the problems in the world – the debt and shrinking of labour supply – we’re just going to get low growth until 2020, and we largely have. Which made me think, well, equities are just no good, so forget them and go into fixed interest and that’s it. Right? 

But then I realised that there’s this big world up here that was looking for a home down here – and it was increasing at a rate which was far greater than the real world’s output. So in other words the real world isn’t producing enough opportunities for all that money. It isn’t. 

So what happens is that money goes into a market, forces the market up, forces the yield down, probably to an overvalued territory, and when the real world doesn’t really justify that valuation, it just gets out and you’ve got volatility and that’s it.   

So I guess it would lead you to believe, getting down to the subject, that if a market has a really good year, because the money’s flowed into that market, it’s probably going to have not so good a year next year. As an interesting point, if you look at equity since 2008, the only time equities have gone up is when the Fed has been actually buying securities. And if you look at all the periods, and that’s about 40 per cent of the time where they weren’t buying securities, the market actually went down. 

Obviously that’s why people get nervous every time the Feds sort of make any hint that maybe they’re not going to buy securities. And that’s not buying, that’s not selling them, that’s just buying them. 

In other words this financial world is having a great impact on markets and in particular on the equity market. The equity market – if it reaches a point where it’s not delivering on profits because it’s been forced out of an overwrought territory – investors hop back into fixed interest. 

I would say that I agree that maybe the equity market is most at risk at the moment, and fixed interest is okay because growth isn’t suddenly going to be 4 or 5 per cent. Because this is supposed to be a recovery period, and normally it’s 8 per cent growth in a recovery period – but it’s not now. 

So it’s going to hang around and keep disappointing. And every time people are disappointed in the search for yield they start getting into unbelievable things: part of that world is big superannuation funds, and what have they done on infrastructure? 

Mike Taylor, Money Management: Jason you’re nodding there. Do you have a response to that? 

Jason Blumberg, van Eyk Research: Not really. I sort of agree with everything that Stephen’s just said. I don’t know how we’re going to deal with the massive financial ruin that sits on top of this real economy and, to me at least, they seemed to run a bit ahead of themselves.  But how does that work itself out? How do you shrink that world to get to the size of this world? I don’t know... 

Mike Taylor, Money Management: Without blowing everything? 

Jason Blumberg, van Eyk Research: Exactly, and I think that’s the game that Bernanke’s trying to play now. 

Mike Taylor, Money Management: Jeff Brunton? 

Jeff Brunton, AMP Capital: I think that just takes time. On our analysis there is a quite a bit of leverage because of the GFC that’s still yet to be worked off, particularly as the sovereigns in many parts of the world came into underwrite growth and do stimulus programs that were really just code for a lot more debt at the public sector level. 

You see glimpses of that impacting on markets. It can be around an election in Greece or in Italy, or information about the true state of the finances of sections of the Spanish banking sector. But the central banks have done a pretty good job of really dialling down that risk to keep it there, but not really as a driver of markets.  

We’re most likely in for a period of quite weak growth as we won’t be able to have a credit-fuelled cycle as we usually have had over the last 20-odd years. We’re coming back to a more natural rate of growth, connected to the rate of productivity, the rate of demographics and population changes, the rate of innovation. It’s going to feel a lot weaker than what we experienced over the last 20-odd years. 

Mike Taylor, Money Management: Australian versus international fixed interest? Stephen van Eyk, your thoughts? 

Stephen van Eyk, Stephen van Eyk Consulting: On the one hand you’d say, well, Australian growth’s definitely coming down, China’s still coming down, all that sort of stuff. 

What impact does the falling fixed interest and also currency have on decision making? Will Australian superannuation funds have a 10 per cent change in their allocation to offshore investments now, and if that’s the case – even though US growth is stronger than Australia – does that have an impact on Australian fixed interest markets, given the relative size of our superannuation market versus the real economy is pretty big? It’s about fourth relative to GDP in the world. 

So will there be a change in strategy, because basically these funds have not much in international for a long time, but now you’ve got a falling Australian dollar, you’ve got falling Australian growth. 

So will they shift money offshore and will part of that be fixed interest, or will it just be equities, and will it have an impact at the margin on Australian fixed interest anyway, and be different than what you think? It’s always trying to second guess the original. 

Stephen Nash, FIIG: Can I answer this? 

Mike Taylor, Money Management: Yeah, go for your life. 

Stephen Nash, FIIG: I’m going to answer it exactly. Typically when large funds allocate to local fixed income they do it in sovereigns, and particularly hedges, so there’s not much currency impact.  

But to me – when we need a lot of infrastructure development in this country – putting money in lower yields and then hedging it back to get a pick-up on your rate, which by the way is quite costly when you roll-out a hedge every month or so, doesn’t make a lot of sense to me. 

There should be probably a larger allocation to Australian fixed income, and obviously some growth in issuance sizes and some of the fixed income offerings in this country. I think there’s a lot of momentum to try and get that going at the moment.   

Jeff Brunton, AMP Capital: I totally agree. I think it’s pretty clear that Australians are terribly underweight of Australian fixed income.  The portion of our bond market owned by foreigners is at all time highs. Offshore... 

Stephen van Eyk, Stephen van Eyk Consulting: And what do they do when they’re falling over? 

Jeff Brunton, AMP Capital: Well that’s right. With their falling Australian dollar or with their changing view on China or of the mining sector, perhaps they might see better fixed income prospects elsewhere. 

But we come back to the fact that our bond yields are much higher than the rest of the world still; our credit quality at the sovereign level is much stronger.  

Our bond yields can play much more of a defensive role. Because we think about the role in a retail portfolio or a client’s portfolio that fixed income is really playing – can play too – it can do two things. 

One’s for income, and there you don’t really want a lot of duration. You want that to be focussed on having a modest amount of credit in there but not a lot of duration, and you can still get some interesting income in Australia. Yields of 4 to 6 per cent are available depending on the level of credit risk that you’re willing to take. 

The other need is to buffer your equity portfolio and that’s where you do need duration.  

So if you’ve got clients who are in accumulation phase, wanting to own a lot of equities – well, if that bet turns out to be wrong and equities start to fade and to fall, the good capital gains from falling Australian bond yields are much more likely than falling US or UK or Japanese bond yields. So the defensive play that fixed income can make in a client’s portfolio is a stronger effect than money in Australian fixed income. 

Mike Taylor, Money Management: Claire, you’ve been sitting there quietly and you come at it from a very different perspective being a planner. But in terms of bonds, in terms of fixed interest and in terms of what we’ve just been hearing from our panellists about basically balancing equity exposure and bonds, what are you talking to your clients about?  How do you tell them that story? 

Claire Mackay, principal, Quantum Financial Services: That’s very much the case. All our clients are keen to understand how their portfolio is invested to achieve their financial goals and lifestyle goals. So as you were saying yield and protection on the downside are the two key issues that all clients are looking to seek to address.

So the amount of allocation to fixed income as compared to growth assets is a big discussion that we have with our clients. 

I guess for us, though, the key thing is what is fixed income? For a lot of clients it’s understanding what that actually is. They understand equities. They know the companies they’ve invested in. We have a wider understanding of investing in Australian shares. 

Whereas we don’t have that when it comes to fixed income. We don’t have depth in the bond market. We don’t have a retail understanding of what fixed income is. 

A lot of people who experienced the GFC thought they were in fixed income and they weren’t. So they associate the definition of ‘fixed interest’ or ‘fixed income’ to something that may actually not be what we are talking about as fixed income. 

A big thing for us is education and promoting understanding; “Well, are you looking at a single bond issue with a counterparty risk? Are you looking at a diversified bond portfolio or an NTF? Are you looking at domestic or international, as we’ve previously discussed? And what is its purpose in the portfolio?”

So it’s actually a much longer discussion with clients about not just the asset allocation in their portfolio but what is its purpose. Protection on the downside is a big thing. And the yield: obviously if you’re looking for higher yield, you’ve got to be prepared to take higher risk. 

For many years term deposits were a proxy for fixed income because they were low risk, they were things that people understand and they were giving a relatively strong yield. As that’s come off, the discussion around bonds – corporate or sovereign or diversified mix – has been a discussion we’ve been having. 

But a lot of our clients are hesitant to take that initial risk on something they don’t really understand, given the recent experience with the GFC. 

Stephen van Eyk, Stephen van Eyk Consulting: I must admit that in my career I thought that if I could finish my career having this industry understanding you can lose money on fixed interest then it would be about the most worthwhile thing I could do.  

Because I can remember in ‘94 I did a paper on how your stable fund isn’t stable.  And there was just incredulous looks around the room from a lot of financial planners as well as people that as interest rates went up you lost capital value. 

Do you think you’ve achieved that with your clients? 

Stephen Nash, FIIG: We talk about super all the time but we talk about the assets on and on and on. We haven’t talked about the liabilities that the underlying clients have. 

We never think about matching or getting an asset that helps ensure or take a lot of those risks out of bonds over time, because people typically think about their returns in terms of CPI-plus to fund benefit schemes. Obviously we’ve got DC here – defined contribution – so everyone thinks that’s completely different but a lot of the time your underlying clients have the same expectations, CPI-plus.

This whole topic of asset liability matching is quite big in Europe and the UK and other places but in Australia it’s dismissed as irrelevant. It’s a bit of a pet subject of mine. I won’t go there if people don’t want to discuss that one. 

Mike Taylor, Money Management: Well, Jeff, I think it is a good discussion. What’s your perspective? 

Jeff Brunton, AMP Capital: The considering of liability is important. I can see how an individual investor gets overwhelmed because we don’t have a fixed income culture in this country. 

It’s heavily equity and there’s some tax reasons why we’ve gone down that route, but when a person comes to this asset class they are thinking of something that is usually safe and is reliable and is not where they’re taking risk. 

I think that suits more with a view of someone who’s at or into retirement and the capital stability is important, because the capital needs to yield a level of income to allow them to meet their living requirements. 

In that world of fixed income, you need to be well diversified, so I think that’s why the market has latched onto TDs as being that safe low-risk option. But TD rates are falling and are going to continue to fall. 

To get that diversification, we try to hold 80 to 120 individual bonds in a portfolio to make sure that we’ve spread the unforeseen default risk low enough. Because history teaches us that consumer preferences can change and tastes can change and industries in favour today can go out of favour tomorrow.   

You need to actively manage and survey fixed income holdings. Now there is a case, though, for thinking in a portfolio context with a few bonds or a few TDs, rather than a managed fund. So they understand that. 

I think in terms of the liability stream for someone who’s not in retirement, I think its right to think about the need for your savings to match inflation or purchasing power concepts – and whether you use inflation securities or you use growth bets such as equities to try to give your capital some upside.

In that world you shouldn’t be thinking about safety there, you should be thinking about your fixed income portfolio needing to perform if equities are falling. And really the only the way that happens is if you have duration. 

So if you have something that rises as interest rates are falling – it’s very difficult to get duration in a direct fixed income capacity. There are some government bonds that are going to be listed on stock markets – and longer duration government bonds would be where I would start first if I wanted to get an asset that would gain as equities were falling. 

Mike Taylor, Money Management: Well this is one actually for Claire more than I guess the rest of the panel. There have been a number of mentions now of the GFC and the manner in which people thought they were in fixed interest-type products. 

But the reality was they might have been marketed that way, but they certainly weren’t that. Have you seen the industry, from a planner’s perspective, move on and actually correctly label what’s going on. I’ll come to Jason after that to get a ratings house perspective that speaks to it as well – whether we’re seeing true-to-label on fixed interest. 

Claire Mackay, Quantum Financial Services: I think there’s been a big push in understanding of underlying investment, whatever it is, on equity or combination thereof, in terms of financial planners, through some fairly high profile instances where people learned the hard way that just because something is said, they’re not absolved from doing their own due diligence and truly understanding that. 

Investors have become a lot more savvy from having read about these unfortunate cases, and are being a lot more demanding of more information and not blindly trusting in any adviser. I think that’s a great thing. 

I think that people will be more aware, they’re more involved in their finances. So questions are great and it’s beholden on us as advisers to ensure our clients do understand what risks they’re taking, what the real risk is. 

True labelling across the financial services industry is an issue. Is it really that stable? That’s been a gripe of mine because clients’ day job isn’t financial services or investing, and so they are relying on the information provided to them.  

We as an industry use labels to make people feel good about whatever that investment is. So we say ‘high yields’ as opposed to ‘high risk’. We say ‘capital protected’ because that gives people comfort. 

I think that you said earlier that although it’s ‘safe’ – that perception of it being safe – it’s still at risk. I think that it’s an ongoing journey in terms of understanding, because as mentioned earlier, we don’t have a culture in Australia of investing in bonds and I think that there is a long way to go in understanding how bonds work. That’s the first conversation I have with pretty much all my clients, and some of them are very sophisticated investors but they don’t really understand bonds. 

You can’t encourage someone to invest in something they don’t understand or don’t even have the beginnings of an understanding of, because they’re taking a risk and they should be aware of those risks.

A lot of the hybrid structure products – those sort of things that came out pre-GFC and then either froze or didn’t behave as anticipated during the GFC – were big lessons both from an industry and consumer perspective. A big discussion that I’ve had with clients who came to me after the GFC was, “I want to be able to get my money out. It’s in there for growth or it’s in there for whatever, but if I need the money I want to know that I can get it out”.  So liquidity is a big thing that a lot of clients are demanding as well. 

Stephen van Eyk, Stephen van Eyk Consulting: I can remember back at that time there was a lot of those products that were high risk – and I’m putting my foreman cap on here if you don’t mind, but what do you want from a researcher? 

There was one product back then that I can remember, it sticks out vividly, and do you want the research house to say, “This is one of the highest risk areas to invest in, but if that’s what you want, that’s the best manager of the most high risk area”. 

And there was one product like that – well there was more than one – but I remember one in particular in relation to a major financial planning firm. We had said, “This could lose all your clients money, but if that’s what you want, if you want to be in this area, these are one of the best”. 

And it was black type and all that, and I come across one client – a major, major group, a bank group – that had 30 per cent of the clients’ portfolio, their high net worth clients, in this product. And in the report it had been written that, in terms of allocation, no more than 5 per cent of your client’s portfolio should be in something which is as high risk as this. 

It was 30 per cent – and it was only a client of theirs that alerted me. I was sort of “holy mackerel”. We were recognising that was high risk ... so should we have just said, “It’s too high risk for the market, so you don’t even go there”, or should we have said, “Well, it’s high risk but...”.  What would you think?  

Claire Mackay, Quantum Financial Services: I have clients who come to me and say, “This percentage of my portfolio was in highly speculative stocks and I’m happy to – I can lose it all”.  And the consumer – it’s their money and if they are aware of the risk that they could lose it all and that they’re prepared to take that risk because they’ve allocated that amount to their portfolio, that’s fine. But if they don’t know, if they’re not aware that 30 per cent of their portfolio is in something that has been considered to be high risk, then... 

Stephen van Eyk, Stephen van Eyk Consulting: Terrible 

Claire Mackay, Quantum Financial Services: That is terrible. It is because clients are looking to us as a profession and as an industry to help them provide security in their financial future, and if we’re not prepared to say, “You know what, this is higher risk and be aware of that before you go in”, then we’re not doing our jobs. 

Jason Blumberg, van Eyk Research: I don’t think fixed income funds have really changed what they were doing previously. 

Mike Taylor, Money Management: This is more along getting on the lines of hedging variety? 

Jason Blumberg, van Eyk Research: Yeah. 

Mike Taylor, Money Management: Higher risk. 

Jason Blumberg, van Eyk Research: We definitely notice that. I think it goes down to the deeper issue of not understanding the subtleties within fixed income. So you can take a war sovereign bond, completely stable in the extracting bond float, and then you can put the high risk credit portfolio. Clients that we meet look at both of those as fixed income. 

And I find that in the hybrid space as well. Because we have clients who have to be allocated to bonds, so I’ll go for one of the highest that’s going to pay the most. And that’s a hybrid. It’s labelled as a bond. I mean, it is technically speaking a bond, but it’s much more equity as bond registered. I don’t know if others have noticed it, but that’s what I’ve seen. 

Mike Taylor, Money Management: That’s not very good is it? 

Jason Blumberg, van Eyk Research: Yeah. 

Mike Taylor, Money Management: Jeff. 

Jeff Brunton, AMP Capital: A couple of comments on high risk. It’s very topical, I guess. Hybrids should be thought of as somewhere between equity and debt. You need to do the work on the detail, on the covenants and the package around that hybrid, because some can be closer to debt, some can be closer to equity. 

There are really good opportunities there to outperform other investors who don’t do that work and who will buy a security based on the brand of the issuer, and that’s where you will find there’s a risk of poor decisions being made. 

Within a fixed income portfolio, much more than 5 per cent or thereabouts in hybrids is probably too much. So hybrids do play a role within fixed income, but the weights need to be kept very small. 

It’s topical in our market at the moment and globally, with Basle 3 and the re-regulation of the financial system, that banks globally need a lot of hybrid capital.  They hybrid have today is not applicable under the rules going forward. They need to replace all that hybrid capital with new hybrid capital.  

We think at the moment that in terms of the guidelines – there’s still some flux around there, but they’re generally sure enough for now for us to be able to envisage that fall of capital. Importantly, the regulators are saying that that hybrid capital needs to be loss-absorbing, which is very different to how it behaved five years ago. 

So with your hybrid issuance from an Australian bank or from a US or European bank now, if those institutions come under pressure, those hybrids will absorb some losses. We know financial markets will run well ahead of the actual point of non-viability, meaning the volatility of the capital price of that instrument – should the macro view or the industry view change on that particular region or company – will show itself. 

Those bonds won’t be defensive at all and they’ll fall in price as investors try to flee. If you have clients with significant allocations with those types of instruments, it’s best for those clients to account for them in their growth bucket because they are growth bets. They’re not going to be defensive enough if the stress test occurs for them to really tick the fixed income box.