Fixed interest strategies find favour as equities lose their lustre
While equities no longer have the appeal they had prior to the financial crisis, sophisticated fixed interest strategies are springing up in their wake.
“The cult of equity is dying.”
With this simple sentence, legendary PIMCO managing director Bill Gross unleashed a storm of debate last month.
He argued US investors in 2012 could periodically compare the return of stocks for the past 10, 20 and 30 years and “find that long-term Treasury bonds have been the higher returning and obviously ‘safer’ investment than a diversified portfolio of equities”.
It is a point most fixed interest enthusiasts take little issue with.
{^image|(width)600|(height)277|(mouseoverheight)370|(url)http://media.cirrusmedia.com.au/Money_Media_Library/Print Images/120913/MMSEP13_1.jpg"http://www.moneymanagement.com.au/tag/peter%20dorrian">Peter Dorrian, believes the changing investment environment and potential return from equities over the next few years means advisers need to reconsider the way they use fixed interest.
“Most planners start with a high equity allocation based on historical trends, but over the next three to five years – given the outlook for lower growth – we believe they should flip this and make fixed interest the first allocation to lock in known returns,” he says.
“We are saying to planners to start with a core exposure to the asset class where you know what your income is going to be. You can then add an equity allocation around that offering the possibility of extra return,” Dorrian says.
Dorrian is not the only one arguing for a new approach to fixed interest. Threadneedle’s UK-based head of fixed interest, Jim Cielinski, believes advisers need to carefully consider its return potential.
“You need to throw out the old framework for fixed interest. Higher yielding markets can deliver high returns versus government bonds and even equities, so fixed interest can be a return generator in the portfolio,” he argues.
“It is no longer playing a single role in the portfolio. It is both defensive and for return.”
Christopher Remington, a US-based vice-president and institutional portfolio manager for Eaton Vance, agrees the function of fixed interest is changing.
“Investors are faced with a lower return world today, thanks to slower global growth and the reality that much of yesteryear’s returns have been borrowed at the expense of those in the future.
"As a result, fixed income markets – particularly those in credit segments – may provide a complementary performance experience relative to a lower returning equity landscape,” he says.
“Looking ahead, the income component of many clients’ total return is likely to comprise the majority. Particularly for credit segments of the market … investors may benefit from attractive yields, a solid ‘base’ for total returns and diversification from heightened bond risk and the more volatile equity markets,” Remington says.
A knowledge gap?
Given the changing environment, Stuart Piper, MLC Investment Management’s head of debt assets research, believes advisers need to be more sophisticated in their use of these assets.
“You need to be nuanced in the selection of fixed interest, as it is not just a defensive asset class. The nuance is needed in matching or aligning the various characteristics of the sectors with investor needs,” he explains.
However, while the argument for more sophisticated fixed interest allocations is gaining traction, it faces a significant hurdle in Australia – lack of knowledge.
AMP Capital head of credit markets, Jeff Brunton, finds this a common issue when speaking with adviser groups. “It is the least well understood asset class despite being relatively straightforward,” he says.
“There is a degree of complexity with fixed interest as the yield is price related.”
Piper believes the evidence is clear.
“You only have to look at the amount of fixed interest in financial planners’ portfolios to see there is a disproportionate allocation to equities and less to fixed interest and this may indicate less understanding of the asset class,” he notes.
“Most planners feel more comfortable with property and shares. Fixed interest is more complicated to get your head around and there are a lot of layers to consider.”
This includes the risks. “Planners need to get across both the credit risk and interest rate risk in fixed interest and how they behave at different times to give good advice to clients,” Piper says.
He thinks a greater understanding of the asset class and the variety of instruments available beyond government bonds will help advisers use the asset class more creatively.
The sheer size of the global market (which is several times larger than that of the equity market), means advisers require at least a basic understanding of the asset class and available offerings, Cielinski explains.
“They need to have a knowledge of the assets to make good asset allocation decisions. Some planners have the expertise, but if you go international, it is a different game,” he says.
For Darryl Trunnel, the US-based portfolio manager for Principal Global Fixed Income, the key for advisers is to understand the philosophy of their fund manager and the nature of the assets in the portfolio.
“Planners don’t need to fully understand the complexity of the sector, but they need to understand the manager’s process and approach to the sector – whether it is opportunistic or index based,” he says.
One area Trunnel believes many advisers struggle with is how returns are generated within a fixed interest fund – in particular, global bonds.
For example, Australian investors in Principal’s global bond fund are protected by currency hedging, which effectively captures the local cash rate on top of the asset class performance.
“So in our Global Strategic Income Fund, you get the global credit index and any outperformance, plus the 3.5 per cent cash rate,” he explains.
Hybrid confusion
One area where adviser knowledge about fixed interest seems to be patchy is when it comes to hybrids or subordinated note issues.
The Australian market saw something of a ‘mini-boom’ in note offers earlier this year, with issuances from household names like ANZ, Westpac, AGL and Tabcorp all seeking to reinforce their capital position by offering rates slightly higher than term deposits.
“With income notes the understanding is pretty poor and there has been a lot of issuance – around $10 billion. Many clients and planners think it is just like a higher yielding term deposit,” Dorrian notes.
However, fixed interest experts point out hybrids have both debt and equity characteristics and can include unforeseen risks.
“We don’t own hybrids, as at a time of market dislocation they act exactly like an equity instrument. Our focus is on managing risks and these don’t achieve that,” Dorrian says.
“Many companies have seen an opportunity to refinance at attractive rates, but you are way down the capital structure – very subordinated.”
Brunton argues hybrids require careful research.
“It is very important to read the fine details of instruments that find their way into the retail market. The terms and conditions are crucial to understanding how instruments will go if there is a problem.”
Despite the possibility of investors suffering in a risk-off environment, Piper believes this is an area where knowledge levels can be low.
“We don’t knock hybrids, but each one is a bit different and you need to know they potentially have limited liquidity, are not necessarily callable and have equity-like characteristics.
"They suit some people, but some investors don’t fully understand their characteristics,” he says.
“There are lots of other alternatives that can give you income in other sectors of the fixed interest market.”
Remington believes the challenge presented by fixed interest instruments has led some advisers to recognise their limitations.
“Given the breadth and complexity of the fixed income space, the age of ‘do-it-yourself’ planners seems to be closing.
"No longer simply buying and holding government bonds, planners are increasingly outsourcing clients’ fixed income allocations to active managers across a combination of markets,” he says.
“I think this is a plus, given planners’ expertise often lies in overall financial planning rather than fixed income asset management.”
D is for diversification
The heavy focus by many advisers on traditional fixed interest assets such as government bonds may mean a shift to outsourced management is a good thing, as some commentators have claimed current portfolios exhibit insufficient diversification.
“Diversification isn’t just for equities. While adding to fixed income may help balance client portfolios, there are land mines to avoid. Planners focused only on developed market sovereign bonds may be increasing risk as opposed to avoiding it,” Remington notes.
AMP's Brunton agrees this is vital for good portfolio construction.
“Diversification is critical, as you can’t find bonds that will double in value to compensate for those that fall. The first line of defence in fixed interest is to hold a lot of bonds for protection,” he says.
“We hold lots of bonds and believe an investor needs 100-150 individual bonds to be diversified. This is very difficult for retail investors.”
Even investors in very safe instruments such as government bonds need to diversify.
“It is increasingly important to look beyond government bonds, as future returns will normalise and so there will be mark-to-market losses,” Brunton warns.
Trunnel is another who believes diversification is vital for Australian fixed interest investors.
“Diversity is very difficult to gain in one local market – especially in Australia – as bonds are very tied to the currency and the local economy and they may not give you protection, as was shown in the GFC [global financial crisis],” he argues.
While fixed interest can be defensive, Trunnel believes at the moment a diversified portfolio can also play an important role in generating returns for client portfolios.
“Right now – given the uncertainties in the world such as the slowdown in China, the European problems and the issues in the US – there is a strong argument for investors to have some fixed interest in their portfolios for defensive purposes,” he notes.
“However, lower interest rates also means there is a role for diversification as you can take advantage of opportunities elsewhere as they emerge.”
Piper feels having a home country bias and sticking with government bonds means missing out on potential areas of opportunity.
“Traditionally, there has been a domestic focus by Australian investors, but the best offers are global for investors wanting a diversified fixed interest portfolio. For example, most of the best credit opportunities are overseas,” he says.
“Non-investment grade or high yield fixed interest tends to be a very significant part of the retail offering in the US and UK as it offers high income and prospective returns in line with equities.
"The return is in the form of income and not capital growth, so it is more consistent. This sector is almost non-existent in Australia.”
Principal Global Investors’ Australian chief executive, Grant Forster, agrees a lack of diversification means many local fixed interest investors are losing out.
“The technology sector is not available in the Australian bond market, so we are missing out on that entirely – and a lot of credits in Australia are tied to financials,” he explains.
Brunton believes diversification is pivotal for fixed interest portfolios.
“Many people think that if they have a portfolio of term deposits and a few hybrids, that is diversified enough – but it is nowhere near enough in this asset class.”
Dorrian agrees portfolios need to be well diversified not only across sectors, but also issuers.
“Australia is well regarded worldwide and is stable and growing, but there is still opportunity for diversification. We have begun diversifying out of Commonwealth bonds to semis, as the headline rate for Commonwealth bonds got down to the high twos.
"The semi-government market has not contracted as much, because these issues are not as well-known overseas,” Dorrian explains.
“It is important not to be exposed to any one market anywhere.
"Political risk is now a big issue. Once credit risk only applied to corporate bonds, but now it applies to government bonds as well. When political risk is high it can turn suddenly and change everything.”
So what’s attractive?
For planners keen to take the advice of fixed interest experts and begin increasing the diversification in their client portfolios, where should they look to invest?
The big favourite at the moment seems to be corporate rather than government bonds.
For Brunton, credit instruments look attractive given the ongoing market uncertainties. “We think the time is right to seek duration in your income portfolio and that means five-year corporate bonds.”
He believes an allocation to credit is important as government bond yields are at a very low level due to the sovereign debt crisis.
“As yields decline prices rise, so investors are buying government bonds at very high prices. Credit spreads on the other hand are really wide compared to the default risk.”
For Trunnel, offshore corporate paper remains appealing. “Looking at global fixed interest, we are of the opinion that a lot of companies are making money – maybe not enough to satisfy equity investors – but they are cutting expenses and managing profitability and generating significant cashflow,” he says.
“We like high quality investment grade companies and high yielding, high quality companies that may be re-rated to investment grade.”
He points to Ford Motor Company (which was re-rated to investment grade by Fitch in April), as an example of the benefits of this approach. Investors pounced on its debt after the announcement, with The Wall Street Journal noting its 2031 bonds immediately jumped US$3.50 per US$100 of face value to US$126.
Over at Eaton Vance, the most appealing sectors in the fixed interest market are high yield corporate bonds. Remington says floating-rate loans and emerging market bonds are also attractive.
Cielinski believes it is a fascinating time in the fixed interest market.
“The Australian market is still at attractive levels but it is hard to see that continuing,” he says.
“The core, high quality bond markets won’t deliver, so that leaves everything else such as high yield and emerging markets. These are likely to be the strongest improvers in the near future. The return potential for these is better than from other sectors.”
Local advisers will need to begin shifting their focus offshore, he argues.
“The Australian Government bond market is one of the few markets where rates can come down. For Australian investors, you could have a core defensive strategy of government bonds and then collect higher returns from international fixed interest,” Cielinski suggests.
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