Investors regain their taste for vanilla investments

The global financial crisis (GFC) has taught Australian investors a great deal since the sub-prime fallout of 2007.

Yet above all, it has highlighted the change that has occurred and the complexity that now exists within investment markets.

Put simply, investment markets have changed to the extent that an allocation’s traditional role may have long since been thrown out the window.

And in the case of fixed interest, the traditional role of which should have seen its allocation safely through this crisis, Rob Mead, head of portfolio management for Pimco Australia, said that the magnitude of a portfolio’s defence depended largely on how close investors stuck to that tradition.

“The definition of the defensive asset classes that comprised investors’ portfolios was the key driver behind whether that part of the portfolio performed appropriately,” he said.

“If investors stuck to traditional fixed interest, invested in bonds and avoided assets like infrastructure, mortgages and others with a yield element, then they would have been protected from the effects of the financial crisis quite well.”

For Roger McIntosh, head of fixed interest and investment solutions for Vanguard Investments Australia, traditional fixed interest investments performed as shrewd investors would have expected.

“But the problem is that those expectations may have been conditioned by the investment environment leading up to the GFC,” McIntosh said.

“As yields have risen, returns have gone down, but people forget that short-term negative rates become long-term positive rates.”

Bond markets

Looking at bond markets in particular, Nick Bishop, portfolio manager for Aberdeen Asset Management, said the performance numbers for bonds had looked good throughout the financial crisis and particularly in recent months.

“On aggregate, US bonds have risen 18 per cent for the year to date,” he said. “And they are comfortably outperforming equities over a 10 to 15-year period.

“So while bonds are always expected to outperform in poor economic and financial conditions, they have also outperformed over that 10 to 15-year period when many investors would have thought otherwise.

“Looking at volatility-adjusted returns, so return per unit of risk, bonds have been far superior to anything else.”

Yet despite the clear performance differential, Bishop said he was not suggesting investors increase their allocation to bonds to the exclusion of other asset classes.

“But at Aberdeen we do believe super funds and investors have been underweight bonds for some time,” he said. “And that lack of diversification towards bonds and a high weighting towards equities has perhaps cost investors recently.”

More fixed interest winners

Commenting on other winners under the fixed interest banner, Mead said that different fixed interest assets had performed better for investors at different times.

“The thing to look at is the volatility that various fixed interest assets went through,” he said.

“Different sectors went well or did poorly at different times, but over the 12-month period, the products faring best were high quality credit, that which was single A-rated and above.

“Australian residential mortgage-backed securities also did well,” Mead continued. “They were sold off in the first half of the year but they have rallied back well.”

Contrasting the government and corporate bond markets, Bishop said that with Australian interest rates set to rise, short to medium-term government bonds would have rising yields leading to significant constraints on their absolute returns.

“Given those circumstances, we’re predicting a return from government bonds of 2 to 4 per cent,” Bishop said. “And if we compare that with credit, where over the next 12 months we’re set to see a 6 to 9 per cent total return, there’s a reasonable variation.”

However, Bishop added that 6 to 9 per cent was “still pretty favourable with respect to cash”. “The caveat is that in a recovering environment, it will be difficult for bonds to outperform. They are an investment that does best in a declining market, but we still think investors can expect good, consistent returns.”

According to McIntosh, in recent months, fixed interest managers have been boasting not only the good returns and performance seen from corporate bonds, but also the exposure they may have had to sub-investment grade fixed interest and any mortgages they might have picked up cheaply.

“But while those asset classes have done well, there is a need to keep picking it,” he said. “Every bonds and fixed interest manager under the sun was suggesting moves towards credit and taking an active approach, but I think I’d balance any claims of shrewd asset selection in active managers against the exposure in their portfolios on aggregate.”

“In terms of standout performers, it’s been almost a case of ‘don’t fight the Fed’ [the United States Federal Reserve System],” McIntosh said. “But overall, fixed interest investment has fared well.

“As financial and economic conditions improve, they’re seeing a kick-up in returns and in the long run, fixed interest continues to do its diversification job.”

Yet with hindsight it was always going to be easy to see what the right fixed interest moves would have been. The situation was not always so clear and, according to Bishop, many investors continue to search for too much yield when they should be focusing on what makes their fixed interest investment defensive.

“We had a period in the fourth quarter of 2008 and the first quarter of 2009 when no asset was too safe or too boring and where anything with an element of risk was shunned,” he said. “But that turned around pretty quickly.

“Some tier one securities, securities that are just a short step above equities, went way down before bouncing back strongly,” Bishop continued. “And yet their risk characteristics haven’t changed.

“I think it’s just human nature to chase returns without due respect for risk.”

Mead said that, to some extent, he also saw investors make the same fixed interest mistakes.

“The performance of high-yield credit and bank loan markets since March of this year, returning approximately 30 per cent over that six-month period, suggests there is still money going into it,” he said.

“There will always be some demand for assets that are undervalued, but the real test will come in the next 12 months when assets that are currently oversold move back into fair-value territory.”

Mead believes that as equities bounce back, it may well be an opportune time for investors “to take some chips off the table”.

“It’s a nice opportunity for the Australian investor who was previously too aggressively invested to become more defensive,” he said.

“From our point of view, the last 20 years have seen fixed interest allocations diminish to the point where it’s not a question of whether investors will allocate away, it’s a question of how much they will allocate back.”

A risk by any other name

Alternatively, McIntosh said he feared many investors had simply moved out of fixed interest hybrids and structured instruments into fixed interest investments that had similar, if slightly different, risk profiles.

“People have seen through the really structured instruments that had equities-like characteristics,” he said. “But the question is whether they’ve just moved on to the next big thing.

“So I suppose the answer as to whether investors have stopped making the same fixed interest mistakes is ‘no’,” continued McIntosh. “Because while many may have moved out of hybrids and other structured instruments and into fixed interest assets with different risk profiles, like lower tier debt, they remain in risk assets.

“The risk may be different but it is still of a similar degree.”

McIntosh said if investors were thinking of sub-investment grade credit, then they would be setting themselves up for a fall at some point in the not-too-distant future.

“Investment-grade assets are the most important element of a fixed interest portfolio because their chance of default is an order of magnitude lower than anything else,” he said.

“So if all they’re doing is replacing structured debt and hybrids with lower grade credit, investors are just going to that different kind of risk.

“The key to success in fixed interest is diversification within investment-grade instruments.”

For Bishop, it is important that investors learn from their mistakes without becoming too cautious or too risk averse.

“Before this financial crisis reaches its conclusion, we’re going to see a lot of end-investors burned by exotic securities,” he said. “And many will have their ability to invest in such products heavily constrained.

Plain flavours are in

“Anything plain vanilla is once again favourable to the extent that I don’t think we’ll see some of those exotic structured products ever again. There will be a certain preference for companies that are easy to understand, companies with high transparency and high levels of liquidity.

“That’s the direction in which this pendulum is surely swinging,” Bishop added.

But while he admitted that caution and due diligence were the orders of the day for fixed interest, Bishop urged investors to avoid throwing the baby out with the bathwater.

“Not all non-government bonds equal bad and government bonds do not necessarily equal good,” he said. “Because at this stage of the cycle, it is government bonds that are likely to perform worse.

“It is possible, after all, to take too much risk off the table.”

So in circumstances where investors have seen the more creative fixed interest products falter and must now consider drifting back to equities in the hope of an upswing, it seems to be decision time. And for McIntosh, it comes down to whether investors will change, whether they will temper their pursuit of return with a greater emphasis on defence through fixed interest or indeed, whether the industry will see its bad habits continue.

“Irrespective of an investor’s stage of life, there is an ongoing role for fixed interest in any portfolio,” McIntosh said. “And its diversification arguments were well borne out even through the worst of the GFC.

“Fixed interest needs to be considered in the context of risk appetite and individual circumstance, but people can get too carried away,” he said.

“With fixed interest, the best approach is both long term and simple.”

Finetuning allocations

Reflecting on the events that had brought investors to what could prove an investment allocation turning point, Mead said the key to navigating the global financial crisis successfully had been understanding correlations.

“It came down to what assumptions were made with respect to the underlying volatility of what made up a defensive portfolio,” he said.

“As definitions were watered down, those investors that were more aggressive and those that were more willing to populate their defensive portfolio with more illiquid, more risky assets, they were the ones to experience dramatically different and, in some cases, dramatically worse performance.”

Mead added that post-financial crisis, investment realities had not and would not change.

“Through 2005 to 2007, we saw credit spreads reduced to such tight levels that it almost encouraged investors to be lured to higher-yielding fixed interest assets,” he said. “But with changing spreads in the higher quality fixed interest, there should be less compunction to go towards that risk.”

Markets and investors will always switch between greed and fear, Mead noted.

“Some investors will already be looking for the next opportunity and will have short memories, and others will rethink their allocations and liquidity requirements and end up with a dramatically different portfolio in the next few years.”

But the current financial and investment environment offers a great opportunity, he said.

“It’s always difficult to sell at losses and make strategic shifts, but with equities coming back, this could be the time to make a change or two.”

Speaking about the future of fixed interest investing, Bishop said there were a number of broad market developments he would be looking out for.

“I’m expecting a gradual economic recovery that will see yields drift up over the medium term,” he said. “But it won’t be an environment where yields rise out of control and I would urge investors not to be scared of yields rising a little.”

And in light of what the global financial crisis has taught investors with respect to their fixed interest investments, Bishop advised investors to know their products well.

“Know what’s in them and know where they fit on the risk/return curve,” he said.

“More is not necessarily more,” he added.

“A 100 per cent chance of a 5 per cent return is often better than a 50 per cent chance of an 8 per cent return.

“Bottom line, sometimes less can be more.”