Depressed times ahead for fixed interest despite a sea of changes

Investment researchers van Eyk Research recently completed its annual survey of Australian fixed interest managers. The firms senior analyst, Angela Ashton, found most fixed interest managers are finding it an increasingly tough battle to add value in the sector.

Most Australian fixed interest managers have not performed terribly well over the past few years. Ten year bond yields have fallen from double digits in 1994 to now rest at about 5 per cent. The bull market in bonds has been spurred by the systemic eradication of inflation in developed nations.

Holding long dated bonds through this period would have led to outperformance of a magnitude not recorded by any manager in this survey. Theory tells us that the trade off for this lower return should be lower volatility, but the average manager has generally maintained volatility in line with the index.

Thus the unfortunate conclusion from this data is that managers have not done a great job in earning their fees from their active management of this asset class over the past few years.

Of the twelve managers with a five year performance history, five have beaten the index and one has matched it. The average manager has detracted a small amount of value from the index.

It is worthwhile noting that the range of performances was quite small, between 0.3 per cent above the index and 0.3 per cent below the index or a total range of 0.6 per cent. Therefore, over the medium to long term, performances between managers has not varied tremendously.

The risk/ return graph (figure 2) is similar to a snail trail but shows the position of every manager in our survey with three years performance history at 30 November 1998.

It shows only one manager is placed in the top left quadrant (that is above index returns with below index risk). Six managers are positioned in the top right hand quadrant (indicating higher than index returns and risk). This means seven managers beat the index over three years. Eight managers resided in the bottom two quadrants (or those that indicate below index performance).

This is a fairly typical story in the world of Australian fixed interest management - just under half the managers added value to the index over the three years.

In the two quadrants where risk is lower than index, being the two left quadrants, there are again seven managers. This indicates again that about half the managers were able to provide less volatile returns than the index.

The future

Most fund managers believe the debt markets in Australia have changed over the past few years likely to continue for the foreseeable future. There are a number of key changes that most managers point to:

The increasing globalisation of bond markets,

The benign outlook for inflation will lead to lower volatility in markets and interest rates,

The decreasing supply of Government bonds leading to the increasing issuance of corporate and asset backed bonds.

Due to the abandonment of artificial barriers between economies and the increasing power of technology, economics has become more global by nature.

The growing globalisation of markets means that forecasting the general direction of interest rates will become a decision based on global, rather than local factors.

In the absence of external shocks, the benign inflationary environment looks like continuing for the foreseeable future. Following on from this, managers believe interest rate markets should become less volatile.

The absolute level of rates is low and should remain so. This should lead to less volatility in markets - and less value to be gained by picking the general direction of interest rates. Thus, many managers believe the duration decision is becoming less important.

As a group, van Eyk Research does not agree fully with this statement. The effect of a 1 per cent increase in yields from 5 per cent to 6 per cent is much more significant to bond prices than a movement from 10 per cent to 11 per cent.

Thus, even if volatility decreases in absolute terms, movements in relative terms will probably be similar to those experienced by the market in the past.

As Commonwealth and State Governments become more fiscally responsible, and budget deficits become less and less the norm, supply of Government issued paper is slowing. Continuing demand for quality debt, however, continues.

This is leading to a situation where corporate or asset backed issues are becoming more accepted, and more issues are coming to market. This trend is set to continue, so the ability to analyse credit and take on the risk in portfolios is becoming more important.

Conclusions

When we considered the ratings due to managers, we took into account their ability to manage fixed interest at the moment, their people, their processes and their resources. Added to that however, we made an assessment of their ability to handle future market trends. Thus, of our five A-rated managers, four have established global links, most have strong ability in a number of different methods of adding value and most can effectively analyse credit at this time. The five who received an A rating were AMP Asset Management, Barclays Global Investors, Credit Suisse Asset Management, Macquarie Investment Management and UBS Brinson.

In all, the fixed interest sector is a difficult one - few managers have added value consistently and fewer have added sufficient value to compensate for fees. None have done so on a retail level. The range of performances recorded by managers is also small. Over the past five years, there is approximately 0.6 per cent between the best and worst performers. Further, some of our more detailed work shows clearly that in the recent past, managers who take on more risk (or are more active) have tended to perform worse than those who have hugged the index. These things could be due to a number of reasons. For one, it is difficult to generate tracking error in a market with few securities and the market is much more efficient than, for example, equity markets.

Therefore, the case for indexation, with it more assured returns, lower volatility and low fees, is strongest when levied at this sector.

Angela Ashton is senior analyst at van Eyk Research.