Fixed income investments find favour amid the gloom

Fixed income has performed well during 2010 and investors are certainly starting to sit up and take notice, according to Damon Taylor.

Few could deny the strength of the Australian equities markets in years past and, more importantly, the rewards that investors have been able to reap.

Yet in circumstances in which those markets have rallied and then come back again, the reality is that financial markets and their performance going forward remain uncertain.

Now is the time to place safer bets and according to Peter Dorrian, head of global wealth management for PIMCO, recent fixed income performance has done much to inspire confidence.

“Fixed income performance continues to be quite strong in both Australian portfolios and in global portfolios,” he said.

“Just thinking about the last few months when we’ve had May and June and now August that have produced negative returns in the Aussie equities market, all those months have produced positive returns for the Aussie bond market and decent positive returns as well.

“In May, I think the index was up about 1.5 per cent, similarly 1.4 per cent in June and in July, when the ASX came back quite strongly — I think it was up about 4.5 per cent, the Aussie bond market index still did about 0.3 per cent,” Dorrian said.

“And then as of today, the Aussie bond market is up about 1.7 to 1.8 per cent for the month of August. So it continues to plod along pretty well and, more importantly, pretty consistently.”

Echoing Dorrian’s sentiments, Darren Langer, head of portfolio management at Tyndall, said fixed income had done particularly well in the last three to six months.

“As equity markets have come off their peak, bond markets have rallied quite strongly and that’s been coupled with a lot of fear about the United States sliding back into recession,” he said.

“So bonds have actually done quite well. You’ve also seen credit markets start to improve again with spreads, although still relatively high compared to where they used to be, still being a lot lower than what they got to over the crisis.

"So with a pickup from rates as well as credit, fixed income’s done quite well.”

Looking at individual fixed income investments in greater detail, Langer said there were a number of interesting trends worth noting.

“Certainly bonds would have outperformed cash over recent periods,” he said.

“Cash is still quite low even though it has been going up over the last few months so depending on the time horizon you’re looking at, you would have done better in a diversified bond fund than what you would have out of cash.”

“In terms of credit, it’s also done quite well and that tends to be your main distinction, whether you’re in a more diversified or a pure sort of credit type product,” Langer added.

“Obviously, credit was hurt quite badly during the global financial crisis (GFC) and some of the good performance we’ve seen is just getting back the return that was lost during that period of time.

"But if you got in during the GFC or towards its end, you would have done quite well out of that too. Fixed income has certainly done a lot better than many people thought it might.”

Yet while fixed income is generally receiving a glowing report card for its performance throughout the 2010 calendar year, that performance is academic if investors are failing to look at how fixed income investments may best fit within their current portfolios.

Fortunately, Matthew McCrum, director, investments for Omega Global Investors, said he could see a definite trend towards investors paying much greater attention to the roles different fixed interest investment were suited to play.

“If we roll back to post-GFC, a lot of people were really scratching their heads and wondering what they would do with fixed interest,” he said.

“They probably not so much ignored it but left it to the side or they went into mortgage backed securities or structured credit to try and juice up the return a bit and they probably didn’t think about the risk as much.”

“Now though, people are definitely spending a lot more time thinking about fixed interest and they’re realising that it comes in a lot of different flavours,” McCrum continued.

“You look at the more traditional, more vanilla fixed interest playing a defensive role in your portfolio but then there’s a lot of other offerings.”

McCrum said that with offerings such as corporate bonds, high yield corporate bonds and emerging market debt, a lot of investors were trying to work out how they could best fit high yield bonds within their current portfolios.

“Do they classify them more as an equity type of investment rather than a bond type investment?” he asked.

“Emerging market debt, where do you put that? Corporate debt has a relationship with equities markets so where do you put that in your portfolio?” he asked.

“So there are definitely a lot of people working through that,” McCrum said.

“I think the way it will end up is still having government bonds and investment grade credit, still having that as the defensive part of your portfolio. But then the more high yield corporate bonds that are more sub investment grade, have that as more like low risk equity.”

Dorrian from PIMCO said he too had seen a much greater awareness of what fixed income could deliver from more and more retail investors.

“From our point of view, and particularly from the non-institutional investor, whether a family office or private bank or a general adviser, there’s certainly been a much greater level of interest in what’s going on within a fixed income portfolio,” he said.

“It’s a much greater level of interest in what’s happening at a country level and a much greater level of interest in what’s going on within the various sectors.”

But as to whether the non-institutional investor was looking to take advantage of the spectrum of fixed interest investments to fulfil different roles in portfolios, Dorrian admitted that approaches varied.

“It depends on what particular role an adviser or planner might assign to fixed income in a client’s portfolio,” he said.

“There are a couple of big themes emerging though and one is that as people begin to accept that the outlook for equity markets in the next couple of years is not as rosy, there’s a lot of talk, a lot of thought and some action in terms of people considering replacing part of their equity portfolio with a good, high quality credit portfolio.”

“That’s probably one of the big trends that we’ve seen not just in terms of discussions and feedback we’ve had from advisers and planners but also in terms of flows,” Dorrian added.

“We run both a global credit fund and a domestically oriented credit fund and the flows into both of those this year have been really strong and the reality is that some of that is coming at the expense of cash flow that would normally have gone into equity funds.”

Offering an alternative perspective on investors’ current appraisal of fixed interest, Roger McIntosh, head of investment, strategy and research at Vanguard, indicated fixed income managers were wary of interest being generated by term deposits at the moment.

“That’s one of the things we’ve had to try to manage and defend,” he said.

“People wanting to take money out of fixed income and cash and, of all things, put it into term deposits and there’s a whole bunch of different dynamics that go with that as well, particularly around liquidity, that are issues more generally.

“The banks are certainly offering some good returns in term deposits,” McIntosh said.

“But it’s at the expense of two things — one, there’s a higher degree of credit risk because you’ve got your money with one entity and not spread across a wide number and two is liquidity.

"Once your money’s in a term deposit, then it’s locked up and your ability to be opportunistic isn’t necessarily there.”

Langer from Tyndall said the argument against term deposits was one of diversity. “That’s probably the main thing we would look at,” he said.

“While no one’s ever lost money here in term deposits, we saw how easily the banking sector got itself into strife and realistically, even though the Australian banks were better placed through the whole GFC, they still did require the government to come in and guarantee their deposits.

“So from that point of view, if you want to rely on the government to always back the banks (and we think they probably would), from a retail investor’s point of view it’s not really that big a risk,” Langer said.

“But in saying that, within a diversified bond fund, you do get the advantage of capital gains when interest rates come off, you’re getting access to a much wider range of risks and an active manager should be able to add some value to that process.

"I will agree, however, that given the relative return on a term deposit, other forms of fixed income may be difficult to sell.”

Dorrian from PIMCO believes investors need only look at the performance of their term deposits over the last six months versus that of the fixed income market to realise that fixed income held some distinct advantages.

“With term deposit rates at reasonably healthy levels at the moment, the question is whether we’re finding that they’re our biggest competition?” Dorrian asked.

“And the answer is yes but there are a couple of things here. One is we are absolutely not saying, and would never say, that there is not a role for term deposits in a client’s portfolio. What we do say though is that they don’t replace fixed income and that they should be looked at more as part of the cash component of your portfolio,” Dorrian said.

“People think that term deposits are effectively riskless and, just like a bond, they are if you’re absolutely happy to hold it until the term expires. But with all the volatility and turmoil in markets, liquidity has become very important to people in terms of their portfolios and, more importantly, the ability to have liquidity quickly.”

Using an investor coming out of the depths of the GFC when Australia had taken the cash rate down to 3 per cent as an example, Dorrian pointed out that equity markets had been decimated and that many people were thinking very carefully about what they were going to do with their money.

“At that time you could get a five-year term deposit at around the 4.25 to 4.5 per cent mark,” he said.

“And I’m sure a lot of people, given that they were faced with what was a very bleak environment, locked money away for five years at 4.25 per cent.

"But fast forward six months from that to when the cash rate went from 3 per cent to 4.5 per cent and term deposit rates for five years were between 7 and 8 per cent,” Dorrian said.

“So the opportunity cost of an investor who put their money away for five years only six months before that was very significant.”

By contrast, Dorrian said that with performance of 11.5 per cent for the year to date in PIMCO’s Australian bond fund, an investor in a term deposit would have given up a lot of return.

“At the end of the day, the decision depends on what the client’s needs are and what they’re happy with but those rates are going to continue to fluctuate as the economy moves between periods of optimism and periods of pessimism.”

Of course, if anything can change the current state of affairs for fixed interest and provoke one of the periods of pessimism alluded to by Dorrian; it is likely to come in the form of inflation. Yet while inflation may have been a concern some months ago, Langer from Tyndall said it was something that had largely fallen off the radar.

“It’s an interesting topic because inflation seems to have fallen off most peoples’ radar in terms of being a threat,” he said.

“When you have high levels of inflation, bonds tend to underperform and, in that instance, you’ve then got the alternative of investing into the index-linked market which has inflation protection built into it. We do both of those markets and have separate funds for that kind of thing,” Langer said.

“However, at the moment, inflation is probably considered under-controlled, meaning that longer term bond yields will come off and bonds are set to do relatively well.”

Langer said that if the spectre of higher inflation returned, there is certainly a lot of evidence that there are price pressures in the economy and that in that kind of environment, long bonds were likely to underperform.

“There may be problems down the track but given the global backdrop of fears in the US, inflation at this present time isn’t really a fear in most investor’s minds.”

Sharing Langer’s view, Dorrian said PIMCO didn’t see any risk of inflation re-emerging as a threat to bond investors any time in the next two to three years.

“It’s very difficult to see what catalyst, what ignition point, there would be for any serious bout of inflation and, in some countries, the risk is on the other side,” he said.

“Many people make a case that the US is facing a similar decade to what Japan had in the last 20 years, so periods of very low growth and an almost deflationary environment.”

“Now, we’re not quite that pessimistic but certainly, on balance around the world at the moment, you’d have to say that the risk is on the deflationary side rather than the inflationary side,” Dorrian said.

“The emerging markets are obviously the exception to that where they’ve still got good economic growth numbers coming through.

"They’ve gone into the crisis in pretty good shape and therefore haven’t had to resort to the same level of stimulus measures and high levels of indebtedness that many of the developed markets were forced to.

"You really are seeing the world looking like a very different place in a very short period of time, particularly from an economic growth perspective.”

Changing tack to comment on whether, despite the turmoil in a number of global markets, there were fixed income opportunities for those investors willing to look offshore, Dorrian said that the whole credit sector had come through its recent challenges reasonably well.

“Most companies in many parts of the world took advantage of their ability to go out into the market and raise fresh equity to try and get the balance sheets in order, in the 2008 year particularly,” he said.

“As a result of that, from a debt investor’s point of view, they look pretty healthy.

"So corporate spreads, the differences you pay between the interest offered on a sovereign bond and on a corporate bond, have come in, so shrunk quite considerably.

"So the value of holding those bonds has increased quite a lot over that period of time and it’s been a good market as a consequence.”

Dorrian said that in some parts of the world, the residential mortgage market had also performed very well, especially in those countries that hadn’t been affected by some of the housing chaos that was seen in the US and Spain.

“But generally, there’ve been lots of different areas where the global bond markets have seen good performance in the last couple of years.”

Yet despite what has been a good track record for fixed income investments over an extended period, the reality is that Australian equities have been and, almost without doubt, will continue to be the core of local investors’ portfolios.

So while Dorrian admits that that fact is unlikely to change any time soon, he said that fixed income had already elevated in investors’ priorities.

“From an institutional investor’s point of view, I think it’s fair to say that most of the big Australian super funds let their fixed income weighting go to all time lows over the last ten years,” he said.

“But I’d contrast that with the retail market where in the last 12 months we’ve seen a tripling of inflows compared to the previous 12 months.”

“Everywhere we go in terms of giving presentations to financial planning groups and the like, there’s a much greater level of interest in fixed income funds, what’s going on in the bond market and what is happening in terms of sector and direction of interest rates,” Dorrian added.

“That heightened level of interest is undoubtedly there to be seen.”

For his part, McCrum said if investors thought that growth rates around the globe weren’t going to be as high as before the GFC, then from a return perspective, that made fixed interest look a lot more attractive.

“Everyone bandies around the magic 10 per cent number for equities but let’s say it’s probably going to be lower than that,” he said.

“If we say that you can invest in global corporate bonds at 8 per cent yield for investment grade, so that’s 8 per cent yield or 8 per cent return compared to something that’s probably going to be lower than 10 per cent.

“So from a risk perspective, equities are 12 per cent risk compared to bonds at 4 per cent risk,” McCrum said.

“That means you’ve got three times less risk investing in global credit for a similar return. That should make everyone think about their allocations and what their allocation to fixed interest is like.”

Langer said that finding the right place for fixed income in an investor’s portfolio would always be difficult because everyone had slightly different needs and requirements.

“We would generally argue that fixed income is under-represented in most peoples’ investments because they’re just not something that’s high priority,” he said.

“Equities tend to take up the vast majority of peoples’ thinking and people then have a bit of cash in term deposits as their fixed income allocation.

"If anything, the GFC showed us that having some sort of defensive assets in your portfolio is a good thing but it’s the question of how much that is very much an individual preference,” Langer continued.

“What we say to people is that the reason you have defensive assets is for things that are unexpected.

"So while everyone is looking towards things being relatively benign and rosy right now, it’s only when things suddenly blow up that everyone thinks ‘oh, I wish we’d had an allocation to fixed income’.”