Keep the backstop in the game

The recent turmoil in asset markets has served to remind investors of a hitherto growing disconnection between risk and return in fixed income markets.

Credit spreads (the difference in yield between benchmark sovereign debt and other debt securities) had narrowed substantially as investors were willing to accept lower relative yields for non-sovereign risk.

The narrowing of credit spreads has been driven by an unprecedented (and inter-related) demand for investable assets from a wide variety of market participants: yen carry trade players (where funds are borrowed from low interest markets and invested in higher yielding markets); sovereign wealth investors and countries such as China and Japan holding large current account surpluses; leveraged investment from hedge fund participants and the ongoing flow of funds from compulsory pension savings schemes.

Strong equity markets have sidelined investor interest in traditional fixed income investment as flat yield curves and low interest rates in most countries meant returns from fixed income remained relatively low.

In response there has been wide-scale development of structured fixed income investment vehicles such as collateralised debt obligations (CDO) and collateralised loan obligations (CLO) as investors sought higher yields from their fixed income allocations.

We have subsequently witnessed a dramatic re-evaluation of these spreads over the past several weeks as investors attempt to come to terms with the implications of large scale investment in these investment strategies.

In many instances, investors are holding paper that cannot be valued with any precision and hedging opportunities are limited as there has been substantial tailoring of the credit exposure.

Too often there has been a lack of investor understanding or transparency in the investment process.

Investors chasing higher yields have only subsequently found out after substantial defaults or even the collapse of the scheme the real nature of the investment risk.

Witness what has happened with several of the high profile hedge fund and high yield investment implosions.

Although these products would have stated the nature of their investment strategy, investors considered these strategies to be fixed income in nature. Similarly, there has been a greater reliance on the rating assigned to structured credit instruments (particularly those described as AAA) rather than exhaustive evaluation of the terms and conditions.

Would you commit to allocate part of a fixed income component to a strategy that has the possibility of losing some or even all of the invested capital? Is the yield being provided commensurate with this risk?

Why make an allocation to fixed income?

An allocation to conventional fixed interest assets, regardless of the investor’s level of risk aversion, has useful portfolio properties because of the negative correlation of returns between defensive and risky assets. Fixed income is also important for investors seeking capital protection and a diversified source of income.

The most important concept to remember for any fixed interest allocation is that it is the defensive part of the asset mix.

When markets are changing rapidly you want to be sure that the fixed interest component is operating as expected; either smoothing out the volatility of returns for risky asset allocation strategies or providing capital protection and income for more defensive strategies.

The ability for active management to achieve sustainable excess return above the fees charged over long term timeframes is limited as all market participants are exposed to the same interest rate risk factors.

For investment grade securities these yield curve change factors explain in excess of 90 per cent of market returns.

This helps to understand why, in the long run, the difference in returns provided by the best and worst performing traditional fixed income managers is not large — of those that survive and choose to be included. Funds that don’t perform well don’t tend to show up in manager surveys.

According to the MercerInvestment Consulting wholesale survey for Australian Fixed Income managers, the difference in return between the upper and lower quartile managers decreases as the measured time frame increases.

For the three years ended July 31, 2007, this return difference before fees was approximately 0.3 per cent per annum. For the 10 years ended July 31, 2007, it was 0.1 per cent per annum. Costs matter substantially for any investment decision, but especially in fixed interest where the average fee charged is larger than these figures.

The repricing of risk recently experienced highlights the importance of understanding the type of fixed income investments available. Also understand the sources of risk. Investment strategies that provide higher yield can only do so by either investing in lower quality credits or by leveraging invested capital and sometimes both. Holding higher yielding investments carries a higher risk of default. Claims to the contrary ought to be treated with scepticism.

Fixed interest investing is an important element to any asset allocation strategy.

For portfolios with low risk aversion, the negative correlation between growth and defensive assets can reduce the volatility of portfolio returns. For portfolios with high-risk aversion, fixed interest allocations provide income and principal preservation.

Markets have historically experienced situations similar to the present climate of adverse credit spread movements, ratings downgrades and debt defaults.

An appropriate response to mitigate this risk is to have a broadly diversified investment strategy that efficiently captures the returns of the market sector and minimise the costs of managing the strategy.

Roger McIntosh is the head of fixed income at Vanguard Investments Australia .