AS equity returns slow try the X factor

As the new financial year begins, Australian equities continue to be the backbone of strong superannuation returns. Predictably, the ‘safe bet’ fixed income investments have been forced to take a back seat. But in the wake of such success, investment managers are coming to terms with what is an increasingly uncertain market and an environment in which fixed income assets may again be coming to the fore.

According to PerennialPartners head of fixed income Glenn Feben, fixed income investments are currently gaining attention if not a greater overall allocation from many fund managers.

“Fixed income assets still hold their traditional value,” he says. “From a broadly diversified fund perspective, they are investments which offer diversification away from the risks associated with other assets.”

Feben says if investors are worried about equity sustainability, then fixed income would have a significant role in offsetting the risk in that market.

Interestingly, PIMCO’s Kumar Palghat sees domestic equity performance as part of a growing concern that exists within the industry over a complacent market.

“Managers and executives are asking: ‘Where are the guaranteed returns coming from?’” he says. “Yield curves are flat, equities seem fairly priced, commodities are at their near term peaks and property is probably overpriced right now. At the moment, allocations to fixed interest seem to be staying where they are. But at current market levels volatility in most classes is increasing.”

Palghat says much of the increased volatility that the investment market has been seeing is due to chief financing being taken away in the US, Japan and Europe.

“Add to this the reality that a new Central Bank Governor has been appointed in the US and you have any number of factors impacting market volatility,” he says. “If managers are in a defensive asset class, then they want certainty, and at the moment cash at 5.75 per cent is looking pretty good.”

Feben points out in a market perceived to be uncertain and\or volatile, fixed interest investments are about controlling and buffeting the risks elsewhere.

“Fixed income offers something different,” he says. “It provides a low correlation to other higher risk assets, particularly if it is high quality fixed income.”

Feben adds that a large percentage of fixed income portfolios today are made up of non-government securities and managers should be careful to avoid moving towards the lower grades of fixed income.

“Lower quality fixed income has risks that are part of an increased correlation with other asset classes,” he says. “Investment managers should be looking for the duration and high credit quality that comes with government debt and higher quality corporate debt.”

Tyndall’s Roger Bridges has also seen little in the way of significant movement towards fixed income assets despite market uncertainty.

“In the case of bonds, they are backing up slightly in the US, where they are offering a little value,” he says. “They are now more attractive then they were, mostly because of the volatility we are seeing in the equities market.”

However, Bridges is quick to add that bonds are still achieving returns that are around the rates granted by cash.

“From an investment manager’s perspective, bonds may be good if you see a slowing economy based on US Fed [US Federal Reserve] movements,” he says. “But with rates at or around the same levels as cash, they’re just not providing much risk for their added duration. In an uncertain market, bonds are reflecting that uncertainty.”

According to Palghat, there are a number of X factors affecting the bond uncertainty that Bridges refers to.

“Obviously, there are the normal US Federal Reserve concerns,” he says. “However, I would look at a few other issues as being more important. Firstly, there are commodity prices and the flow through of inflation. Add to that our current geopolitical tensions, which is a factor hard to quantify, and the fact that most growth in the world over the last three to four years has come from housing, and there’s a lot to bring to bear.”

In today’s investment market, however, fixed income investments have not been those stealing the industry limelight. In the search for alpha, most fund executives have their gazes firmly fixed upon global equities markets and alternative investments in particular. With that increased attention has come the suggestion that an alternative such as commodities may present a guaranteed return replacement for the more traditional fixed income allocations.

But do such actions have merit?

Feben agrees funds and consultants have certainly embraced different investments that have been broadly categorised as alternatives, but do not see commodities as providing a replacement for fixed income.

“The advantage of fixed income investments is that they produce their best returns when economic conditions are deteriorating,” he says. “That is when they come into their own. On the other hand, commodities aren’t likely to perform the way they have recently and certainly won’t give returns that can withstand a failing economy. They’re simply not a viable replacement.”

Bridges sees commodities and alternatives in a slightly different light, though he admits that Tyndall has certainly not used them as a fixed income replacement within their own portfolios.

“Commodities are a funny one,” he says. “They’ve come raging back in the last year and even the last three to four years. They are an investment with a very different pattern and very different correlations. It is possible that they might fit within portfolios looking for more guaranteed returns, but we haven’t done it.”

Bridges says the question confronting many fund executives contemplating such a move is how alternatives will perform in a changed economic environment.

“If the market was to go through a benign investment period where volatility was low, what products would perform?” he asks. “Alternatives are still an unknown in such a scenario.”

The suggestion that alternatives may be substituted for fixed income investments within portfolios is hardly surprising given the recent attention absolute return strategies have received across all asset classes. However, according to Feben, the ability to invest in a fixed interest portfolio offshore is an additional means of adding alpha.

“Looking at fixed income investments offshore can certainly hedge against negatively impacting events within Australia, but it’s about how much you do,” he says. “It can add great value, particularly when you look at investing in different sectors and securities that aren’t as widely available in Australia.”

Bridges says there are two ways of looking at fixed income investment offshore.

“Firstly, Australian indices are of a much shorter duration than offshore indices,” he says. “In terms of this, going offshore is the logical decision. But it should be top of mind that yield curves are lessening this differentiation.”

“Secondly, when it comes to bonds, looking to pick up a liquidity premium can be a powerful tool,” Bridges says. “Today, CDOs [collateralised debt obligations] and rises in the numbers of structured products are allowing the purchase of a range of vehicles. For true diversification, a portfolio needs to go offshore.”

Palghat sees the offshore issue as simple but one that needs to be viewed with care.

“It should be remembered that when a few fixed income managers around the world are consistently producing alpha, the implication is that other managers are not,” he says. “That said, a global portfolio has far more sources for producing that alpha. It grants a much bigger market than that provided in Australia, where there aren’t enough bonds to go around and there simply isn’t enough debt to buy.”

Looking at the balance of fund allocations and the search for guaranteed income, Palghat says a number of options are available to investment managers, including selling liquidity and looking at the illiquidity in infrastructure.

“You can also go down the credit spectrum and look at emerging market debt,” he says. “Or use leverage as a form of return.”

Bridges sees interesting times ahead for all portfolios, with a lot depending on how the world economy behaves over the coming 12 months.

“Markets have underestimated the strength and durability of this growth cycle,” he says. “So the market has reacted to the numbers and not been in front of them. The forecasts are still saying that growth will be okay for the next year, but that could turn around mid-2007.

“A lot will depend on whether monetary policy in the US has to be tightened,” Bridges says. “At the moment, there’s still enough liquidity for growth. But if yields drift out, then there will be a big risk to the value of bonds. Alternatively, if policy is tightened, then we will see bonds and their fixed income counterparts performing well in a market that favours them.”