Fixed interest investments perform when uncertainty the only certainty

Volatility has continued to give life to fixed interest investments and, as Damon Taylor reports, those with greatest experience in the market do not believe the situation will change any time soon.

As investors ease their way into 2012, there seems almost to be a certain tolerance for uncertainty. So while volatility and large unknowns may persist in global markets, one could be forgiven for thinking that investors were getting used to it.

Yet according to Rob Mead, head of portfolio management for PIMCO Australia, such a situation is a real opportunity for investors to adjust their investment mindsets and ensure they have in place the portfolio insurance policy that fixed income can provide.

“Investors should get used to uncertainty because it will be with us for a while,” he said. “But that doesn’t mean they shouldn’t make adjustments to their investment mindsets.

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“Asset classes shouldn’t be looked at in isolation but rather in terms of their role in building efficient portfolios,” Mead continued.

“In volatile markets investors should be focused on generating real returns with a manageable level of risk across their entire portfolio, and still taking into account their own investment horizon.”

According to Mead, the key point was that fixed income, especially the highest quality components of the credit market, could offer investors both attractive real returns and exposure to what were fundamentally sound companies with stable cash flow streams.

“This increased certainty of cash flow generation from fixed income acts a portfolio anchor,” he said. “And, more importantly, it can mitigate risk in uncertain economic environments.”

In giving an overview of current fixed income performance, Nick Bishop, senior investment manager at Aberdeen, said there was no doubt that the more investors were exposed to certain market events, the more they got used to them.

“You essentially get a bit numb to the headlines,” he said.

“And I think that’s been reflected in the pretty fantastic performance we’ve had from equities in the last few weeks.

“Now, why then does that not mean that everyone’s just abandoned fixed income and piled into equities?” asked Bishop.

“Firstly, if you look at the volumes involved and the volumes traded on the share market indices, they’ve been absolutely awful. In the US and Europe, for example, volumes have been exceptionally low for early on in the year.

“So I don’t think it’s fair to say that investors are piling in en mass to equities. On the whole, I think we’ve seen share market performances which haven’t really been reflected by their underlying flows.”

For Bishop, such factors cannot help but amount to an attractive outlook for fixed income. But the risk, according to Clive Smith, fixed income portfolio manager for Russell Investments, is what impact market normalisation could have.

“For most investors, I think fixed income is still looking quite attractive,” he said.

“At this stage, markets are still remaining quite wary and this is giving an element of safe-haven investing.

“But if we start to see global conditions normalise and materially improve, this does increase the risk that longer duration assets will be sold off as investors start looking to add more risk to their portfolios.”

However, for better or worse, market normalisation and rising bond yields are not scenarios Bishop is currently anticipating.

“In fact, we don’t think yields are rising aggressively for the medium term and that’s down to two factors,” he said.

“Firstly, on a global basis, growth is weak. So part of why the markets feel a bit better in the last few weeks is because what we’ve managed to do is avoid the cataclysm that markets were pricing in in Q4 of last year.

“Things were looking so bleak last year that anything that’s not as bleak as that is a form of relief and that becomes a source of good news,” Bishop continued.

“But if we take a step back from that and look at some of the fundamentals, they’re still really mediocre.

"We’ve got 8 per cent-plus unemployment in the US, we’ve got massive levels of indebtedness across the developed world, we’ve got a European economy that’s probably in recession now or certainly will be in 2012 and revenue growth – earnings growth – is pretty soft.

“The growth outlook really isn’t brilliant and that’s one thing that should serve to keep bond yields well behaved; you won’t see large negative returns from your bond portfolio whilst growth is so weak.”

Bishop said that the second observable impact on bond yields was various central banks’ efforts towards quantitative easing measures.

“So they’re embarking on non-conventional monetary policy because growth and growth prospects are weak enough to mean that they need to use more than just the overnight cash rate to try and stimulate the economy,” he said.

“As we know, the Federal Reserve has had interest rates at effectively 0 per cent for some time and is committed to doing so through to around 2014.

“But quite simply, that isn’t enough to get the economy going and to reduce unemployment to the level that they need to,” Bishop added.

“They have to do something else. They can’t take interest rates below 0 per cent so the central banks have to do more; they have to actually squash down bond yields further out in the term structure.

“So this form of quantitative easing is again another yield suppressant and that’s what the central banks are trying to do. They’re trying to squash fixed income returns down so that investors go to something more exciting like credit, like equities, those riskier assets.”

Yet while managers may be cautiously optimistic about the outlook for fixed income, the often-expressed view within Australian superannuation is that its value within a portfolio continues to be underestimated.

In fact, John Wilson, head of PIMCO Australia, was quick to point out that Australia currently had the lowest fixed income weighting of any OECD pension system.

But it is a position he believes must – and will – change.

“People started off with relatively low member balances and so the industry saw its objective as trying to accumulate up a reasonable lump sum for people,” he said.

“In order to do that, they were biased towards growth assets; that’s probably the most generous reading you can give but I think that that’s broadly what the industry saw its mission as.

“In executing that mission, people have foregone some pretty fabulous returns in fixed interest, particularly over the last decade,” Wilson added.

“Whether you were invested in global bonds or Australian bonds, you would have handily outperformed the median superannuation fund return over that period of time, at considerably lower levels of volatility and without any of the wild ride that people have had as a result of being invested in balanced fund structures.

“To put it bluntly, you would have done roughly 7 per cent versus 5.2 per cent and change.”

Expressing a similar view, Bishop said that while many investors, both institutional and retail, continued to favour equities or equity-like investments, the fixed income message was gradually gaining traction.

“Unfortunately, I think the best thing that could happen to make the case for fixed income again quite obvious would be another slump in the stock market,” he said.

“And that’s simply because we found a lot more people wiling to listen to us when we were touring around the country two years ago, coming off the back of what was obviously a really ropy time for stock markets.

“Even today, if you look back at the last 12 months or so, fixed income returns do again look extremely healthy compared to equity returns,” Bishop added.

“That case is still demonstrated and the market data still validates it, but to really change the Aussie super landscape, we think you need to see something more like a 10 to 15 per cent shift in fixed income allocations rather than the 3 to 5 per cent that we’ve seen from what we’ve observed recently.”

Alternatively, Smith said that he could see the value of fixed income being better understood by the greater focus investors were giving different types of fixed income investment.

“If we go back to pre-global financial crisis (GFC) periods, investors saw fixed income, both domestically and globally, as being largely generic,” he said.

"They didn’t really differentiate risk between types of investments and, furthermore, they were really quite happy to go along with standard-type benchmark construction, in particular issuance weighted.

“But those two things have changed now,” Smith continued.

“On the first point, this has been quite notable in some of the offshore markets where we previously saw developed countries, developed sovereign debt, being all lumped together.

“But we’re now seeing much greater differentiation based on ability to pay and I think we’re going to continue to see investors put more of a focus on identifying what are the appropriate risks within fixed income and looking to more proactively manage those risks.”

With regard to fixed income benchmarks, Smith said that there had been a similar focus shift.

“What we’re starting to see, and something which will continue to develop, is investors looking at benchmarks and identifying whether or not those benchmarks are truly representative of the risks they want in fixed income markets,” he said.

“And I think that the key area that investors are now starting to look at with issuance-weighted benchmarks is this fact that the largest weight is to the largest borrowers.

“They’re starting to ask, ‘is it logical for me to really be tilting my portfolio towards the largest borrowers?’” Smith outlined.

“There’s been a realisation that they need to proactively structure their fixed income portfolios to better represent their investment objectives rather than simply assuming that a broad market, issuance-weighted benchmark is appropriate for them.”

However, beyond the lessons to be learned post-GFC and any proof borne out in returns, Wilson said that superannuation investment behaviour was most likely to occur as a result of trustees closely examining the composition of their funds.

“Trustees are already starting to realise that a lot of their assets are, in fact, owned by people over 50,” he said.

“So if you’ve got age on the horizontal and you’ve got assets on the vertical, the 18-to-50 year old group is a very short column with a very wide base, where the 50-plus is a very high column and a very narrow base.

“The realisation they’re coming to is that most of their assets are owned by people who are at or near the retirement phase, and that introduces a whole new class of members for most superannuation funds and a whole new problem for super funds to think about,” Wilson continued.

“And as superannuation funds understand the age-related assets in their funds and understand that group of members who are nearer retirement or, indeed, have retired, they realise that that group values different things.

“It’s a group that values stability of capital and reliability of income above all else at retirement. And, in turn, that drives the demand for a different composition of assets than we’ve heretofore seen in the industry.”

So while the outlook for fixed income is healthy based on both the investment market outlook and the growing needs of Australian’s superannuants, the one impact yet to play out is that of MySuper. 

For all fund managers, the broad acknowledgement is that cost, particularly with respect to active versus passive management, has become a key focus. And yet the key for Bishop is that super funds are less focused on cost and more focused on value for money.

“And in the sense that MySuper will cause people to focus on value for money rather than just cost, that’s a good thing,” he said.

“Its particularly good for active managers because when you look historically at what an active manager’s been able to achieve compared to their costs in fixed income, versus what an active manager can achieve compared to their costs in equities, it does make fixed income look like reasonable value.”

Indeed, Bishop anticipates that MySuper could well make investors look more closely at the perils and pitfalls of passive investing when trying to assess the value-for-money argument.

“The first problem with index investing in fixed income specifically is that, by definition, its benchmarks are dominated by issuers that are the most heavily indebted,” he said.

“So the more debt outstanding, the bigger you are in an index and that’s generally not a great thing.

“Secondly, the issuer chooses when you buy the debt,” continued Bishop.

“So with a bond index, an issuer will issue bonds when the price is good for them – ie, when yields are low – so that’s when it appears in your bond index and that’s when an index investor has to buy it and, again, that’s not a great thing to do.

“You wouldn’t let your bank tell you when to buy a term deposit but that’s essentially what you’re doing there.”

Bishop said that the third problem was that the credit rating agencies determined, to a large extent, which bonds appeared in an investor’s bond index.

“And credit rating agencies, historically, have had a very questionable track record in telling you which bonds are likely to default or not,” he said.

“Then the final problem that we have with index investing is that it closes off to you quite a broad range of ‘off-index’ investments that actually might be quite good for your portfolio on a risk-adjusted basis.

“So, for example, in the Aussie bond index there’s no issuance from some of the true- blue Aussie corporates that fund themselves in the US dollar market,” added Bishop.

“There’s no BHP, there’s no Rio, there’s no Qantas, there are very few examples of some of the top-tier Aussie corporates because they fund themselves overseas.

“Now an index manager can’t buy those bonds but we can. We can buy the high quality names when attractively priced, and then hedge the overseas currency and interest rate exposure to get that bit more diversity.”

Offering a different perspective on the active versus passive debate, Wilson said that it was his belief that investors regularly overpaid for the promise of excess returns in growth assets.

“Now, it’s no surprise that I’m saying that because I work for a bond manager, but the fact is that if you look at returns per unit of fee paid, you get a very handsome payoff in fixed interest,” he said.

“If you think about it logically, the place you can achieve the greatest cost savings if you’re a superannuation fund is to pay less to the people that you pay the most expensive fees to and, in this instance, that’s the equity managers.

“Fixed interest managers don’t command anywhere near the same sort of fees, so my belief is that there will be less pressure on fixed interest fees in a MySuper environment,” Wilson continued.

“And the reason I say that with reasonable confidence is that as people look at the volatility characteristics of fixed interest relative to equities, they’re going to own more of them because their membership will demand it.”

According to Wilson, those sort of circumstances dictated, quite simply, that fixed income would have to play a larger role in superannuation portfolios than it had previously.

“If you’re trying to construct a very simple, transparent fund that is battle-worthy in all different environments for your average investor, then fixed interest needs to play a very important role in that,” he said.

“And further, if that fixed interest allocation comes at the expense of equities, then the total costs of the funds are going to go down.”

So how then is the fixed income story likely to play out for 2012? 

For Smith, whilst the world is starting to see some positive sounds coming out of Europe, it was important to keep in mind that the outlook remains uncertain. 

“Some positive things are occurring in Europe with the Greek situation but there still is a lot of water to pass under the bridge before we get a resolution,” he said.

“I would also say that whilst Europe is starting to put together a cohesive strategy for dealing with the issues, that’s not the only issue that’s about.

“Debt and the reduction of debt globally that’s been taken on by sovereigns post the GFC is going to be something that will continue to weigh on markets,” continued Smith.

“And, indeed, the markets’ next focus could be on the US and how the US intends to get its house in order.

“So I think that that, overall, really does highlight that for fixed income markets and for asset markets in general, we are going to continue to have more volatility.”

According to Wilson, investors, whether fixed income or otherwise, could expect more of the same.

“So what I mean by that is that government policy is going to be an important component in markets in a way that, if you wound the clock back 10 years, it most certainly wasn’t,” he said.

“Once upon a time, as a fixed interest investor, you had to be very, very focused on economic fundamentals, because economic fundamentals determined the cost of capital, and the cost of capital then determined what interest rates were in various countries, along with inflation expectations.

“But now that you’ve seen growth come down in very large parts of the developed world, inflation is less of an influence and Government policy is a greater part of the mix.”

However, despite what continue to be large unknowns, Bishop maintains that it isn’t a bad environment to be in.

“It’s definitely going to have its risks and we’re going to remain in a period where volatility is the norm rather than the exception,” he said.

“I think investors should still expect to be either surprised or appalled when their superannuation statements arrive.

“I don’t think that’s going to go away any time soon but we’ve certainly changed the stance of our portfolios from being really quite conservative and essentially having a negative exposure to credit to having a more positive one,” Bishop continued.

“We’re feeling a bit more optimistic about the world than we were, for example, in Q4 last year.

“And that, hopefully, is encouraging.”