Super funds stick to fixed income allocations

Domestic and global equities may have been the main drivers for double-digit superannuation returns closing out 2013 but, as Damon Taylor writes, there are good reasons why super funds are maintaining their fixed income allocations. 

Against the backdrop of favourable central bank policy globally, recent years have seen fixed income become a mainstay for Australian superannuation funds. 

Indeed, despite rising yields and fears of a bonds bubble, returns have been solid. For Nick Bishop, head of Australian fixed income for Aberdeen Asset Management, although gradual declines are in evidence, the outlook for fixed income remains positive. 

“If you look at recent history, then fixed income returns have been very solid,” he said. “In January, for instance, you had over 1 per cent in total return from Aussie bonds and you had a little better than that from US treasuries. 

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“That was really quite solid and that’s in the context of equity markets that gave you about -2.5 per cent, maybe -3 per cent in January and obviously worse if you were in some of the sexier areas of EM (emerging markets),” Bishop continued.

“So at Aberdeen, we viewed January as a nice reminder for anyone who has fixed income exposure as part of a balanced portfolio that one of the reasons it’s there is your insurance policy. 

“It’s there to give you that negative correlation against riskier assets when times are less favourable, and January was a great example of exactly how that works.” 

Offering a similar perspective, Benjamin Kelly, executive vice president and account manager for PIMCO, said that fixed income returns had been sound for overall balanced funds over the last year. 

“And that has certainly been helped along by the levering of public balance sheets and obviously hyper-accommodative central bank activity as well,” he said.

“But when it comes to fixed income, I do think we need to be mindful of the fact that we’ve already seen a large increase in global yields, which has had an impact on overall returns. 

“So if you recall, the low in the Aussie 10-year government bond yield was about 2.7 per cent back in June of 2012,” Kelly explained.

“It got to around 4.5 per cent at the end of the last year and I think as I walked off the desk just now, it’s hovering at about 4.05 per cent with a bit of a rally on the back of the Qantas news. 

“Similarly in the US, the 10-year yield reached a low of about 1.38 per cent in July of 2012 and it’s around about 2.7 per cent today.” 

Kelly said it should not be surprising that such a large move up in yields in the fixed income asset class had an impact on historical returns. 

“But for 2013, bonds still generated a return of about 2 per cent, which in my mind seems like very cheap portfolio insurance,” he said.

“So I think the discussion has actually moved on from the fear of rising rates back to the role of fixed income inside a balanced portfolio. 

“And I would argue that a AAA-rated government bond yielding 4.5 per cent as being very fitting for the role of things like diversification, capital preservation, liquidity and income.” 

Of course, while recent performance and even the immediate outlook for fixed income may be reasonably sound, the asset class is not without potential headwinds.

In fact the most likely medium-term challenge, according to Bishop, is one that has already been demonstrated. 

“The reality, unfortunately, is that there can be periods where that fixed income insurance policy falters,” he said.

“And the recent example of that is mid-2013 when we got the first indication from Ben Bernanke of the FOMC (the Federal Open Market Committee) that they were looking to remove quantitative easing or long-term asset purchases in the US. 

“Now, that worried fixed income markets because one of the key reasons bond yields and generally asset volatility have been low is the amount of non-conventional monetary policy from global central banks, and the Fed is right at the forefront of that,” Bishop explained. 

“So when Bernanke surprised markets, making it clear that quantitative easing could be removed and removed quickly, bond markets put the brakes on and yields backed up quite significantly.” 

However the real issue, according to Bishop, was that the FOMC’s announcement had coincided with falls in riskier asset classes as well. 

“Now that’s unusual in history,” he said.

“Usually you find that if risky assets like equities or emerging currencies or high yield bonds are falling in price, you see treasury yields and government bond yields falling in a flight to quality fashion as well. 

“But that didn’t happen in the middle of last year,” Bishop continued.

“So one of the threats going forward is that you get that happening again – you get yields rising, so in other words negative bond returns, but at the same time you’re not getting a complementary rise in higher risk assets. 

“Its almost like the perfect storm for the investor where none of the parts of your portfolio work, and while I’d stress that that isn’t our central case expectation, it is certainly a possibility.” 

Indeed for Kelly, while the US Federal Reserve’s monetary policy is central in terms of how fixed income returns are impacted, the real key is what he termed the ‘escape velocity’. 

“The focus of fixed income over the next year or so continues to be central bank policy, particularly the extraction of the Fed’s balance sheet or the taper,” he said.

“But the real key is what PIMCO likes to call the escape velocity, so how exactly these markets and economies are going to maintain self-sustaining growth. 

“This is particularly important in the case of the economies that have been heavily reliant on the massive support of central banks,” Kelly continued.

“So I think given this key risk, we all need to be cognisant of managing down expectations of overall returns, especially with regard to risky assets that have been the main beneficiaries of levered public balance sheets.” 

Therefore the most likely scenario, according to both Bishop and Kelly, is one where the world’s economic growth continues to improve gradually. 

“In our central case, it’s a world where growth is a little bit better in the US, it’s a little bit better in Australia and yields are a little bit higher,” said Bishop. “And so bond returns are not super-exciting, they’re low single digits but not negative in an absolute sense. 

“So in other words, you get some coupon income over the year and you get a small decline in the capital price of your bonds,” he added. “And adding those two together, you get a total return that’s weak and below cash but its not negative. 

“That’s our central case.” 

Yet while market and economic challenges abound for fixed income, there are equal challenges within an evolving superannuation industry.

As super funds’ MySuper options continue to take shape, it seems clear that fixed income allocations will be affected, but according to Grant Forster, CEO of Principal Global Investors (Australia), the question lies in when and how. 

“Whether we’re talking about MySuper products or lifecycle options that may be a part of that, the problem is that we’ve yet to see the data,” he said.

“I mean, it only came into effect in July, but what I will say is that Principal is one of the leading lifecycle, target-date, target-risk providers in the US and they do make a lot of sense. 

“But even with our experience in the US, you don’t actually see fixed income as a key part of a 401k lifecycle,” Forster added.

“You do see it gradually increase as you get closer to retirement, but with ageing now, many of our lifecycle products take a +15, +20 year view and so if you retire in 2020, we’re going to manage that. 

“We’re not going to take you all out of equities in 2020; we’ve going to manage that down through to say, 2035, through that retirement period.” 

The reality, according to Forster, is that material changes to fixed income allocations, at least in the short term, are unlikely.  

And for Bishop, the relative immaturity of the Australian superannuation industry makes significant change even more unlikely. 

“So one thing we’ve got to bear in mind is that the Australian super system is still relatively immature,” he said.

“You’re just now coming up to the first vintage of super savers who have been in a compulsory super system for most of their working life and they’re just now approaching retirement. 

“But that’s the first wave. Prior to that there was no compulsory super so we’re only just at the very beginning of a period where you get a consistent roll-off of people coming out of the super system, people who have been accruing well throughout the whole of their working career,” Bishop continued.

“Now, as those numbers start to swell, and with the baby boomers getting closer and closer to that point, that’s when you’ll see a material ramp of people in the drawdown phase, that post-accrual phase, where you do need to be looking at more stable sources of income. 

“So at the margin, that definitely suggests an increased interest in fixed income, but I don’t think we’re there yet.” 

In fact for Bishop, the more pressing MySuper issue was with regard to fees and cost. 

“Firstly, let me say that it is a laudable aim for the Government to be focused on fees, particularly where a compulsory super system is in place,” he said.

“The challenge though is in focusing purely on the level of fees as your determinant of a product’s worth, because I think that distorts the message for the member or end user. 

“Take active management strategies, for example,” Bishop continued.

“It costs money to do the amount of detailed research that houses like Aberdeen do into every issuer we buy, into every sovereign bond market we invest in, every research paper we put together to come up with our active views that enable us to earn alpha or excess returns over time. 

“And we’ve done that, our long-term numbers show that, but it does come at a cost.” 

Equally concerned about the distinction between value and cost, Kelly said that a divide in terms of how both super funds and fund managers understood that distinction was inevitable. 

“If we roll the clock back and think back to the early origins and focus of MySuper, it was to ensure that members were getting value out of their superannuation provider,” he said.

“That key word being value. And so for many providers, this made them focus on cost while others continued to focus on return relative to risk and overall member objectives. 

“So I’m not sure that MySuper has really been a game changer for fixed income allocations,” continued Kelly. “It’s just emphasised the bifurcation of providers who preferred to deliver markets returns and those who want to deliver more active returns. 

“For me, the game changer has really been bringing the focus back to the member and that is always a good thing.” 

Of course, irrespective of how the super industry’s MySuper products evolve, it seems clear that fixed income’s role in portfolios is assured. Indeed with the weight of members moving from accumulation to decumulation only increasing, it seems allocations must increase in parallel. 

Yet for Bishop, it is all a question of timeframe. 

“In the short term, I think there are a couple of things that could impact fixed income allocations,” he said.

“If we see the Abbott government push more strongly into this idea of co-funding of infrastructure finance with the idea that governments take, say, a 10 to 15 per cent equity exposure in an infrastructure project and then the balance of the funding is done from the wholesale bond market, then those bonds will all need to be placed and they’ll all be fairly long-dated in nature. 

“If that took place, you could see super funds move to acquire those quite aggressively or you could see a move from the Government to encourage the super funds to cooperate and help fund those infrastructure projects,” continued Bishop.

“So that could result in an increase in infrastructure-specific debt funds that get quite a lot of interest from super funds. 

“And that could happen fairly quickly if it’s done in this political term.” 

Alternatively, Bishop suggested that a growth slump could be equally impactful. 

“That’s what we saw in 2011 when you had a growth scare and the European sovereign crisis,” he said. “Bond yields fell really quite aggressively right through to the back half of 2011 and we got some really solid funds flowing into all of our fixed income funds. 

“Now, what could cause that? Well, the most likely cause regionally for us is a policy mis-step in China,” Bishop explained.

“We know the Chinese government is navigating through this period to try and change the mix of growth away from heavy fixed asset investment, which is very resource intensive and also quite polluting, away from that to a more consumption-led economy, and while it’s very good at this sort of command-economy management, one misstep could have grave ramifications for Australia. 

“It may not be all that likely but if it did take place, it would likely see interest rates plunge quite sharply and also quite a high demand for the safety of fixed income products.” 

But while such short-term events would certainly be significant, Bishop was quick to add that over a longer time horizon, super funds’ fixed income allocations were only going one way. 

“So medium term, I think fixed income allocations are only going one way and that’s up,” he said. “And the reasons are that you get this progressive maturing of the super system and a big roll-off of baby boomers over the next 10 to 15 years, all of whom will be in drawdown phase. 

“So that medium-term backdrop is fantastic for income-producing assets,” added Bishop. “And I wouldn’t just have fixed income in there; it would also be constructive for blue chip, high-dividend paying equities with low beta as well.” 

In fact for Forster, the industry’s increasing focus on retirement was the fixed income asset class’ best guarantee. 

“Australia’s ageing demographics cannot help but impact the status quo,” he said. “The move to decumulation products and capabilities will definitely increase the need for income, but I don’t think fixed income is necessarily the sole beneficiary. 

“So within fixed income, you’ll undoubtedly see more bank loans, higher yield, and emerging market debt to some extent,” Forster continued.

“But I think you’ll also see more things like global REITs (real estate investment trusts) and infrastructure as well. 

“Assets with an eye to income will come to the fore, but it won’t necessarily be fixed income as we’ve traditionally known it.”