Superannuation funds fixated on fixed interest

A less than stellar quarter to end the last financial year combined with continuing global uncertainty means fixed interest remains on the radar for most superannuation funds, writes Damon Taylor.

In recent months, the superannuation investment story has consistently been about rallying equities markets.

Yet while equities may often be the star performer, steadier fixed income investments are those that saw many funds safely through the trials of recent years and, according to Nick Bishop, portfolio manager for Aberdeen Asset Management, continue to deliver returns that should not be overlooked.

“Fixed income performance has actually been pretty solid, especially considering what equity markets have been doing,” he said.

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“If we look, for example, at the composite performance for our fixed income funds generally, then the one-year numbers to the end of June were at a 10 per cent total return, for two years the average annualised return was over 11 per cent, the three-year was over 8 per cent and the five-year is looking like a slightly more normal 7 per cent.

“So in the context of what equities have been doing and in the context of an RBA [Reserve Bank of Australia] that’s been hiking rates, that’s actually a pretty solid return,” Bishop continued.

“But what’s really been driving that has essentially been forward-looking growth — it’s not been good enough to mean that yields sell off in an aggressive way, so there’s still been solid support for yields.

“High yields have remained relatively low and that’s meant that returns haven’t been negative — have in fact been positive — and you’ve had a correction in credit spreads.”

Bishop added that there was obviously a reasonable correlation between credit spreads and equity markets and that when equity markets did well, spreads contracted and resulted in a positive for fixed income.

“So depending on what you get from credit markets, it’s not always the case that rallying equity markets mean rubbish returns from fixed income,” he said.

Also seeing good performance and good returns from fixed income investments over the last 12 months, Roger McIntosh, head of investment, strategy and research at Vanguard Investments Australia, said it was no surprise that credit had done particularly well in light of equity market rallies.

“Of course, as yields have risen, government bonds haven’t done as well,” he said.

“But if I had a dollar for every person who’s been worried about what’s going on with governments globally then I’d be a rich man — at the end of the day, while what’s going on in Europe might be an interesting conundrum, intrinsically governments can’t default on debt in their own currency.

“People have been inordinately worried about it but returns have still been good. Our fund, over the last year to the end of May, was up around 6 per cent in Aussie, and obviously credit has done well too,” McIntosh continued.

“So rough and dirty, you’ve seen about 6-‘ish’ per cent from the index for Aussie, and for global it’s higher at around 11 per cent, give or take a bit.”

McIntosh said that while fixed interest returns hadn’t been as strong as that from equities in recent months, with yields rising and the price dropping, those with diversified bonds portfolios were seeing their coupons reinvested at higher yields.

“So the returns tend to stay even though they drop in the scheme [as a] whole,” he said.

“All these people crow and worry about government debt and I kind of worry about people who say government debt is not a good thing and that you should only be in credit.

“We still believe there’s a genuine role for both asset classes — it’s not like you have to be in one or the other,” McIntosh added. “Long story short, fixed interest has done well as an asset class, especially given that equities have been the stellar performer.”

GFC lessons

Of course, the performance of fixed interest investments matters little if super funds are not paying attention to what lies within their fixed income portfolios.

However, according to Matthew McCrum, director of investments for Omega Global Investors, most funds have taken the lessons of the global financial crisis (GFC) to heart and are paying much greater attention to how fixed interest portfolios are structured.

“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.

“But now people are definitely spending a lot more time thinking about fixed interest and we’re seeing a lot of the bigger super funds actually hiring fixed interest specialists into their investment teams,” McCrum continued.

“Internal investment teams are a trend that’s been going on for a long time, but fixed interest has been left off to the side.

“Now we’ve got funds hiring people and spending a lot more time thinking about it.”

More specifically, Bishop said that he could also see super fund investors examining fixed income quality and exposure much more carefully, but he added that Aberdeen would warn funds against segregating risk for the wrong reasons.

“At the more sophisticated professional investor level, I think there’s more attention being paid to credit quality and to credit exposure and equally to sectors within your credit exposure,” he said.

“Pre-crisis we’d seen a much more aggregate-based approach where popular products were those that combined lots and lots of different sectors within fixed income, so-called DFI or diversified fixed income, but there are some global asset allocation advisers who are now recommending the segregation of those kinds of risks and saying on the one hand, treat your credit risk totally separately and give that to one manager and on the other, treat your government bond risk separately — give that to another manager.

“Now we have a very strongly performing DFI product and we absolutely think that the way to approach fixed income is by accessing a number of different alpha opportunities, but what we don’t necessarily agree with is dividing your risk into a bucket that’s deemed to be low risk, which is your government bond portfolio, and a bucket which is deemed to be higher risk, so your credit portfolio, and then allocating between them on that basis,” Bishop said.

“We think that the assumption that your government bond portfolio is the low risk portion of your portfolio is flawed and so what you really need to be doing is treating your portfolio fairly holistically and still as one aggregate mass, but being cognisant of the different risks that are coming from different sectors.”

According to McCrum, while many funds are certainly re-examining their fixed interest portfolios, the strategies coming from those examinations remain works in progress.

“Fixed interest comes in a lot of different flavours,” he said.

“You can 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 — you can go into corporate bonds, you can go to high yield corporate bonds, you can go to emerging market debt — and so a lot of people are trying to work out where they put high yield bonds.

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

And 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?” McCrum asked. “So there are definitely a number of funds working through that and working out the answers to those questions.

“But on average, funds will continue to have government bonds and investment grade credit as the defensive parts of their portfolio while high yield corporate bonds that are more sub-investment grade will be treated more like low risk equity.”

Global fixed interest

Perhaps not surprisingly, the sideline to what roles various fixed interest assets are playing within portfolios has been how global fixed interest is entering the equation.

The reality is that financial and economic disruption within Australia has been relatively mild when compared with the rest of the world, but according to McCrum, the result has been some interesting opportunities for those investors looking to diversify offshore.

“What we’re seeing is that a lot of investors who went through the GFC have realised the need to diversify out of Australia, and out of the Australian bond market in particular,” he said.

“The reason for that is that the bond market in Australia, particularly on the corporate debt side, is very, very exposed to financials (the banks), and because there aren’t that many in the Australian market, the real genuine exposure to corporates isn’t there.

“So when looking offshore as a result, it’s one thing to talk about diversification but the flip side of that is to think about the return equation and the risk side,” McCrum continued.

“On the return side, offshore bond markets, particularly offshore corporate bond markets, are offering at very high yields, which is particularly good when you consider the risk being taken.

“Normally you’d think of high yields being proportionate to risk, but coming out of the GFC, it’s meant a lot of good opportunities, particularly in Asia.”

Interestingly, Bishop said that while the ups and downs of global fixed interest markets had been much more severe than those experienced in Australia, they had nonetheless followed the same patterns.

“Performance overseas has been an exaggerated version of what we’ve seen locally,” he said.

“Credit markets offshore underperformed much more dramatically in 2008 and early 2009 but they also bounced much more dramatically from March 2009 onwards.

“Look at high yield returns in the US, for example, they outstripped equity returns in 2008-09. In absolute return terms in 2009, the US high yield market returned 58 per cent, which is a huge number, but in 2008 it was at negative 26 per cent,” Bishop said.

“So that’s an awful lot of volatility that you just won’t have in the local market, and that’s because we don’t have the types of securities that will be affected in that way.”

However, Bishop said the key question was where to from here.

“And that’s not necessarily clear because Australia is very different in the sense that we’ve already started our tightening phase and arguably closer to the end than the beginning of monetary policy tightening,” he said.

“Our yields have already risen a bit to reflect that monetary policy tightening, and that’s definitely not the case in the US or Europe and, as a consequence, you’ve now got some quite interesting spreads between Australian bonds and US and European bonds.

“There’s no doubt that if you’ve owned overseas government bonds, you’ve been rewarded, but more importantly, it’s been about owning high quality overseas government bonds,” Bishop clarified.

“If you’ve owned Germany, if you’ve owned the US, remarkably even if you’ve owned the UK, you’ve been rewarded because the yields have fallen so low and total returns have been so high.

“Now, the proviso in all of that lies in what you’ve done with your currency and how you’ve hedged it against a volatile Australian dollar, but that’s obviously the risk in investing overseas.”

Liquidity

Yet the concern overriding fixed interest portfolio construction for trustees continues to be liquidity. For most, if not all, Australian super funds the experience of the GFC is clearly top of mind, and for McIntosh that focus has also entered fixed income discussions.

“What you’ll find is that because you had a number of other market participants temporarily suspend redemptions and put moratoriums and extensions in place, and to be fair that’s not just fixed interest, what that did was sharpen investors’ focus on liquidity as one of the aspects that they consider,” he said.

“One of the things I think indexing offers is that certainty of liquidity, and certainly within our portfolios that’s one challenge we want to ensure that we can always meet should the same circumstances happen again.

“Previously, investors may have thought of liquidity as a secondary consideration, but now it’s a primary consideration.”

McCrum said that just as institutional investors were asking more questions about the roles of various fixed income assets, they were also asking more questions about how liquidity was fitting into the picture.

“A lot of institutional investors are asking a lot more questions about liquidity, asking about whether these investments are liquid,” he said.

“But the issue with fixed interest investments is that it’s hard to define what liquidity is. So what I mean by that is, with an equity market you can look at it and you can measure liquidity, you can analyse it, you can see where the bid and offer is, you can see how much is there.

“With fixed interest that’s hard to do because it’s not an exchange traded market,” McCrum pointed out.

“The issue with fixed interest markets is how you measure liquidity. It’s easy to say that government bonds should be more liquid than corporate debt and that investment grade corporate debt should be more liquid than high yield corporate debt, but it goes further than that.

“The problem is how you measure that in a market that’s not transparent like an exchange traded equity market, and that’s what a lot of funds are grappling with.”

In terms of portfolio construction, Bishop said there was little doubt that fixed income managers were a lot more cautious when it came to liquidity.

“We give a lot more time to making sure that our analysis of risk across portfolios captures liquidity as a risk and we do factor it in,” he said.

“For example, buy/sell spreads are an important area where an investor will see the effects of liquidity on their funds, so most operators of unit trusts are applying a much greater bias than they would have in 2006-07, and that can make switching more costly for the retail investor and indeed someone who is invested in that fund.

“So higher buy/sell spreads are a direct product of a relative lack of liquidity, but it also means that you have to take a longer-term approach to your investment philosophy,” Bishop continued.

“What we’re typically saying to clients is that while you might like the attractions of emerging market debt that is high yield, you have to be cognisant that you’re not going to be able to turn around and exit that market quickly if suddenly you don’t like it as much.

“We have to communicate to clients that you need to treat these investments on a three to five to 10-year investment horizon rather than a six to 12-month horizon.”

Asked whether liquidity had forced changes in fixed interest allocations, Bishop said that it had probably provoked what he termed a barbell approach.

“What I mean is that if we want to preserve liquidity in portfolios and, at the same time, earn a reasonable return, we’re probably going to have a mixture in our funds of a higher amount of highly liquid securities (for example, semi-government bonds), commonwealth bonds and yet, at the same time, a dedicated allocation to less liquid securities that are paying us a very high yield,” he said.

“So maybe some of the subordinated debt from European financials, some of the capital securities that you get from those financials, which are certainly not liquid, but they are paying you very high yields and a very high spread.

“The fact that liquidity is now an issue means that you have to really adopt a barbelled approach in a portfolio where larger portions of your fund are in more liquid instruments but, at the same time, you have to ensure that you can offer reasonable returns to investors and you need a portion of your portfolio in those less liquid securities to earn a decent return.”

Portfolio fit

However, despite the events of the GFC, it seems likely that equity markets will again deliver for super funds, if not to the extent that they did previously.

So the question, as always, lies in how fixed income investments will fit into superannuation portfolios and what role they will play.

Contrasting equities performance with that of fixed interest, Bishop said that according to research released by the Organisation for Economic Co-Operation and Development (OECD) in 2008, of the 30 OECD markets for superannuation returns that were looked at, Australia’s was second worst.

“Now why was that? It’s not because the Australia equity market tanked worse than the rest of the globe because it didn’t, it’s because super funds were overinvested in equities and so they took a bath,” he said.

“So what we would contend is that even if you’re bullish on equities, in terms of downside protection and increasing the efficiency of returns from your portfolio, you need to have a reasonable fixed income allocation.

“I would rather pay away a per cent or two of annual return for the safety that my capital is going to be much better preserved in a crisis event,” Bishop continued.

“We think it’s a price worth paying because it will repay you hugely if we have another 2008 scenario.”

For McCrum, if growth rates around the world aren’t going to be as high as before the GFC, from a return perspective fixed interest has to be a lot more attractive.

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

“If we say that you can invest in global corporate bonds at the moment 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 in equities, from a risk perspective equities are 12 per cent risk compared to bonds at 4 per cent risk.

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