Superannuation funds reap the rewards of fixed interest

Fixed interest may not be fashionable, but as Damon Taylor reports, those superannuation funds that maintained a focus on the big picture and resisted the temptation to move to fleetingly fashionable allocations reaped the rewards.

By tradition, fixed interest allocations have been an insurance policy against uncertainty for Australian superannuation funds.

Unpopular when markets are bullish, they provide funds with a portfolio safety net when the going gets tough.

Of course, some of the worst superannuation returns the industry has seen for 17 years are proof that this financial crisis has shattered much of what would have been termed traditional.

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But according to Glenn Feben, head of fixed interest at Perennial Investment Partners, if funds stuck to pure fixed interest and were not distracted by the promises made by high yield structured debt, their fixed interest insurance should have paid off.

“Traditional fixed interest has performed particularly well over the past year or so,” Feben said. “The Central Bank responded to the GFC (global financial crisis) by shifting its focus from controlling inflation to limiting the damage to the Australian economy.

“We’ve seen one of the biggest falls in interest rates that we’ve had for many years and, as a result, fixed interest returns have been very good,” Feben continued. “They’ve behaved as you would have expected given the environment of the last 12 to 24 months.

“It’s just unfortunate that many investors didn’t have as much fixed interest in their portfolios as, in hindsight, they would have.”

Asked how fixed interest had fared compared with less defensive assets, Scott Tully, head of FirstChoice Investments at Colonial First State, said credit and bonds had obviously performed a lot better than super funds’ equities allocations.

“While the characteristics of fixed interest weren’t quite what was expected, the one-year returns for most bond funds were still positive,” he said.

“And that’s significantly better than what was received in equities, with returns around negative 20 per cent.

“Fixed interest did at least some of what it was meant to do.”

From the super fund standpoint, Bruce Watson, chief executive officer of AUSCOAL Super, saw the investment market shake up generating similarly unexpected characteristics in fixed interest returns.

“Fixed interest investments generally suffered during the GFC and experienced increased volatility compared to expectations,” Watson said.

“However, over the financial year the defensive nature of fixed interest came to the fore and provided positive returns, proving their worth in our portfolios.”

In terms of particular winners under the fixed interest banner, Tully said the recipe for success had been simple.

“Anything that was a government bond and heavy strategy did well,” he said. “And anything with any degree of spread to government debt did badly.”

Similarly, Watson felt there had been a flight to quality within all super fund allocations.

“Sovereign bonds outperformed due to the flight to quality,” he said. “Credit suffered with the increase in spreads and inflation-linked securities suffered as the market considered the prospects of deflation.”

For Feben, in this kind of environment, any fixed interest asset with a long duration is always going to do well.

“When interest rates fall, duration is a good thing to have in your portfolio,” he said. “So in terms of defence, those funds that maintained a high level of exposure to high quality, long duration fixed interest would have been well served.

“But other funds, those with fewer quality fixed interest assets and a greater exposure to corporate bonds, would not have fared so well.”

Yet it is easy, with hindsight, to see what the right moves within fixed interest allocations would have been.

Twelve months ago the situation was not so clear and there was ample concern that investors, even those at the institutional level, had been searching for too much yield and losing sight of what made fixed interest investment defensive.

Feben suggested that the problem with super funds having less exposure to quality fixed interest assets leading up to the financial crisis and the reasons mistakes had been made was related to investor attitudes.

“Allocations to pure fixed interest weren’t as high due to bond returns being so poor leading up to the crisis,” he said.

“That meant investors’ attitudes shifted — they asked why they had the poorer returning fixed interest in their portfolios and looked to other fixed interest assets with better return prospects.

“We moved further down the credit curve and we saw many investors pursuing higher returns and compromising on the insurance that fixed interest provides,” continued Feben. “But I don’t think we’re seeing those same mistakes now.

“There’s been a recognition of the necessity of keeping fixed interest defensive.”

Alternatively, Stephen Halmarick, head of investment markets research for Colonial First State, said fixed interest mistakes had ceased occurring because the products causing the most problems no longer existed.

“The issue now is around fixed interest supply,” he said. “The balance has tipped in favour of government rather than corporate bonds and it means that the structure of the market is changing dramatically.

“Some of those problem products may never come back, but we’ve been left with a market set to be dominated by government bonds for quite some time.”

As to whether super funds themselves had fallen into fixed interest traps, Watson said the super industry had learned a great deal from the experiences of the last 12 months.

“From our discussions with industry participants, we believe there is no demand for the highly complex, less liquid and less transparent instruments that were more popular prior to the GFC,” he said.

“Additionally, the volatility experienced in credit markets highlighted the risks of chasing yield.”

But for Watson, there had been no sure-fire recipe for success.

“There was no one thing,” he said. “But we felt sensible asset allocation, a degree of flexibility around SAA (strategic asset allocations) and active managers who were able to reposition our portfolio and manage unfolding opportunities were what gave us the best chance.”

According to Feben, summarising the financial crisis and its impact on fixed interest is quite simple.

“When you boil it down, those with a good understanding of fixed interest’s role were always less likely to make mistakes,” he said.

“Bonds may only get good returns once per cycle, so once every five to seven years, but that’s when you’re going to be most grateful.

“The principal role of fixed interest is risk mitigation,” Feben continued. “Some investors lost sight of that but most have since relearned it.”

Changing focus from the behaviour of institutional investors and fixed interest investments throughout the financial crisis to the lasting changes that could be the consequence, Feben predicted funds would be tweaking portfolio construction rather than portfolio weightings.

“The focus probably won’t be on the amount allocated to fixed interest,” he said. “It will be on the manner in which that amount is constructed.

“There were institutional investors out there who ran down their exposure to low risk, high quality fixed interest in favour of the more high yield products,” Feben continued.

“Some super funds had a clear picture of the role fixed interest should play but others simply got the balance wrong.

“They went too far, had too much focus on generating a return and they compromised their defence. The focus now will be on turning that around.”

And according to Halmarick, there is evidence that many super funds are doing exactly that.

“I think there’s probably a growing understanding and interest in fixed interest,” he said. “And an increase in the supply of government bonds is likely to create further knowledge.

“Bonds, and perhaps fixed interest as a whole, are likely to become more interesting for all investors — retail and institutional.”

Looking to how fixed interest investment might change, Watson said the global financial crisis had tested many assumptions on risk and the correlations between various asset classes.

“Funds will likely place greater emphasis on testing the risks characteristics of proposed investments,” he said. “But investor preferences will ultimately be determined by their individual risk and/or time thresholds.

“Investors with a longer-term investment horizon and a higher tolerance of risk will continue to be overweight growth assets.”

As to whether the more creative fixed interest products in structured debt and collateralised debt obligation (CDOs) had caused difficulties and been portrayed as defensive, Watson said there was more to an asset than its label.

“Fixed interest is a broad asset class and some parts of the asset class performed more like equities than bonds,” he said. “Asset managers and owners should be able to understand the different characteristics of the securities they are investing in and not rely on a label.”

Urging people to look at both sides of the investment equation, Feben said as a fixed interest manager, Perennial Investment Partners was always trying to identify the best possible value adjusted for risk.

“Clearly, corporate debt has performed very poorly under these circumstances,” he said. “But the spreads available on what was a wider range of corporate debt were compelling.

“It was a very large illiquidity premium being built into corporate debt pricing and corporate debt yields.”

Feben added that he did not necessarily believe there were a lot of fund managers who were guilty of marketing high yield fixed interest products as being defensive.

“In a lot of cases, they were quite upfront about the risks,” he said. “But time has shown that high yield debt becomes very closely correlated with equities under financial crisis conditions.

“At the time you were looking for something that performs well whenever everything else doesn’t,” Feben added. “And high quality, long duration government bonds were the only thing doing that.

“Not even cash did the job as well.”

Of course, one of the global financial crisis’ key features was particularly significant for fixed interest investment. Liquidity and the flexibility that it gave portfolios was a concern for all super funds but, according to Tully, it did not necessarily increase fixed interest’s popularity.

“Liquidity needs haven’t necessarily made fixed interest more popular,” he said. “Because most funds have been redeeming their bonds and cash to rebalance their portfolios.”

Tully also pointed out that if a super fund’s bond exposure had been complex or heavily illiquid, selling down those assets would have been made very difficult.

“Fixed interest assets were used as the ATM of super funds,” continued Tully. “And if a fund had a heavy skew towards unlisted assets, it was twice as necessary.

“Funds had to understand what each asset class was providing in terms of liquidity.”

Echoing Tully’s thoughts on the need to understand what provided liquidity, Feben said fixed interest investments had played a key role in investors learning liquidity lessons.

“All investors saw that in such extreme conditions, there were types of investments that were thought to be liquid and were proved not to be,” he said. “Even good quality corporate debt was proven to be relatively illiquid.

“It’s forced a rethink on how fixed interest portfolios are constructed.”

Feben said his concern had been that investors would lose sight of the benefits of non-government debt.

“The 12 months to two years have been very difficult,” he said. “And the danger lies in investors thinking that non-government debt wouldn’t perform when credit spreads come back and risk appetites improve.

“But now that liquidity is returning to the investment grade corporate market, I think that in some respects those concerns may be receding.”

But the biggest change set to impact fixed interest investment has not been prompted by liquidity concerns or investor attitudes following the financial crisis.

Research conducted by Colonial First State has flagged that the fixed interest space is set to a see a large increase in the number of state and Commonwealth bonds entering the market in coming years and, according to Tully, funds and investment advisers will need to take heed.

“The issues lie in benchmarks,” Tully said. “And this change means that if you invest passively or close to benchmark, you will naturally be forced to hold more government bonds.

“That may not be what you want if you foresee stress on these issuers,” Tully continued. “So funds will need to be cognisant of it.

“It is a change that will happen by stealth rather than by active decision.”

Looking at the current composition of the Australian bond market, Feben said an increase in the presence of government debt would clearly have an impact.

“Obviously the bond market will move back in favour of government debt and away from corporate debt,” he said. “And from the investor and manager perspective, it will have implications for portfolio construction, particularly for indexed funds.

“Opportunities for corporate debt will come back, but for the time being there will certainly be more on the government side.”

In terms of what could be taken from the experience of the last 12 to 24 months and utilised in the future, Tully predicted that the super industry would see a lot of the fixed interest complexity removed.

“Complexity isn’t what people are looking for anymore,” he said. “I think it will be a while before investors have an appetite for complicated fixed interest products that they may not understand.”

Feben said he also saw moves back to fixed interest purity and tradition for the foreseeable future.

“We’ll see periods again where demand for more creative products increases,” he said. “But short term, we should see a significant reluctance for structured securities.

“Super fund mandates will tighten for those sorts of assets and move back to the more vanilla products.”

For Feben, the simple message to be taken from the financial crisis was not to underestimate those vanilla fixed interest products.

“It’s about having an appropriate balance between chasing return and sensible risk management,” Feben said. “And the financial crisis saw that balance swing too far.

“That is the lesson investors must learn.”

And though Watson pointed to fixed interest opportunity being out there for active fixed income managers, Feben’s lesson is one he is clearly conscious of.

“Risk is a two edged sword,” he said. “And it is critical that investors understand the exposures that they put into their portfolios.

“They must not rely on labels for comfort and excuses not to undertake the necessary research to understand the characteristics of the securities they are investing in.”