There’s been a quiet revolution in the income fund sector over the past decade. Gone are the days, for instance, when a typical bond portfolio held sovereign and corporate debt, with a bit of interest rate management for good measure. The rapid growth of credit and derivatives markets means that many income fund managers now invest in multiple sources of potential value-add, such as asset- and mortgage-backed securities, hybrids, and high-yield, sub-investment-grade, and emerging markets debt.
This increasing sophistication has led to the emergence of “enhanced income” funds, designed to provide regular income streams above the return from cash. The popularity of these funds grew as traditional mortgage funds struggled to outperform cash, because of increased competition in the mortgage sector and resulting large cash positions in their portfolios.
Additionally, the low interest rate environment in conjunction with an inverted yield curve made these enhanced income funds more appealing to yield-hungry investors. Because in recent years the short end of the yield curve has been at a premium to long bond rates, investors have not been rewarded for taking on term risk, hence the attraction of funds offering cash-plus returns with little exposure to long-term bond rates.
The majority of these next-generation income funds do not take interest rate risk, preferring to source excess return from a variety of credit and structured credit assets including hybrids and asset-backed securities. Credit risk is perceived by these fund managers as manageable and a good source of alpha, while limited exposure to interest rate volatility has also been seen as a positive characteristic by investors seeking an alternative to mortgage funds.
These funds had a dream run until recently. Stable credit market conditions combined with historically low default rates made these strategies look almost risk-free. The reality is that credit premiums driven by yield-hungry investors reached very low levels in which the associated risks far outweighed the rewards. Figure 1 shows the passage of US credit spreads for a range of credit qualities, from A-rated through to high-yield, over a 20-year period to 2007. The graph also shows the compression in yield premiums. Credit premiums peaked in 2002, and then fell dramatically up to the middle of 2007, the most recent spike the result of the sub-prime crisis which emerged from August 2007.
The effects of the sub-prime crisis show how susceptible many of these enhanced income funds have been to adverse credit conditions. Depending how credit markets behave over the next year or so, we may see fund managers returning to interest rate strategies. One thing is for sure: as the fallout from the credit crunch has revealed, income fund managers now have a far wider selection of value-adding strategies than ever before.
The environment for mortgage fund managers has also become more difficult. Investors favoured mortgage funds in the early years of this decade, seeing them as a safer haven when sharemarket funds were producing negative returns. Mortgage funds ended up victims of their own success, though, struggling to source suitable loans to match the waves of incoming cash. Returns subsequently suffered because of the lower margins on these high cash holdings. At the same time, cash management funds emerged offering returns in excess of cash with little apparent risk. While it’s not immediately clear that these models can be sustained over the long term, their appeal relative to mortgage trusts is understandable given their lower fees.
Another challenge for mortgage funds is increased competition from the major banks, which have entered the sector aggressively. This has led to a margin squeeze, the flow-on effect being lower investor returns, in turn reducing mortgage funds’ attractiveness to retail investors. Anecdotal evidence suggests that mortgage fund managers previously enjoying margins of around 150 basis points above cash are now being forced to lower this to around 110 basis points or below to source loans, and may be using their much larger balance sheets to compete aggressively on margins.
A proliferation of new entrants has also clouded the definition of exactly what a mortgage fund is, making it increasingly difficult to compare products. A common theme among these new entrants is a return profile much higher than that of a vanilla mortgage strategy. Because of this, we have introduced a new category, Mortgages – Aggressive, for the expanding number of mortgage funds with wider investment universes such as mezzanine financing and construction and development loans.
The most recent development has been fallout from the US sub-prime lending crisis. Unlike the United States, Australia does not have a sub-prime sector as such. (The closest we have locally is no-doc lending, which has had some defaults, although nowhere on the scale of the US problems.) The greatest effect on local mortgage funds is in the re-pricing of risk, and resulting changes in mortgage spreads, which could ultimately prove positive for mortgage fund managers.
Given all these issues, advisers and investors may ask why they should bother with mortgage funds at all. However tempting it may be to disregard mortgages as an income asset class, the issues facing the sector appear to be cyclical, and therefore likely to pass. Mortgage funds remain worthy of consideration as a component in an income portfolio.
It’s our view that retail investors in Australian income funds are overpaying by comparison with their wholesale counterparts. The average annual fee for wholesale fixed interest funds is 0.68 per cent, while for retail funds, it’s more than double that at 1.45 per cent. Although the added costs of retail distribution mean that there’s always likely to be a disparity between retail and wholesale fee levels, if a fund is offering two per cent above cash, then a 1.50 per cent management fee will eat into three-quarters of potential alpha.
A related issue is the level of risk taken on by retail investors over their wholesale counterparts. When we looked at the offerings for retail investors, we found most shops pushing higher-risk, higher-yielding strategies. Fund managers claim that investors are searching for a higher-yielding product, although it’s our belief that many investors do not realise the level of risk they’re taking on. Income is a defensive asset class, yet many higher-yielding funds have come unstuck since the credit crunch, which began in 2007. Given the greater number of lower-risk products available to wholesale and institutional investors, revenue generation considerations appear to be playing a major role in income fund manufacturing and promotion.
Finally, we noted that performance fees have started to sneak into this area – four of the 30 strategies we assessed charged these at the time of writing. All Star Income charges 15.38 per cent for returns above benchmark (one-year interest rate swap), and Colonial First State’s Enhanced Yield and Challenger’s High Yield strategies have 20.0 per cent performance fees for returns above their respective benchmarks, while PM Capital Enhanced Yield has a 25.0 per cent performance fee for returns in excess of the cash rate. These performance fees are typically all for retail funds, and aside from PM Capital’s 0.55 per cent per annum, the others all charge at least 1 per cent as an ongoing fee – arguably akin to daylight robbery.