The return of governments to global bond markets is forcing a fundamental restructuring of markets and provides some golden opportunities for investors. Simon Hoyle reports.
Investors in boring old bond funds have recently had more reason to smile than most other investors. The performance of some fixed interest funds has been a notable bright spot on an otherwise fairly gloomy investment landscape. Bond funds outperformed equity funds by something in the order of 65 percentage points in calendar 2008. Equity funds lost about half their value (some faring better than others, of course), while the typical fixed interest fund gained in value by about 15 per cent. Not a bad result for an asset class often derided as dull, and looked down upon as the “defensive” part of a diversified portfolio. But 2008 was a tale of two halves. As research firm Zenith Investment Partners explains in its 2008 fixed interest sector review: “While government bonds have showed their diversification appeal, credit funds have behaved like ‘low beta’ equity investments, providing limited diversification benefits and negative absolute returns – in some cases making a mockery of their absolute return benchmarks.” “The events of 2008 have been described as the ‘perfect storm’ for credit markets,” Zenith says.
“Falling prices have placed margin call pressure on leveraged investors and this situation was further compounded by higher borrowing costs (relative to risk-free rates) and large-scale redemptions – no doubt made worse by government guarantees on bank cash and deposit accounts. “It is difficult to forecast when buyers will return to credit markets and when the de-leveraging process will end, but…credit market valuations now look attractive to longerterm investors if they can forgo short-term liquidity and are prepared to weather short-term volatility.”
However, the same global crisis that has wreaked havoc on some sectors of the fixed interest sector is also likely to cause a fundamental structural shift, and to present fixed interest investors with a once-in-a-generation opportunity to access very attractive rates of return, with relatively low levels of risk. Governments around the world are scramblingto issue bonds to fund budget deficits to support their massive stimulus packages; it’s a fixed interest securities buyer’s market at the moment, effectively reversing the situation of the past decade, or longer.
Governments need to make bond issues attractive to the market, as they compete for a finite source of funding. As attractive sovereign bond issues begin to flow into markets, the role of fixed interest as an asset class, and fixed interest funds as a means of accessing that asset class, may need to be reappraised. In response, there’s a clear “back to basics” message from fixed interest fund managers. When your asset class holds the potential for returns of CPI plus 3 to 4 per cent, without having to resort to the fancy product and financial engineering of recent years (which in many cases amounted to nothing more than gearing),
there’s no need to over-think how to approach it. That may come as a welcome relief to managers and investors alike, after a prolonged period in which each party’s resilience, ingenuity and integrity was put to the test. “If fixed interest funds historically have been considered a routine asset class, events in the latter half of 2007 and calendar year 2008 certainly provided the sector with a fair share of the headlines,” says research firm Standard & Poor’s, in its most recent Australian fixed interest sector report.
“Investment managers have had to contend with issues ranging from liquidity and significant liquidity premiums, historic widening in credit spreads, increased redemptions due to investor sentiment, the introduction of the Australian government’s deposit and wholesale funding guarantee, the rapid round of interest rate cuts, and the sudden demise of Lehman Brothers and other financial institutions.” Jeff Brunton, head of credit markets for AMP Capital, says some of the events currently shaping fixed interest markets represent “generational change”.
“The complexion of the market is changing; with sovereign issues in many countries there are credible estimates that the market is going to double or triple in the space of a few years,” Brunton says. “The credit market is providing investors with very wide spreads; we have very low cash rates and government bond yields are very low in most countries. “Investors have access to meaningful returns above the risk-free rate. For investors who are targeting a CPI-plus-3-to-4-per-cent return, given their investment objectives and time horizon et cetera, you have many parts of the fixed interest market pricing at or near those levels.”
However, even if the absolute returns from fixed interest assets – particularly sovereign bonds – prove to be strong in coming years, the role of fixed interest as an asset class will still be “the bedrock for diversifying other risks in your portfolio”, Brunton says. At the same time, complexity in fixed interest products is best avoided. Investors are again being adequately – some would say handsomely – rewarded for the risks associated with bonds; there’s no need for product manufacturers to aim to boost yields through fancy financial engineering and leverage.
If you think of fixed interest as being a “vintage”, then “the bonds of 2009 are going to be high qual-ity, as they are being created in an environment that is very risk-averse,” Brunton says. Robin Bowerman, principal of retail business for Vanguard, says asset allocation remains the critical decision to get right when determining an appropriate exposure to asset classes. Bowerman says no matter how good your stock picking skills, you probably lost money in the Australian share market during 2008. “Asset allocation is the critical issue,” Bowerman says.