S&P says the key product differences that planners should consider are in the fixed interest and income/high yield income categories. “Fixed interest funds can be split into those that offer a more core solution versus those products that will take on a higher degree of active risk – particularly credit,” its report says. “Credit exposure and the tolerance for securities that sit lower in the capital structure are important to understand and will affect the return profile of the product. “Additionally, we are now starting to see a far greater use of credit default swap (CDS) strategies than previously observed.
While we acknowledge the efficiency gains and opportunities that arise through the use of these instruments, the additional risk resulting from their use and the contribution they bring to the funds’ return have been, and remain, key areas of our focus when reviewing a product.” S&P says that the “income” category of funds includes both income funds and high yield income funds, and the key difference between the two is the amount of the latter’s “sub-investment grade/lower credit quality exposure”.
“Capacity and liquidity are a key focus with evidence that high yield funds with lower levels of funds under management (FUM) and a portfolio of predominantly exchange-traded instruments have had the ability to transact in the markets (in low volume),” it says. “These products have had the ability to execute their desired investment strategy and have fortunately been in a position to provide liquidity when required.” Schroder’s Doyle says the global financial crisis (GFC) is having a pronounced effect on the structure of fixed interest markets, and how managers are responding.
“The shift in borrowing from the private sector to the public sector will fundamentally reshape major fixed income benchmarks in coming years,” Doyle says. “While in global benchmarks, the impact of a surge in US treasury issuance will have a major impact, the local benchmark will also change. The Commonwealth Government is re-entering debt markets after being on the sidelines for a number of years, while state government borrowing is also on the rise.
“This does highlight one of the fundamental problems with fixed income benchmarks, namely that the biggest constituents are the biggest debtors/borrowers, which is not necessarily aligned with investor objectives.” Doyle says the changing nature of markets does not fundamentally affect the role of fixed interest as an asset class in a diversified portfolio. “Fixed income should be held for defensive purposes, and in particular to diversify equity risk,” he says. “The problem has been that it has been misused with investors pushing out the credit curve and assuming ‘equity-like’ risk in the defensive part of their portfolio.
“The fundamental issue here is that the fixed income universe is broad and varied. Some securities and security types are truly defensive while other types (particularly lower-rated credit type securities) are much more equity-like. While these asset types have a role in a broadly diversified portfolio, they often don’t fit neatly in the defensive part.” Doyle says there are “a number of implications of recent developments for financial planners”. “The first is that planners should focus on the role different assets have in the client’s portfolio – not simply on maximising short-term return,” he says.
“For example, advisers have typically shunned traditional bond funds [as being] too boring, but these have performed incredibly well in an environment where risk assets have performed poorly. They provide good insurance to the portfolio. “The second implication is the importance of asset allocation. The biggest driver of return to clients is the portfolio’s asset allocation – not which managers the client is invested in. I’m not suggesting this is not important – but it will typically have less of an impact on client returns. Asset allocation is not easy – but can be done better at an industry level.
“In terms of actually selecting bond fund managers, an important criteria is the alignment of fund strategy and manager philosophy with that of the planner and client. Not all bond funds are the same, and the difference in risks across the fixed income opportunity set means the range of outcomes in fixed income portfolios can be enormous. “Extrapolating past performance is a poor guide. Learning about risk from past performance – especially recent past performance – is likely to be significantly more relevant.”
