The same emotions affect fixed income investors just as much as share investors, says Roger Bridges

The same powerful forces
that drive share investors – greed and fear – also affect the behaviour of
fixed income investors. The greed element was no more apparent than in the
lead-up to the global financial crisis (GFC), with investors’ thirst for
ever-higher returns in a low-interest-rate environment prompting many to invest
(often unknowingly) in higher-risk “so-called” fixed-income securities. However,
the tide has turned, with greed replaced by a prolonged period of fear, and
investors now focused on the aftermath of the GFC – specifically Europe’s debt
and banking problems, as well as doubts about the strength of the US economic
recovery.

Investors are more worried about the return of their capital than the return on their capital. They are in
turn tending to shy away from risk, preferring the comfort of good
old-fashioned “safe haven” sovereign bonds (mostly US, Canada, Germany and
Australia at present), sparking strong rallies in global bond markets.

In this
article we provide insights into how the greed and fear emotions and associated
investor behaviours can be tamed, or at least kept at bay. Recognising and
understanding these behaviours is one thing, but changing them is something
else.

As a fund manager, we are not completely immune to these behaviours;
however, there are steps we take and disciplines that we adopt to help minimise
their influence on our investment decisions. Essentially it comes down to one
word – “process”. Having a process that sets boundaries and rules permits you
to challenge the status quo and it stresses your biases; it allows you to have greater
control over the greed and fear emotions, and ultimately make more rational
investment decisions. In this article we share some of the Tyndall fixed income
team’s secrets to successful investing.

The rise and fall of credit

Fixed income, specifically credit, has stolen the limelight in
recent years as a result of the GFC and knock-on effects on world economic growth.
The increased demand for, and supply of, credit in the late 1990s saw this
sector grow rapidly as a proportion of the UBS Australian Composite Bond Index
(Index), peaking at 36 per cent in 2006 (as shown in chart 1). Meanwhile, Commonwealth
Government bonds declined sharply during this period, due largely to the
elimination of the Federal Government’s budget deficit, which was replaced by a
significant surplus.

In a post-GFC world though, the picture has changed. Credit issuance virtually came to a standstill in 2007-2009 with corporates unable
to issue debt due to lack of demand, or their unwillingness to pay the yields
required by investors.

Meanwhile, governments around the world increased their
bond issuance to finance their stimulus spending. In Australia, credit as at May
2010 had fallen to around 17 per cent of the Index while Commonwealth
Government bonds had risen to 28 per cent, with semigovernment debt and Supras
making up the balance. (“Supras” are highly-rated sovereign and supranational
issuers, and securities issued by banks, guaranteed by a domestic or foreign government.)

Index investing doesn ’t
neces – sarily deliver the best risk /return

As an observation, in the early stages of the “de-risking”
process, many investors sought the safety of index investing, perceiving credit
securities to be too risky. The only problem with that, of course, is that at
that time many bond indices had high exposures to credit securities – so
investors weren’t necessarily escaping from the “bad” credit.

This raises one
of the biggest downsides of index investing in fixed income – those companies that
need to issue large amounts of debt end up representing the largest proportion
of the Index, exposing investors to greater risk than they probably realise.

Index
investing can only be justified if the markets are totally efficient. However,
it is our belief that markets are not always efficient. Our experience shows
that markets often incorrectly forecast short- and medium-term influences and conditions.
As market participants respond differently to the information available,
investment opportunities can arise when interest rates move away from their
fair value, therefore creating the potential to add alpha.

From a portfolio
construction perspective the Index is not an efficient portfolio, particularly
in the current environment. As a result of the large amount of Australian
government bond issuance that has taken place in recent times, the average credit
rating of the Index is now close to AAA.

In chart 2, we estimate the Index
(marked with an “x” on the chart) lies approximately half-way between AAA
securities and Commonwealth Government Securities (CGS) but sits off the
efficient frontier.

By altering the composition of assets, less risk and more
return can be achieved to move the portfolio out to the efficient frontier. For
example, by investing in lower-grade credit securities (that is, moving from
AAA to AA) we are able to reduce the risk of the overall portfolio and increase
return. Simply, this means that buying less CGS and more bonds issued by banks than
the Index weighting dictates, can provide an active manager with the ability to
add value and reduce price volatility. However, it requires the manager to be
able to pick securities with a low risk of default and generally stable or
tightening credit spreads.

Herd
mentality creates investment opportunities

The chase for equity-like returns from
fixedincome securities is a classic example of the “herd mentality” where
investors follow the crowd and invest in the latest trend or hot tip – based on
the simple premise: “If others believe, then it is safe to also believe”. It is
one of the many investor behaviours that can lead to the mispricing of securities,
providing investment opportunities for active managers and savvy investors.

In
the lead-up to the GFC, we recognised credit was over-priced, particularly when
spreads between credit and government bonds narrowed from 200 basis points in
2005 to just 30 basis points on average in 2006 (that is, the higherrisk credit
securities were only yielding 0.3 per cent more than AAA-rated government
bonds). Credit margins had declined to the point where they covered very little
of the risks inherent in these securities, particularly those rated BBB and lower.
We subsequently avoided many of these securities, focusing more on the
high-quality, highly-rated securities and government bonds. We suffered
underperformance in the short term as credit continued to run, but over the
long term this strategy paid off for our investors, with no securities in the
Tyndall bond funds defaulting.

Additionally our flagship fund, the Tyndall Australian
Bond Fund, has outperformed its benchmark, the UBS Australian Composite Bond
(All Maturities) Index over the five-year period to May 31, 2010, by an average
of 0.62 per cent per annum before fees – with less risk than both the Index and
median Australian bond fund (Source: Morningstar). Please note past performance
is not a guarantee of future performance.

Tips and tricks

Fund managers are not infallible by any means, but there are steps
and disciplines they implement to help reduce the influence of investor behaviours
on their investment decisions. By far the most important method used by fund managers
is the investment process. The process sets in train steps and rules to follow
- it enforces a discipline to keep them on track to achieve their targeted risk
and return objectives.

At Tyndall, we adopt a multi-layered process comprising
research, analysis, sector allocation and stock selection decisions, risk
management, execution and review. It’s this last step in the process that is
perhaps one of the most important and, if overlooked, can potentially be the biggest
investment trap for investors.

Process over outcome

Our team are strong believers in process over outcome. Often
investors can fall into the trap of focusing on the outcome rather than their
methodology and valuation process. When we receive new information, we don’t
focus on the outcome – that is, the impact on the return we are seeking to
achieve – but we review the process and how the new information affects our
valuations and ultimately positions in particular securities. We believe that
by focusing on the valuation and the risks, the returns will look after
themselves.

Our team of seven investment professionals meet first thing every
weekday morning to review the previous day’s and overnight market movements. We
review what’s happened, why it happened and the impact it may have on the assumptions
and valuations that underpin our investment strategies.

We also question what’s
happened: is it an over-reaction? Often the market can over-react to a new
piece of information, such as a US employment number, which can lead to a sharp
sell-off in bonds. If you focus on the outcome, you may get caught up in the
momentum and sell down your holding.

If, however, you focus on the process,
this information and market reaction could actually be a valuation trigger and
represent an excellent buying opportunity.

Our focus on process over outcome is
the reason we don’t believe in having stop loss positions – it places too much
emphasis on the sale price and not enough on the process and true value of a
security. Having said that though, stop losses can work for some investors -
particularly those who are risk-averse or have short investment horizons.

Expect the une xpected

Another critical component in our process is to
expect the unexpected. In our daily meeting we look at various “what if ”
scenarios. What if the Reserve Bank of Australia reduces rates earlier than
expected? What if Australia’s unemployment rate peaks at 10 per cent and not the
forecast 7 per cent? Or what if the European Monetary Union collapses?

In this
regard, we reframe our mindset from one of risk aversion to loss aversion. We
subject all our positions to what type of loss may ensue if the unexpected
happens. By having procedures in place that allow us to price in the impact of “what
if ” scenarios, it gives us greater control and a sense of comfort that should
the unexpected happen, our portfolios will be better positioned to weather the
storm. It also means we are able to take advantage of investment opportunities when
they arise.

Don ’t get trapped by “groupthink
”

Fund managers are often
criticised for displaying “group-think”, whereby everyone in a team thinks the
same and hence their biases are elevated rather than eliminated. This is a
challenge for fund managers and is something that we work very hard at managing
at Tyndall. The key is having a diverse group of team members on a number of
levels including age, sex and personality.

Our fixed income team ranges from an
age of 25 up to the early 50s; there are five males and two females; and there
are mixed backgrounds and equally mixed personalities and experiences – and to
add a little more spice to the equation, we sit in a very small room.

Having
such diversity provides greater scope for different views and importantly
provides the forum for debate. The biggest challenge here is to ensure that all
team members have a voice and are listened to. In many respects I play a devil’s
advocate role by challenging views, encouraging alternative views and
encouraging the pursuit of a broad range of information sources and contacts in
the industry. At times I even ask each team member individually what they
think, to ensure everyone has a say or provides input.

Embrace volatility

We are no doubt experiencing a period of prolonged
volatility, and it’s certainly been a wild ride for investors. But it’s
important to remember short-term volatility does not equal risk if you have a
long-term horizon. Over longer periods of time, volatility can actually present
active investors with good investment opportunities. We often see too much
focus on the short term, causing panic and large sell-offs during periods of
uncertainty. However, these periods often provide excellent investment
opportunities for the long-term investor.

The GFC is indeed a perfect example
of how investors cannot only be hurt by, but also benefit from, the
ever-powerful forces of greed and fear. As highlighted in our previous
articles, emotions and behaviours can dictate investor decisions – often poor
ones. Adopting a long-term view, remaining disciplined to an investment
strategy, and seeking and listening to advice from a professional planner are
steps investors can take to reduce the impact of these behaviours, leading to more
informed decisions and better investment outcomes.

Outsourcing the investment
decisions to a professional manager is another way investors can overcome these
behaviours. While they are not completely immune to the behaviours, they have a
number of “checks and balances” in place in the form of an investment process
which helps them reduce the impact of these behaviours and make more rational
and objective investment decisions.

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