Fixed income finding its place

Mike Taylor, Money Management (MT): I think probably in the minds of Money Management’s readers, the question is where fixed income actually sits in the greater scheme of things at the moment, and how you feel it should be positioned in the minds of financial planners giving advice to their clients.

I am agnostic as to who we kick off with, but maybe let’s kick off with Aberdeen.

Stuart Dear, Aberdeen Asset Management (SD): Okay. Where does it sit in the greater scheme of things? Probably, for most people here, as fixed income portfolio managers, we feel it is probably under-represented within the allocation of assets across Aussie super.

Comparing our superannuation allocations to other countries it is a well known story: in 2008, Aussie super portfolios were under-performing relative to OECD [Organisation for Economic Co-operation and Development] peers because of the high equity weighting, and again, you saw that last year. 

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Now, obviously the Aussie equity market itself under-performed relative to global equities, so there is a bit of homecoming advice there as well.

But the bigger picture is, we’re underweighting to bonds versus other countries for different reasons.

Nonetheless, there is a structural bias there which is a longer-term public finance risk, if you like, in the event that that future retirement plans fail to provide adequately for a large number of people and they fall back on government pensions to fill that job.

I guess that is probably the opening gambit for me.

Brett Lewthwaite, Macquarie Bank (BL): I think it is interesting because if you go back to when superannuation went from defined benefit to defined contribution, you’re back about 20 to 25 years ago.

And you think about the environment that we had from that point to now, and you look at the allocation of what you’d call a basic portfolio.

It was pretty balanced and was probably appropriate.

But over time, when you’ve taken the decision-making away from someone who is running a defined benefit scheme for a company and you give it to a mum and dad and say ‘Here’s your pension’, it made a lot of sense for 20 years while we had this great leverage trick in play that people gravitated or attracted high returns of equity - so now you have this imbalance.

We think it is actually a very structural change that is going on, that fixed income will increasingly become the core part of a person’s portfolio, and so the decline in interest in fixed income, which has essentially been happening for 20 to 25 years, should turn around.

You’ll see people having the core of their portfolio, whether it be in floating rate or in bond format, a huge allocation to that income.

So it is a shift away from growth investing to income investing, and as such, I think it is only in the early stages of that shift. Bonds will be increasingly important to people as we move forward – that’s the way I think about the environment.

Michael Korber, Perpetual (MK): Yes. I think obviously those sentiments are a good basis, and I guess we’re talking our own book to a degree, but the question we’re trying to solve, and there’s no right answer to this, is: for people’s long-term return, what is their optimal balance of risk and reward?

And if you look at the dynamics of the equities markets, they can have period of very good performance and periods of very bad performance and much volatility.

Bond markets typically are much less volatile and much more consistent, therefore they really dampen the level of volatility in people’s portfolio.

So if they don’t deliver anything else, they are delivering a cleaner run for people’s return over time.

The scenario at the moment is one where you’ve got decent interest rates in this country, you’ve got great credit spreads, and the rewards are actually quite strong.

I think if you look at long-term performance, the cost of the damping of returns by holding a decent chunk of fixed income is very, very low.

Over the long term it works very well for your total performance, and in the analysis we’ve done it takes off a few basis points but halves the level of volatility. So I think that in itself is a good thing.

At the moment the prospective terms of fixed income are really quite attractive. Also you’ve got an ageing population.

I think people’s attitude to risk does change during their life cycle, and as people start to draw down as opposed to accumulate, lack of volatility becomes quite valuable.

So I think it [fixed income] is under-represented, and there are a number of reasons why that should gradually change, and change structurally, as we said.

Andrew Gordon, FIIG Securities (AG): Yeah, look, I would agree with all those sentiments, but I think one of the things that we’re seeing is a huge interest in fixed income being a known outcome.

People can really tailor, as they are into retirement or heading into retirement, tailor what they actually want in terms of returns.

So that forward-looking nature of bonds and fixed income as a whole is very important for people making those decisions in terms of ‘how do I fund my retirement, and how do I fund the next 10, 15 years of what I do?’

And again, then you can get into the detail of fixed versus floating versus inflation-linked, et cetera. 

But when you present clients with forward-looking instruments versus taking a punt on equities and you’re not quite sure where they’ll be, there is a huge amount of interest in that.

Mark Beardow , AMP Capital (MB): I’d agree with that on SMSFs, but there is no such thing as an average retail client.

I think if we’re thinking about how clients’ attitude to fixed income is going to change, it is not going to be the 30 or 40-year olds that have got little interest in super.

They are probably correctly asset-allocated. They are probably feeling the pain, but they are probably correctly asset-allocated.

What we’re really more interested in is those ones who are approaching retirement, or in retirement and have had too many growth assets in their portfolio. 

The question is: how might a planner and their client use fixed income? Traditionally in Australia it has been used just really as an anchor.

Its role as an income provider has been subservient to its role as a diversifier. With such big equity ratings in the portfolio you really needed to allow fixed income to be the diversifier, whereas I think that has undersold its benefits.

It has particularly undersold its benefits to those in retirement and needing an income stream.

So I think that is the opportunity, not as a diversifier but as an income stream, and then there is a range of things for which more developed fixed income markets have shown they can use the asset class.

The post-retirement phase

MT: The theme seems to be around the table that really we’re talking as much about post-retirement and de-accumulation as we are in the accumulation phase. So I am just wondering whether, looking at the whole post-retirement phase, enough has been said about fixed income and bonds and where they sit in that part.

But there are a lot of companies at the moment trying to find products to bring to market for that phase, so I’m just wondering where you think where these products stand in the mix in terms of post-retirement. 

MB: On post-retirement to us there seems a pretty big gap between bond funds that have been designed as part of a diversified portfolio.

Principally in Australia a lot of those have been designed for that purpose. There are others. And then at the other end of the spectrum there are annuities, term deposits somewhere in there.

It seems like there is a big spectrum for focussing on outcomes using fixed income assets and that is going to require some product development, and that is going to require thinking through the asset class a little differently.

Because if you do have investors who have got a 10 or 15-year horizon, then it might be worthwhile structuring funds around that, or around a five-year rise or a 10-year rise rather than having a product which is a one-size-fits-all. 

What we know in SMSF-land is that is not what investors are looking for. They are looking for things that are tailored to their needs.

AG: I think I would also add that investors are getting more educated on fixed income.

Historically they haven’t focussed on that and I think what we find, specifically at our firm, is that they really want to understand a little bit more and understand the risks that they’ve got on a relative value basis.

What is the risk of this versus the risk of that, and am I getting compensated enough? 

Once they start making those decisions, then the spectrum will be the bookends of risk, being cash at one end and equities at the other end.

That will open up the way for an investor to say, ‘well, I’m prepared to take some risks down here in equity’ or ‘I’m not and I want to be closer to the cash end’. 

But as they’re getting educated in that process, their risk-for-return analysis, they are making that themselves.

But again, regarding ongoing education and people wanting to understand what fixed income does, we are seeing a lot of that, primarily from the pre- to -post generation.

SD: Typically I think what we’re getting to in the last few threads of discussion here is that, absolute return-style fixed income funds are becoming popular, and why? Well there is obviously the cyclical element.

But more structurally there is that focus on the objectives, such as that it is an objective-based form of investing that tries to wrap up, if you like, the alpha and beta decision with relation to at least the bond asset class, and perhaps more asset classes, depending on the scope of the absolute return fund.

And it takes that structural allocation decision away, if you like, from the superannuation allocator and it puts it in the hands of the manager, to be long-duration or be right back at cash-like duration, or even have negative interest rate exposure.

So that is like if you segregate the cyclical and structural components of that when you think about the structure of the funds, that is a shift that we seem to be making in the funds management industry or the consulting/funds management industry.

The crossover is sort of blurring, if you like. 

A segue back into equities?

MT: Moving along a little bit, and this is probably moving away from the core of what you guys do, but there seems to me, as a journalist, to be a confusion in the minds of investors about how long they should remain cautiously set in the current market, and when they should start to take up that exposure.

I guess on the basis of a lot of planners telling them that if you miss the upswing, well, you’ve missed it really. You can maybe pick it up a little bit somewhere, but you’ve missed it.

So I guess looking at the overall state of the market, and this is sort of the $1,000 question really isn’t it, is what you guys specialising in the segue to the markets are picking up: we’re never going to get the bull run we had? Is this really a segue to moving back into equities?

MB: I don’t see it like that because, again, I would come back to the retail investors being quite different. So taking a 55-year-old in 2007 - maybe being over their skis in terms of growth assets - coming in 2011 to have a conversation with their planner: should they be increasing their weights to equities?

I think depending on particular circumstances, they probably need to be getting those weights down. They probably need to be thinking about income.

They’ve come into retirement. They might be five years away. They have probably more than halved the amount of income they’re going to receive from their job in that time frame pre-65.

I think the question is: there are some investors for whom it is appropriate to go back to equities and fixed income.

Probably it isn’t the natural segue necessarily. I don’t view it as a mutual fund product, as a natural segue, but for those investors who begin in cash, then certainly - fixed income.

I sort of come back to a point that Michael made, which is when you really start to focus on income, there are some benefits in bond products over floating rate products.

That is, you are much more certain actually on the coupon flow, so you can plan much more effectively on the coupon flow.

Capital becomes less important if you’re living off monthly distributions and you know that they’re going to vary not significantly over, say, a two- to -three year timeframe.

I just sort of contrast that with what we know.

When interest rates fluctuate, perhaps you will hear pensioners relay in the media about how difficult it is to live off reduced deposit rates, and I think that is something that fixed income can address.

BL: I think it is interesting that quite often it is sort of tagged as a stepping-stone to a different place or a better place, but ultimately I think in terms of the environment that we’re in, we’ve gone from an environment where it was a good idea to have a lot of growth assets.

It was a good idea to borrow a lot of money because those assets that people were buying, whether it be property or shares, continued to go up.

I think we are past that tipping point now, and deleveraging is a completely different mindset. So is it a stepping-stone to another place?

Well, not necessarily. I think we’re going to have an environment where there are good trading ranges in what we call, I guess, risk assets, so if you’re a trader you’re probably going to have a good time.

But most people aren’t traders, and if you’re not it could be a bumpy ride to nowhere, the same place you are now or maybe worse.

So I think it is really about saying if you want more than cash, potentially you increase your allocation to fixed income to get that moderately higher than cash, but it is a core situation.

It is something that you base most of your portfolio around, a steady income-reliable return.

There is still nothing wrong with having allocations to all these other asset classes, but there is a much heavier weight in that reliable, positive return situation.

So I don’t necessarily see it as a stepping-stone. It is more a change of thinking.

Brendan Irwin, Count Financial (BI): I thought of bonds 20 or 30 years ago. I came into the business and bond funds were pretty simple. They were duration and they were put in a portfolio as a diversifier and an uncorrelated asset.

You look at the fixed interest market today after inflation having dropped for 20-odd years and 30 years of fabulous bond returns, and I think the dynamics are a lot different today.

You can see that in the type of products that are now coming to market. We never had credit products, or the different types of products that we see today. 

I think the whole bonds sector is becoming a much more interesting and innovative type of vehicle, and there will be some products that people will be looking for in terms of getting the income.

Some will be looking for it as a diversifier, if you like.

With the demographics and the demand in the Australian and global markets for a steady income stream, I think the bond market will continue to innovate. 

Fixed income - is now its time in the sun?

MT: Another one of those questions which plays on everyone’s mind: How long do you think the market is going to play to this strength, in the sense that we continue to have Europe as an unknown, and the US is kind of recovering, notwithstanding this quantitative easing, which seems to be another phrase for printing money?

Underlying all of that, Australia remains fairly strong in terms of the global economy, and China is doing all their things.

So I guess putting all that together, the times have suited you guys in terms of a product set coming back to the fore. How long do you see your time in the sun, I guess, if indeed it is a time in the sun?

I can see a whimsical smile over here. 

I think you have seen many times in the sun come and go, Brett.

BL: I think the fixed income universe has a lot smaller voice. If this is our time in the sun, it has been a time that has constantly been argued by equities that there is a bond bubble, et cetera.

There are all sorts of reasons why we shouldn’t be where we are. It is amazing actually. I think the infrastructure around the fixed income universe is a lot smaller, so I think it is interesting to look at hybrids that are sold through equity channels, and they are very successful.

It is access. How do we create greater access to these sorts of products as well is I think part of it. 

From an economic point of view it is a very challenging environment. It doesn’t mean that different asset classes can’t have good performance periods.

I think most people would have gone into the end of last year surprised that equities have performed as well as they have so far in 2012, but it is an interesting environment. 

If you go back to the big issue around the US and its downgrade in July/August, they got debts and an increase there. It took three months to hit the first one.

They default and they go to the second one. They’ve breached that now. They’ve just approved a payroll tax extension with no cuts on the other side.

There was another one in election year, and we’re heading towards sixteen and a half trillion dollars of bond issuance.

So you talk about quantitative easing but it’s 8 per cent to 10 per cent fiscal stimulus that that economy is getting each year as well and that is not sustainable either. Developed economies are suffering from indebtedness and they’ve got their foot to the floor.

Their sail is full up, so if risk assets aren’t doing well here then potentially the outlook is quite a challenging one.

So it does change that thinking about how do I make a positive return on a consistent basis, so potentially our time in the sun goes on and on.

MK: I think it is funny because the only time fixed income markets ever have their time in the sun is when everyone else is buried in a storm cloud.

MT: I didn’t want to say that.

MK: So you’re already asking how long do we think the rest of the asset sectors will be doomed, and it could be for some time. But I think you’ve also got to look a bit beyond that and think, in Australia in particular, that we are a big importer of capital. 

Interest rates here are structurally higher than in many other places and therefore, in a relative sense, fixed income here is going to be a relatively attractive asset.

The one thing that kills it more than anything else is the tax regime here, which really heavily favours equities ahead of fixed income, but that is less of a factor than the superannuation and pension environment.

So I think structurally we have seen the fixed income market under-represented because the equities market has been so strong.

And I think structurally if that strength in equities tapers off, and obviously it has and it may well continue to do so, the domestic fixed income dynamics are fantastic and good interest rates, low-credit risk, it is to that degree nirvana. 

It is higher predictable returns, and I think once people lose the stars in their eyes about equities, the ongoing dynamics of fixed income will continue to improve.

I think we’ll see continued growth and diversity of cash, and the sorts of issues we see and the sorts of paper that we see. And liquidity begets liquidity.

Those things will encourage ongoing growth, so I think you’d have to be fairly optimistic that it is not just a flash in the pan or a brief break in the clouds. I think it is a structural sort of asset that will continue to do well, continue to develop quite well.

BI: Unfortunately the demographic demand for a stable income stream, as opposed to relying on growth, will I think just mean that there will be a lot more products that will be designed to come to market to feed that requirement.

MT: Thank you very much gentlemen. Those questions probably didn’t suit everyone, so thank you very much for your time.