In the early 90s, a fixed interest investment was very attractive. Compared to the negative returns of equity funds, a positive 5 per cent return from fixed interest was a saver for distressed investor portfolios.
But since the mid-90s, equity markets have bounced back and today who would put money in a fund that only returned 5 per cent?
To make matters worse for fixed interest managers, many advisers switched this cash component of the portfolio into mortgage funds, which offered much better returns.
But fixed interest managers argue their product bears no resemblance to a mortgage fund and the two asset classes should be treated separately in a portfolio.
Principal Global Investors head of Asia Pacific fixed income Robert da Silva said one reason for the popularity of mortgage trusts is people know what the asset class is.
“With fixed interest, people don’t recognise the investments in the product,” he said.
“But everybody has an affinity with property and a perception of bricks and mortar.”
Da Silva said there is also the perception that nobody defaults in mortgage funds, whereas there have been some spectacular crashes with US corporate junk bonds.
This was a misplaced perception, as most of the major fixed interest managers avoided these bonds.
Da Silva said there is also another perception among advisers that because they won’t default on their home mortgage, nobody else will.
“That is true for residential mortgages, but mortgage trusts lend to property developers, greenfield developments and blocks of residential units still being built,” he said.
“It is a risky profile that is not chosen by the investor.”
Risk profile
Portfolio Partners head of income Lance Pupelis agreed mortgage trusts are more speculative and offer the investor a completely different risk profile compared to fixed interest investments.
“Mortgage trusts are on a floating base with variable rates and shorter loan periods compared to bonds,” he said.
“Mortgage trusts have been fine over the last six to 10 years when earnings have been strong, but when the situation becomes more fluid, with rising defaults, the attractiveness of them is not so strong.”
Da Silva said mortgage trusts are linked to economic cycles, unemployment cycles and interest rate cycles, which adds to the risk.
“If you put all your money in one bucket, there is no diversity and we don’t want that in a portfolio,” he said.
Wide investment universe
However, a fixed interest fund invests in a wide range of investments that are not affected by cycles, which makes the risk profile very different.
“Fixed interest can be invested in government bonds which give a very secure risk profile, but can also diversify into corporate bonds, which again varies the risk profile for higher returns,” da Silva said.
Pupelis also argued the selection of investments in a fixed interest product is broader and more secure.
“Mortgage trusts don’t have investments in what is regarded as safe sectors such as government bonds, asset-backed securities and investment-grade corporate bonds,” he said.
“Getting these types of secure investments creates a diversification of good assets in a (fixed income) fund.”
Macquarie Funds Management fixed interest and currency division director Dean Stewart said these secure, non-cyclical investments make fixed interest attractive when things are not going well in other sectors.
“Fixed interest is an investment when things are not going well in the rest of the market,” Stewart said.
“Because of the different types of risk in fixed interest that makes it a good asset class with a list of opportunities.”
This is particularly true when growth rates fall and pressure is put on equities, property and subsequently mortgages.
Diversity
The diversity of fixed interest portfolios has also changed over the years and today there are many different types of investments in a product.
Stewart said in the late 90s a fixed income portfolio would consist of 40 to 55 per cent government bonds, with the rest in semi-government bonds and a small amount in corporate bonds.
Today, most fixed income portfolios have at least half of the investment in corporate bonds.
“Anything that is investment grade is considered for inclusion in a portfolio,” he said.
Da Silva said with the PrincipalGlobal Strategies Fund, managers have access to more than 350 different types of bonds in a global market.
“In Australia we have access to a bond market that is worth $20 billion, but the global fixed interest securities markets is worth $US300 billion,” he said.
“So global bonds are a bigger market than equity markets and have more diversity.”
Ironically, the big fixed interest managers do invest in mortgages.
Da Silva says mortgages are packaged up and offered to fixed interest managers.
“We do invest in fixed interest, mortgage-backed securities from the US,” he said.
“We do analyse the quality of the mortgage book before investing to check it is investment grade.”
Da Silva said with such a wide investment universe for fixed interest, he is surprised people still cling to the small world of mortgage investing.
Stewart says all investments in fixed interest are rated at least A, although some bonds in Australia can be rated A-.
Pupelis said one interesting objection people sometimes raise is they don’t like a particular corporate bond because of the company.
Yet, he finds they will invest in an equity fund that has that same company in the equity portfolio.
While most fund managers have separate income investment teams and mortgage trust teams, Colonial First State has the two in the same stable.
“We have the mortgage team as part of the fixed interest investment team,” Colonial First State fixed interest co-head Warren Bird said.
“In 1998 we moved the old Colonial investment team from Melbourne to Sydney and the mortgage fund team were merged into fixed interest.”
Bird argues a mortgage trust is a form of fixed interest investment — just at a different end of the spectrum.
“It is higher risk, but a mortgage trust is an income earning product,” he said.
Retail investors do struggle with some of the investments in a fixed income product, but they understand what is in a mortgage trust, according to Bird.
“A lot of retail investors don’t want that unit price volatility that can occur in a fixed income product,” he says.
“But people reinvest in fixed interest products and get the compound interest benefits over time.”
Bird said the two products really depend on investor time frames as fixed income take a long-term view while mortgage trusts are more for the shorter-term investor.
“There is room for both in portfolios, but I admit a number of dealer groups don’t see it that way,” he said.
Rising interest rates
With equity markets and property investments still powering ahead, Pupelis said it was time to look at fixed interest investments again.
“When the investment cycle (in equities and property) gets difficult, fixed interest has a big role to play,” he said.
“We have seen interest rates rise 175 basis points during the last four years and monetary policy is tight, so the outlook for fixed interest cannot be ignored.”
Pupelis argues real returns from shares are unsustainable in the present economic climate as the Australian market is on the cusp.
“Fixed interest will be the asset class that will give the investor that return kicker when things turn down,” he said.
