Rough seas ahead for fixed interest

With fixed interest gaining attention, Janine Mace takes a look at what the future holds for the sector.

When discussions about sovereign default and bondholder haircuts become the stuff of the nightly news, you know things are pretty unsettled in international fixed interest markets.

It’s probably a trend we need to get used to, since bond market volatility looks unlikely to disappear any time soon – making picking the outlook even harder than usual.

“There are going to be a lot of very different outcomes in different parts of the world,” explains Pimco Australia global wealth management head Peter Dorrian.

“It will be an environment of continued volatility, and diversification will be essential.”

Perpetual Diversified Income Fund portfolio manager Vivek Prabhu agrees these are interesting times, with the flow-on effects from the global financial crisis (GFC) having a significant impact on the asset class.

“The GFC has led to regulatory changes – especially Basel III – and this has seen increased capital and liquidity requirements. This is positive for bondholders but not so much for equity holders,” Prabhu says.

Asking the hard questions

The big issue hanging over bond markets is the ongoing concern about the level of European government debt and the strength of the US recovery. 

“The problem will be what happens in Europe, and to a lesser extent in the US with its economic growth,” explains FIIG Securities director of strategy and market development Dr Stephen Nash. 

Dorrian agrees the current environment is tricky for investors. “It is not just a developed market versus developing market split, but also about the way different governments have tried to address the debt problem after the GFC,” he says.

“They took different approaches and it is too early to determine the result. For example, the UK has been much more realistic that everyone will have to pay a price for the consumption binge, while in the US there seems to be a collective sense of denial.”

Like many in the sector, Dorrian is concerned about the US’s huge debt burden. “To get the US budget back into balance it would need 4 per cent growth per annum for 10 years,” he says. 

While it needs to sort out the debt ceiling question, there is also uncertainty about the impact of ending the Federal Reserve’s quantitative easing program.

“Stimulus is coming to an end, as has consumer spending. It is difficult to see how the US will get out of it without increasing tax,” Dorrian says. “There doesn’t seem to be any political will to sort out this issue.”

Aberdeen Asset Management Australian head of fixed income Victor Rodriguez agrees there are risks for bond markets, but remains optimistic.

“Bond markets have rallied due to the disappointing US economic data, but we are not likely to see a double dip. Some of the weakness is due to data from Japan, but we are not seeing an oil price spike. A rally in bonds is not likely to be sustained,” he says.

“The risk issues are coming from Europe – mainly Greece – but these risks are affecting credit markets rather than interest rate markets.”

The outlook for the Australian market is more straightforward, according to Rodriguez. “We believe the RBA will be raising rates over the next 12 months, and we think we will see two hikes this year.

Inflation pressures will force the RBA’s hand to some extent. This means domestic bonds will slightly underperform cash as markets are not fully pricing in likely rate moves.”

After a good performance since the GFC, credit markets are looking less attractive.

“When it comes to investing in credit, we are still constructive but cautious. We like high-grade investment credit, but are cautious on lower grade credit investment,” Rodriguez says.

In this environment, credit spreads are expected to reduce. “We will see a slow, continuous spread compression, however, we are not expecting it to be a radical compression,” Nash says.

Staying afloat

Advisers may find they have more funds to allocate to fixed interest, since the appeal of term deposits is likely to wane in coming months.

“We have seen high deposit rates in banks – particularly in term deposits – but with the cash rate increasing, spreads are narrowing,” Prabhu says.

“The term deposit premium over the cash rate has narrowed in recent times and this has led to less inflow.” 

This will mean picking the sectors most likely to perform in the near future, and floating rate paper is viewed as the best bet at the moment. 

“Rates rallied in the past month or so, so we prefer floating to fixed at the moment,” Nash says. “We are doing quite well now with the floating rate at around 5.5 per cent return.”

The RBA’s bias towards tightening interest rates further means the experts believe now is the time to stay at the short end of the curve. “We have a preference for short-term durations as interest rates are predicted to rise,” Prabhu says.

“Short duration is quite compelling in Australia due to the high cash rate.”

One of the other attractive areas in the market is corporate bonds.

“We like the corporate sector a lot due to the deleveraging that has occurred and the decline in the average gearing level. There is also stability in profitability,” Prabhu says.

Dorrian agrees: “Some parts of the corporate market are very good, as many companies used the post GFC period to re-arrange their balance sheets. They look pretty good to us. Some areas of the mortgage market also look good, although you need to avoid the subprime and areas of the overseas commercial property market.”

For Nash, some of the paper from financial issuers looks attractive. “We expect to see a reasonable performance by insurers – and particularly general insurance – as there may be a takeover premium because banks can only look at taking over general, not life, insurers.”

There are also some market sectors that are best avoided.

“There are some geographic areas, for example the PIIGs [Portugal, Ireland, Italy, Greece and Spain] where the debt overhang is so great it can’t be re-arranged,” Dorrian says.

He is also concerned about consumer-related sectors. “There are some sectors of the bond markets that should be avoided. Those very heavily leveraged to the consumer are worth avoiding.”

Nash agrees this is a potential problem area. “The sector most likely to do badly is retailing, but there is not a lot of diversity in the Australian offerings.”

However, Nash emphasises fixed income investing should not be about picking winners. “It is not about trying to pick the direction of rates, but about trying to cut the rate of risk in the portfolio.”

Taking the right course

Unsurprisingly, the active managers believe the current investment environment suits taking an active approach to a bond portfolio.

“Active management will be essential in portfolios – particularly in the bond market – as everything is going in different directions,” Dorrian argues.

Prabhu agrees: “It can adversely affect the outcome if you passively follow the index – especially at the moment. In this environment, active management is most suitable due to the volatility and uncertainty in the market as this creates opportunities to add value.”

They argue the composition of the key indices used to benchmark most bond funds makes active management vital.

“The bond index is market value weighted, which means it is weighted to the US, Japan and the developed markets. These are the areas where debt is continuing to accumulate,” Dorrian explains. 

Prabhu agrees: “You need to think about what a passive allocation would mean. You would get a lot of Southern European government debt. It means a massive allocation to high yield sovereign risk.” 

As an active manager, Rodriguez agrees now is not the time for a passive approach. “In the index, the bigger weights are going to the bigger borrowers.”

He believes many advisers and clients do not appreciate the impact of how the key fixed interest indices are constructed. 

“Financial planners need to understand that investment in the index is not a risk-free approach. You are also taking on – or blindly believing – rating agency assessments that something meets the grade for inclusion.”