Why Australian investors need to rethink fixed income

Let’s face it. Fixed income is probably not as compelling a subject when it comes to watercooler conversation as equities or property.

Sure, a fixed-income investment may not come with a sweeping, grandiose tale like that of a punter who cleaned up after getting a tip from a cabbie about the impending good fortunes of a small-cap gold miner and went all in.

Nor is fixed income investing as central to the Australian psyche as our overly-discussed obsession with property investment.

But while it may not be as much of a talking point or as ‘sexy’ as other asset classes, an under-allocation to fixed income is something Australian investors should be taking more seriously, according to several experts.

“We think people are under-allocated to fixed income in this market – it’s an equity-focused market,” says Mark Mitchell, co-director of Daintree Capital Management.

“The asset allocations that I have seen typically have too much cash, a bit of property, and probably too much equity. That’s typically the way it works.”

There are several possible reasons behind this mismatch, Mitchell says, but whether it’s the Australian “punting culture” or the availability of franking credits for share investors, our ageing demographic means advisers and their clients should have a greater allocation to fixed income assets.

“It doesn’t have to be with us, but it needs to be something that protects capital and provides regular income generation,” he says. “If you’re in your sixties or seventies, do you want to have a lot of capital risk in your portfolio? Probably not.”

Mitchell points out that Daintree’s Core Income Trust is designed as an alternative to term deposits (TDs) which, as he points out, carry with them their own set of limitations.

“If you’re sitting in cash or TDs, your cash probably isn’t working as hard as it should be because you could probably make another per cent or per cent and a quarter without taking on too much more risk and actually have better liquidity compared to a TD,” he says.

In his experience, Mitchell says he has a lot of conversations about equities with financial advisers, which is understandable given that is where investors generate growth in their wealth.

However, he points out that his shop is not about growing wealth: “We’re not going to give you 10, 15, 20 per cent - we’re going to give you three, 3.5 per cent with hopefully minimal drawdowns and a regular income.”

“So, you make your money elsewhere, but then as you get older and you really need to protect that capital, you’ll hopefully look to this type of strategy.”

Mitchell’s co-director at Daintree, Justin Tyler, reiterates this point: “Clearly you start your life cycle by generating your wealth and growing your wealth, but then you move into this phase where you need to protect that wealth and you need to turn that wealth into income.”

“On the income generation side, I think a lot of people are over-allocated to cash, and that’s not growing your income in an optimal way,” he says

In their view, Tyler says that Daintree believes there’s an over-allocation by investors in Australia to two assets.

“Firstly, on the shares side of things, there are people investing in shares for income - now, I’m not saying that’s a bad idea, but I’m saying that if you’re relying on that for 100 per cent of your income, then it’s definitely a bad idea,” he says.

“The second thing that we’re seeing is people investing a lot in listed hybrids, again for the income and for the franking credits that you get from those.

“Now, there’s an inherent tension here between the income generation and the protection element … you’re not protecting yourself, your capital, or the income stream itself if you’re getting all your income from either equities or from hybrids.

“So, when I’m talking about over-allocation … people really do need to move themselves into this middle ground. And we are the middle ground.”

However, Tyler points out that while Australians may have an under-allocation to the asset class, fixed income does not mean the same thing to all people.

“You can’t go to the latest manager survey and pick the top performer and say, ‘I’m going to get my fixed income allocation from that manager,’ because you have no visibility as to what the manager is doing,” he says.

“They may be punting on emerging market debt, or they may have interest rate exposure that’s multiples of what we think is sensible with interest rates rising as they are at the moment.

“So, really what you need to be doing is just thinking about, with your adviser, what is driving these returns. Is it interest rate exposure? If so, why do you think your interest rate exposure is going to give you a defensive characteristic?

“And maybe, when equities sell off, you might be in an interest rate exposure like a duration exposure because you think government bonds will rally. That’s what we’ve seen in markets recently.”

However, as Tyler points out, when looking back over the past five years or so that correlation has increasingly been breaking down. Therefore, when advisers and their clients are looking at their fixed income allocation, Daintree believes that moving towards the absolute return end of the spectrum is sensible given investors can’t rely on government bonds and interest rate exposure.

“You can’t allow that any more to protect you – it won’t work,” he says.

VOLATILITY CAN BE GOOD FOR YOUR HEALTH

And for those investors and advisers who may be troubled by the recent swings witnessed in the markets, Tyler says that the recent pick up in market volatility is a healthy thing.

“In terms of markets, for a long time now there’s been a presumption that the central bank is going to dig ourselves out of whatever hole we get ourselves into and I don’t think that is going to be the case any longer,” he says.

“Volatility is picking up and that means risk is being repriced and market actors are starting to be a little bit more discerning as to the sort of risks that they’re taking in order to get their returns.

“For us, as active managers, that’s a great thing – we need volatility to do our jobs. And certainly, on the credit side, you’ve seen volatility pick up just recently, and that’s been a healthy repricing of risk.”

Tyler also notes that given Daintree’s global and unconstrained approach, it has the flexibility to react to volatile environments in a much more constructive way than some of its competitors.

“We’re a fair-weather friend – we’re not buying an issue and holding it to maturity. If at any time we get worried about the ability of an issuer to pay us back, then we’re out of there,” he says.

“So, that sort of activity in credit markets, you can only do that really successfully if you’ve got a very wide opportunity set like the one that we have.”

Steven Miller, an adviser to Grant Samuel Funds Management, also believes an unconstrained approach is currently the way to go when it comes to fixed income, given the many advantages it offers such as a bigger investment universe, reduced duration sensitivity, or an ability to take currency positions.

Also, as Miller points out in an example, it’s easier for globally unconstrained portfolios to be overweight Australian bonds relative to global bonds.

Other advantages of the unconstrained approach are the ability to diversify away risk while not compromising on yield, while at the same time not giving away the conservative risk profile that is generally associated with bonds, he says.

And this may make more sense given the world is returning to a more normalised climate of volatility.

“I think we’ve just got to get used to the fact that we’ve been through a period of extraordinarily low volatility … 2017 was an outlier in terms of volatility and a return to more normal conditions will mean that we’ll have to get used to more volatility in the prices of financial assets,” Miller says.

“And whether that’s equities or bonds …  investors, I think, have to think about that when it comes to their portfolios.”

In terms of bond portfolios, Miller thinks Australian advisers and their clients now have to be a bit “creative” in the way they look at bonds these days.

“You’ve had extraordinarily favourable bond beta conditions for 35-odd years. You’re not going to get that any more. At best you’re going to see yields low and stay low, which is not great, or yields normalise at high yields - which is a difficult journey there, but once you’re there at least you’re getting a high yield,” he says.

“I think what investors need to think about in terms of their bond exposures is whether they look at some more creative vehicles, or what we call unconstrained or absolute return funds … I mean funds that aren’t tied to one of the orthodox benchmarks, whether that’s a Bloomberg AusBond Composite index or a global aggregate index.”

Therefore, Miller says, by not having as much beta or duration exposure, investors in unconstrained strategies will have more “triggers to pull,” such as perhaps taking advantage of reasonable valuations in emerging markets, currencies, or certain floating rate exposures like US loans.

YOU STILL WANT A BIT OF BETA

However, Miller says this doesn’t mean “chucking the baby out with the bath water,” as investors will still want to have “a bit of bond beta”.

“But investors may want to strategically reduce their conventional allocation and increase their allocation to the unconstrained or absolute return universe, where the return is not so beholden to rates, investors have more diversified exposures, and arguably, can outperform conventional indexes in a period of rising rates,” he says.

Miller explains that whether you’re invested in an active or a passive fund, you’re generally tied to a duration, whereas in the unconstrained universe this is generally not the case.

And now may be the right time to start thinking about putting some of your bond allocation in the unconstrained space as opposed to the conventional, bond benchmark-linked space, he says.

Michael Frearson, director and portfolio manager at Real Asset Management, also believes in including a small component of indexed exposure for low-cost beta but says the majority of his clients’ fixed interest and credit allocation is in active credit strategies.

“This allows us to more efficiently target the right portfolio duration and individual credit exposure in client portfolios,” he says.

Tamar Hamlyn, a portfolio manager at Ardea Investment Management, says the case for indexing is a strong one when bond yields are high – but the current environment couldn’t be further from this.

“Bond yields are still low, which makes the return from passively owning bonds low as well. With yields low, bonds are also exposed to the risk of rising interest rates causing mark to market losses,” he says. 

“Active management strategies invest selectively in order to improve returns, preserve capital, or minimise downside. Active management is therefore much better placed to navigate volatile or low‐return environments such as the current one.” 

GET BACK TO BASICS

At an even more basic level, Daintree’s Mitchell points out that people who don’t understand fixed income often assume, incorrectly, that you can’t make money if interest rates are rising.

“But you absolutely can - by being in absolute return, by being in floating rate securities, by generating returns from potentially going short,” he says.

“That’s a very basic lesson that I don’t think everyone gets when looking at fixed income. Part of the education process for us is to make sure you understand that just because rates are rising, it doesn’t mean you have to flee bonds.”

Mitchell is also quick to point out that fixed-income markets have undergone a material change - and that this is one of the central themes underlying the Daintree strategy.

“For the past 30 years or so you could basically just be long any sort of interest rate product, either in an index or with a fund manager. Anyone would have an interest rate duration of three, four, five or six years and you would’ve done fine. You could set and forget,” he says.

“That’s not going to be the case going forward, so we’re strong believers in active management … you have to be able to make relative value calls, and importantly, you need to be able to go short.

“If you’re only long, either through an ETF (exchange traded fund) or some composite bond-type manager, and rates move up, you’re going to lose money.

“And that’s the bottom line. So, we think in fixed income you have to be active.”

AUSTRALIA: THE LAND OF “LESS WORSE”

Mitchell believes the Australian fixed income sector currently represents compelling value for several reasons.

He notes that the Australian market is smaller and tends to be a little more illiquid, while a lot of the securities don’t sit in the large indices that people manage against. Therefore, you see higher spreads and lower volatility.

“And with the changing interest rate differentials, it becomes a little bit less attractive to go offshore. As US cash rates move higher, and you hedge that back into Australian dollars, it becomes a little bit less attractive,” he says.

“So, Australia, we think, is kind of where the value is at the moment.”

In his own eloquent way, Steve Miller, an adviser to Grant Samuel Funds Management, largely agrees with Mitchell, saying Australian bonds are doing “less worse” than elsewhere.

“The reason I say that is I don’t think the RBA (Reserve Bank of Australia) is in any hurry to raise rates here,” he says.

“My own view is that the Aussie policy rate at the end of this year will probably still be 1.5 per cent – there might be one increase but I’m thinking the most likely outcome is unchanged. So, you’ve got a circumstance where our policy rate is substantially below the US policy rate. That doesn’t happen very often.”

So, taking this into consideration, Miller says it’s likely that Aussie bonds will largely outperform their U.S. and European counterparts.