Waiting for the tide to turn

Looking at equity markets, it would be fair to say the fear that pervaded investor sentiment in the post-global financial crisis (GFC) years has well and truly passed.  

In the years following the crisis, there was a well-documented rush into defensive assets, with fresh memories of multi-million dollar losses at the hands of an unstable market.  

Fixed income, like cash and term deposits, became a safe haven for investors scarred by the GFC and a default for planners wanting to protect their clients' income.  

But in 2012, planners' flows into fixed income investments peaked, with almost a third (32 per cent) of clients money placed in the asset basket, and have been on a steady downward trajectory ever since, according to Investment Trends' May 2014 Planner Business Model Report.  

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As the market started to pick up, the proportion of funds channelled into fixed interest dropped to a quarter in 2013, then to just over a fifth (21 per cent) earlier this year.  

"Clients' outlook for the share markets were quite weak in 2012," Investment Trends' senior analyst Recep Peker explained.  

"Coupled with high interest rates, we found planners' usage of fixed income investments peaked in 2012, but has since come down with more clients now chasing growth." 

BT Investment Management's head of income and fixed interest, Vimal Gor, said it's worth noting that Australian asset managers and planners have traditionally allocated a lower proportion of funds to fixed income - a trend he tips to change.  

"I think the numbers are roughly that the average portfolio in Australia owns about 15 per cent in fixed income, with the rest of the world it's closer to 40 to 50 per cent," he said.  

"Remember the demographics in Australia are shifting in line with the rest of the world too, so I would fully expect that Australia moves to having to include more fixed income in their portfolios over the coming years."  

Indeed, according to portfolio managers in the space, 2015 could quickly see the mood shift and planners adopting a more defensive approach to investing their clients' money.  

Much of the anticipated shift rests on what the Reserve Bank of Australia (RBA) does with interest rates, which have been kept on hold for 15 consecutive months. 

Early signs of a change 

While the last couple of years have provided a ripe market for growth assets, the trend cannot continue for much longer, according to Gor, who expects a swift move towards defensive assets in the new year.  

"I think it's the realisation that we're coming out of a world of low volatility and into a world of higher volatility and I think the performance of the equity markets over the last two years is unlikely to be repeated and therefore you need an asset in your portfolio that balances off against your equity exposure," he told Money Management.  

"Remember high quality fixed income is pretty much the only asset class which gives you a negative correlation to equities in times of stress.  

"The RBA will be cutting rates some time next year and that's obviously very supportive for bonds, so we would expect bonds to perform very well in that environment." 

On the volatility front, Western Asset Management's  - head of investment management/head of Australian Operations, Anthony Kirkham,  said planners should be able to capitalise on shaky markets by gearing investments towards the risk.  

"There is going to be increasing volatility and if you can capture that in a risk-orientated way, then you can add some value and add some return to that sector of your portfolio," he said.  

Indeed, knowing that the RBA still has the interest rate lever to pull puts Australian investors in a unique position and one that lends itself nicely to fixed income, Kirkham said.  

"If we did have a scenario where the global economy does hit a bit of a wall and there is a need in Australia to ease monetary policy further, then we certainly have the ability to do so with cash at 2.5 per cent.  

"Bond yields may actually be able to provide a bit of an offset in terms of performance, relative to an equity market that may actually be moving south quicker." 

Fidelity's global CIO fixed income, Anthony Wells, said 2015 should see a "stable but positive environment" for fixed income, again hinging on economic conditions.  

"Falls in growth and inflation are likely to support government bonds but to the detriment of credit, and vice versa," he said.  

From a global perspective, he said any rate lift by the US Federal Reserve would be "gradual and increasingly reactive to the bond market".  

AMP Capital's head of retail and corporate business, Craig Keary, said he expects the new year to be "relatively consistent" for fixed income, with "nothing specifically on the horizon that's likely to give us cause for concern".  

However, for others, question marks still hang over the direction the economy and its mediators. 

Monitoring risks 

Given the current global economic environment, traditional fixed income risks, like inflation, are ranking fairly low on the agenda of portfolio managers, but are still worth watching, they said.  

Fidelity's Wells said history has proved the worst times for bond yields are usually those that precede a rise in interest rates, such as in 2013.  

He said in the US, there are still strong indicators that rates will continue to remain on hold for a significant part of 2015.  

"We expect inflation to stay low in 2015, but rising US wage pressures is the key risk to our view," he said.  

BTIM's Gor added: "the main risk you have with owning bond portfolios is inflation surprising to the upside and we consider that an incredibly low risk at the moment".  

"We're more worried about a continued deflationary environment globally over the next couple of years." 

Western Asset Management's Kirkham agreed economic factors will determine the risks and benefits of the bond market.  

"From our point of view, we are quite constructive on the direction of the economy at this point. We don't think that it's running hot, but we think that it's transitioning through the cycle  - managing the transition from the mining boom to broader economic growth," he said.  

"We don't feel that there's anything major out there, but it's hard to get some solid growth out of some of these economies. That's basically the crux of it." 

A definition in flux? 

Another area of contention, when it comes to fixed income, is whether it has stepped beyond its traditional capital preservation role to offer competitive returns.  

While those on the corporate side paint a compelling picture for yield, it appears planners are still sticking to what they know.  

"Where financial planners use fixed income investments for clients, their top priority is capital preservation - even more so than maximising yield or liquidity, so allocation has been inversely linked to share market confidence over the last four years," Investment Trends' Peker said.  

His statement was based on the group's survey of 1038 financial planners.  

AMP's Keary's view is that fixed income's value will always be linked to its preservation properties.  

"If investors are looking for income, there are other things to use," he said.  

However, he discouraged planners from adopting the mindset that fixed income is the only defensive asset.  

"Fixed income is important, but it's not the only solution¬ [There's also] infrastructure and direct property," he said.    

He stressed the importance of diversification.  

"This is not the environment where you would want to be exposed to a single name or a single sector, so it's about making sure the portfolio of fixed income assets you're investing in is well researched, diverse and they're actively managed." 

Nonetheless, BTIM's Gor and Western Asset Management's Kirkham said the fixed income's return capabilities should not be overlooked too quickly.  

"While bonds are generally considered a boring asset class, you can see that the returns on offer are still quite considerable," Gor said.  

He said the asset class has suffered from a "perception" problem, which has seen investors only resort to it as an anchor against equities, rather than exploring its income-generating offerings.  

Kirkham said if investors or planners are looking for income generation, they need to be more creative in the way they approach fixed income.  

"So you've got your fixed income bench, but you're a bit more opportunistic in terms of the positioning," he said.  

The rationale is to properly capture the risk, without taking on too much exposure to countries that won't generate solid returns for investors.  

"People look at the current benchmarks and are not so comfortable about them because they are weighted by the most indebted countries and they're not necessarily the place we want to be, which is why there's obviously a big movement towards unconstrained type of funds and that clearly is a theme that's running through the market at this point," he said.  

As far as performance, Kirkham said he sees bonds as a surprise basket that promise consistency, but often deliver above.  

"It's interesting looking at where fixed income has been this year¬ What we have seen is bond yields have continued to climb, so of course returns in bonds have been quite strong," he said.  

"Our core bond funds have something like six or seven per cent, but if you had asked me a year ago I would have said it would have been closer to three or four." 

He said it's up to the economy to give fixed income the kick it needs into solid growth territory in 2015.