Why invest in term deposits or global bonds when you can invest in Aussie bonds and get a better return? Jeff Brunton reports.
Since the global financial crisis, many people have been taking a closer look at their investments in fixed income.
The answer for many has been to invest in index funds.
While this may be a rewarding strategy for other asset classes, when it comes to fixed income it does not make sense.
Looking at the Barclays Global Aggregate, over 80 per cent of the index is in the United States, Europe and Japan (ie, the countries with the biggest debt).
Looking at figure 1, we can see that fixed income benchmarks are inefficient and don’t make sense because the biggest borrower is rewarded by getting the biggest index weight.
Some investors want to invest passively in fixed income, but as a passive investor you are buying more debt from countries and companies that are issuing the most debt (ie, the biggest borrowers, not the best borrowers).
This does not make sense.
We believe in an active, rather than passive, approach to investing.
Active management has the potential to add value through sector and stock selection.
Interest rates globally are at very low levels, meaning income generated from these bonds is very low. By only investing in the benchmark, investors are missing out on higher returns elsewhere.
Additionally, when interest rates inevitably normalise, the resulting capital losses will eat into the modest income being generated – and subsequently the total return will be low.
Sticking close to home
Interest rate and economic cycles in Australia are different to the rest of the world.
Due to Government stimulus and the Asia growth story, Australia has a healthier balance sheet – particularly at the Government level. Interest rates remain much closer to normal levels and are much higher than the rest of the developed world.
There will be fewer future interest rate rises here than in the rest of the world, since the Reserve Bank of Australia has done a lot of the heavy lifting already. In addition, due to higher growth prospects in this region versus other developed markets, Australian corporates have better potential for growth.
The opportunity to earn income with Australian investments, and in particular Australian credit, is much higher. Interest rates being closer to normal suggests capital gains and losses will be muted, which means total returns will be relatively higher compared to the rest of the world.
There is also protection on the possible downside. If markets were to turn down again, the higher starting point of interest rates in Australia means that as rates fell in response to a shock, Australian corporate bonds would deliver good returns due to the capital gains associated with the falling interest rates.
This would act as a buffer against the inevitable widening in the credit spread.
For an Australian investor looking to use fixed income to diversify Australian equity risk, an Australian bond portfolio is more likely to give capital gains to offset capital losses in equities than a hedged international bond portfolio.
This is because global markets are unlikely to move as much as Australian markets on the back of an Australian risk event, which means Australian fixed income is embedded with natural defensive characteristics.
Furthermore, recent history shows an overweight exposure to corporate bonds also captures much higher excess returns relative to government bonds.
A defensive play
Rather than passively buying the debt of the biggest borrowers, why not search out the better borrowers, as you would in an equity portfolio?
Look for borrowers in the right industries with sound fundamentals, strong financial positions and good management.
Investing actively is not only investing in better borrowers, but also increasing diversification within your portfolio.
The adage ‘don’t put all your eggs in one basket’ is crucial for bonds – much more so than equities.
This is because, unlike equities, the best you can do with bonds is get your money back (plus interest) – but on the other hand, you could lose it all if a borrower were to default.
So you need to spread your single name risk (ie, use more baskets).
We see a lot of investors who satisfy their income needs by holding a handful of term deposits and a couple of hybrids or bonds. While we wouldn’t say that Australian banks are unsafe, as a professional investor, this approach is too risky – it is undiversified and not defensive.
What do we mean by not defensive?
We believe this approach is unlikely to deliver strong returns from fixed income when you need them the most.
That is when other parts of your portfolio are under the most stress. So having an active fixed income manager investing across over 100 individual bonds gives you a diversified portfolio with defensive characteristics needed to balance the risks you are taking in other parts of your portfolio.
Why Australian fixed income now?
Even though fixed income has delivered two years of exceptional performance, there are still risks in the world. Risk associated with the European sovereigns defaulting, the removal of the US stimulus without disruption, political upheavals, high oil prices, and natural disasters.
This means that staying in fixed income is as important now as ever.
Fixed income funds are the best diversifier against equities, because it is the duration that helps fixed income deliver positive returns when markets are falling.
With banks still deleveraging and still working through the implications of Basel III, balance sheets for Australian corporates are in good shape and credit spreads still wide.
In addition, income generated particularly in Australia is higher than what it typically would be. So now is still the time to be investing in Australian fixed income.
Jeff Brunton is AMP Capital’s head of credit markets.
