AFI bond managers strongly positioned to navigate unchartered territory

From

Andrew Yap

In an environment where macroeconomic and geopolitical uncertainties have weighed heavily on investor sentiment, Australian Fixed Interest (AFI) bond managers have continued to demonstrate their resilience and produce strong risk-adjusted returns.

For the 12 months to 30 April 2019, the median manager in Zenith’s AFI bonds sub-sector produced a net return of 7.2%, broadly keeping pace with the Bloomberg AusBond Composite Bond Index (0+ Years). In absolute terms, returns across the sector were large in a historical context, benefitting from a strong rally in Commonwealth Government Bonds (CGB), where the key 10-Year term rate fell to 1.64%, nearing a historic low.

In Zenith’s 2019 sector review, we explore the movements in domestic bond markets (including CGBs, semi-government and corporates) and link this to active manager positioning. Our analysis notes a structural ‘short bias’ across the bonds sub-sector (expressed through both directional and steepener trades) and overweight credit positioning, particularly leading into the sell-off in risk assets in 4Q18.

While these key positions detracted from performance, different outcomes were noted across ‘Core’ and ‘Core-Plus’ offerings, with the former tending to produce more consistent risk-adjusted returns as active risk was generally expressed in a local context with more sensitivity to the benchmark. This outcome was in part counter-intuitive given their more constrained mandates and fewer sources of active return.

Zenith’s Head of Multi-Asset and Australian Fixed Income, Andrew Yap stated “AFI Bond managers are well positioned to navigate an environment where interest rate cuts are already priced into forward curves and deteriorating macroeconomic fundamentals have the potential to impact the credit cycle.

In our opinion, through this period of transition, active AFI managers should produce superior risk adjusted-returns and demonstrate greater capital preservation qualities relative to passive investment approaches. That said, investors should expect that in a market where volatility rises, a greater dispersion of performance outcomes across the asset class, reflecting differences in investment styles, focus and the ability of managers to extract value given prevailing market conditions”.

Yap added, “with the yield on 10-year CGB’s trading at a historic low, the risks associated with a shift or steepening of the CGB yield curve are increasingly asymmetric, and managers need to be diligent with respect to their interest rate and yield curve strategies – this point is particularly pertinent when considered in light of the benchmark’s duration which has continued to lengthen. Further, with credit markets expected to become more volatile and less directional in nature, opportunities to add value are expected to be concentrated in the areas of relative value and idiosyncratic risk”.

While Yap believes it’s feasible that bonds continue to rally and underpin the performance of the asset class more broadly, the longer-term prospects of AFI Bond managers is expected to be closely aligned to their (i) breadth of mandate, and (ii) propensity to take active risk in the areas of interest rates and bottom-up credit selection.

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