Chris Dickman

Altius Asset Management says investors are generally failing to realise there are significant differences between bond funds, and that different management styles are hugely influential in determining whether performance meets investor expectations.

Mr Chris Dickman, senior portfolio manager at Altius Asset Management, says rather than thinking of bonds as a homogenous asset class, investors should look at the differences between bond funds in order to ascertain which are performing well, and which are not.

In contrast to traditional fixed interest managers, Altius takes an active, diversified approach to bond fund management.

“The objective is to look after investors in all parts of the cycle, not just when rates are falling or stable,” Mr Dickman says.

“Our nimble style, driven by our objective of beating both cash and bond returns, is an advantage for investors. We focus on generating income when bonds are generating capital losses, but we are swift to shift our focus to also exploit the potential for capital gain when the time is right.”

Unlike many fixed interest managers, Altius does not take a set and forget approach, and would rarely hold a bond to maturity.

“We take an active approach and will only hold a bond until it has reached its return targets. We carefully monitor and adjust our portfolios accordingly,” Mr Dickman says.

Altius’ approach combines both credit and duration strategies, in an effort to optimise returns for investors in all market conditions.

“Credit risk is a key consideration when investing in fixed interest, as it reflects the probability of timely repayment of interest and principal. More creditworthy securities have higher credit ratings and are considered to have relatively low probability of default, while lower rated securities can constitute medium to high risk,” Mr Dickman says.

“For instance, corporate bonds are generally issued by companies on an unsecured basis. In Australia, the credit quality of the market is very high and dominated by major banks and blue-chip industrial companies. These bonds provide higher yields than comparable government bonds, but do have credit risk that must be assessed.”

He says duration risk is another factor to be taken into account when managing fixed interest portfolios.

“In a falling interest rate environment, a longer duration instrument will enjoy a larger capital gain than a shorter duration instrument, while some investments like cash or term deposits provide no capital gain potential at all,” he says.

Commenting on the outlook for the bond market in Australia, Mr Dickman says the shape of the yield curve for fixed interest is quite steep, especially in corporate and semi-government bonds. However, he says the three to five year part of the curve is quite attractive. This means it is possible to pick up a relatively high yield, compared to what is possible elsewhere, by buying a similar security that is only a fraction longer in duration.

“In the current environment, the pick up in yield out of bank term deposits and into intermediate maturities (such as corporate and bank) is quite high.

“Given the upward tendency in Australian government bond interest rates and the low running yield, we retain a bias toward a shorter maturity profile but favour higher yielding semi-government and corporate bonds,” Mr Dickman says.

The pace of transition away from mining investment in the Australian economy continues to be sluggish, and he expects further weakness in the Australian dollar as the US economy strengthens and US interest rates rise.

“A falling Australian dollar will do some of the heavy lifting for the RBA and reduce the pressure to reduce interest rates further. However, the RBA’s concern with the employment market remains acute, thus inviting further moves to reduce interest rates.”

He says the path to rising bond yields is likely to be slow and somewhat volatile. Any upward march of bond yields will be further tempered by below trend growth.

“While we expect Australian cash rates may fall further, we believe longer dated bonds, especially Commonwealth, will sell off modestly, driven by higher yields in longer dated US Treasury bonds,” Mr Dickman says.

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“With yields at historically low levels, investors holding fixed interest portfolios that reflect the benchmark rather than being actively managed do run the risk of incurring capital losses.
 
“However, it’s important for long term investors to have a well-diversified portfolio that holds fixed interest because having a duration exposure is the best way to cushion portfolio losses when there is a downturn in equity markets, typically driven by a poor economic outlook,” says Bill Bovingdon, chief investment officer at Altius.
 
“Whether investors believe the global economy will recover or will deteriorate further, having some fixed income exposure to provide duration is important to maintain a balanced portfolio.
 
“In either economic environment, active fixed interest fund managers can add value with well-constructed strategies that also help protect capital.
 
“For example, while duration is your friend in poor economic environments, it can quickly turn into a foe when the economy improves if the bond investments are not well-managed.
 
“In a rising rate environment, this could include investing in short-dated bonds which have a lower duration and are therefore less sensitive to interest rate changes.
 
“Short-dated corporate bonds that have a yield above the cash rate benefit from capital gains (in addition to accrued income) as the yield falls toward the cash rate over the life of the security.
 
“Other strategies include investing in floating rate notes (FRNs), as they pay a fixed margin above an agreed level such as the bank bill swap rate and avoid the downside of rising interest rates by giving up some of the potential upside if rates fall. In a rising interest rate environment, spread compression can lead to capital gains in FRNs. Using interest rate swaps to swap fixed rates for floating rates can also benefit returns.”
 
Mr Bovingdon said unfortunately traditionally managed fixed income portfolios and index funds do not provide this flexibility for investors.
 
“There is a tendency for investors to lump all fixed income funds into the one bucket, yet active managers that have developed processes and strategies – such as the ability to switch into credit strategies and floating rate notes – can add real value.”
 
He added Altius believes that domestically a two-speed economy remains and the transition is unlikely to be smooth or perfectly timed.
 
“With inflation tracking at the mid-point of the inflation objective, the Reserve Bank of Australia (RBA) is able to provide further stimulus if required.
 
“Overall Altius believes the short end of the Australian yield curve will be underpinned by RBA easing, while upside surprises on global growth will put pressure on longer dated bonds.
 
“China and the US, in general terms, have seen improved economic performance year on year since 2010. While data releases for the second quarter of 2013 have mostly been weak, it is likely this is a temporary soft patch due to the US sequestration and seasonal factors (second quarter data has been weak for the past three years).
 
“Such scenarios mean it is important to have fixed income exposure in a broader portfolio context to act as a counter to equity markets. In rising rate environments fixed income does not need to be the enemy,” Mr Bovingdon said.

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“Indeed, there is increasing evidence that many investors are confused by what fixed interest really means. 

“Equating fixed interest with term deposits is not a balanced approach and, from a diversification point of view, is not much better than having no fixed interest investments at all,” Mr Bovingdon said. 

He said that fixed interest securities play a crucial defensive role in any well-balanced investment portfolio. 

“Fixed interest can provide predictable, regular income and act as a foil against the losses made on equity holdings during an economic downturn. 

“However, a poorly constructed defensive allocation will fail in meeting defensive and risk-management objectives in times of market turmoil, such as we have seen in recent years. 

“Investors need to do some research to educate themselves about fixed interest investments. 

“Advisers should encourage their clients to spend the same sort of time understanding fixed interest as they do equity markets, to ensure they have a basic knowledge of the range of products that make up the fixed interest sector and the benefits and risks associated with each. 

“Not all assets that have been labelled fixed income are ‘true to label’, and furthermore, not all bonds are made equal. 

“Advisers and their clients need to be aware that some are inherently much more risky than others, and others are just not fit for purpose if the objective is to create a safe, predictable source of income that also diversifies a portfolio’s equity risk,” he said. 

Mr Bovingdon said investors and advisers should appreciate the two desirable characteristics of fixed income in a portfolio. 

He said they provide:

• a predictable and regular source of income (the investor gets predetermined coupons plus the principal back at maturity, making cash flows predictable)
• portfolio diversification.

“The importance of defensive role of bonds cannot be underestimated for all investors, and for some, such as retirees, it is particularly critical. 

“In addition, the relative stability of bond returns not only reduces overall portfolio volatility, but also over the medium to long term, bonds are negatively correlated to equity prices which improves the risk return profile of the overall portfolio. 

“These are points that investors should understand about fixed income,” he said. 

Altius has developed a list of risks that investors should consider for fixed interest investing, as well as a definition of investment products that make up fixed interest (see attached).

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Australian equities manager Platypus Asset Management; international equities manager Wingate Asset Management; and fixed interest manager Altius Asset Management all agree that the economic, investment and financial world has continued to change over the past seven years and many rules that previously held true will need to be reassessed if investors are to see positive returns this year.

Mr Donald Williams, chief investment officer at Platypus, said that since the global financial crisis there has been a number of further shocks, including the current European debt crisis but he believes things are now beginning to look better for equity investors.

“The second half of 2011 was a very difficult time for equity investors. However, 2012 has already shown more positive signs.

“The data from the US is upbeat and we are about as certain as we can be that there will be no ‘double-dip’ recession.

“China’s inflation appears under control and while the problems in Europe remain serious, it seems governments there are at last treating the issues with the urgency they need.

“At home, we think the Australian dollar (AUD) will remain uncomfortably high this year, and in the short term it could make new highs against the US dollar (USD), as it has already done against the Euro.

“This will continue to affect a number of industries directly and make USD/Euro revenue earners less attractive. The only positive to come from this is that the Reserve Bank of Australia (RBA) is likely to be more aggressive on rates to keep a lid on the AUD. Most of last year they were cheering on the AUD strength – now it is a policy problem.

“However, the RBA has done the right thing by cutting interest rates at the end of last year, and overall we believe the Australian economy is in a solid position.

“Our view is that the Australian market will stay relatively subdued for the next six months while overseas issues play out and Australian investors achieve a level of comfort with what is happening there.

“After that, and assuming there are no more major shocks to the system, we believe the market could end the year having overcome the 5000 point milestone,” Mr Williams said.

Mr Chad Padowitz, chief investment officer at Wingate, agrees investors now need to take a new look at investment options and approaches they may previously have disregarded.

“It can be easy for Australian investors to dismiss international equities as too risky, too exposed to the downturn in the US and Europe, and look to the past 10 years’ subdued performance as justification.

“Certainly there are some serious adverse overseas considerations that must be taken into account. Global deleveraging is continuing – as it should, with debt having been built up for over 50 years in most developed countries that now needs to be repaid.

“Additionally, the risks from Europe have the potential to create a ripple effect around the world, in the same way the Lehman collapse did. Another failure by a major organisation such as a bank, or a major shift to the hard left – or for that matter extreme right – in politics could create global problems.

“But at the same time, many top tier global companies have good earnings and strong balance sheets, despite the difficult economic environment. Therefore they should be very attractive to investors, particularly because of the yield being offered on current prices.

“On top of this, many companies are buying back their own shares as opposed to over-investing in potential future growth, which by itself will create better returns for investors in those companies. Home improvement retailer Lowes is a good example of this,” Mr Padowitz said.

Mr Chris Dickman, senior portfolio manager at Altius, said bond markets are also an example of how many of the traditional axioms of investment markets no longer hold true.

“The exceptional level of interest in Australian bond markets by international investors and central banks surprised many investors in 2011, who did not expect our market to perform as well as it did.

“We believe this interest from off-shore investors will continue in 2012. The Fed has announced it will be keeping US rates at very low levels for the next couple of years. In this light, Australia continues to offer high yields compared to other developed economies, which will act as a magnet for ‘carry trades’.

“This is in addition to the benefits of being seen as a safe haven, having a relatively strong economy, one of a diminishing number of AAA-rated, and a hedge against the risk of a Chinese slow-down,” Mr Dickman said.

Altius also believes 2012 will see some positive activity in bond market issues added Mr Dickman. “Globally there is something of a log jam of issuers who have been waiting for the ‘right’ time to issue but at some point during the year they will simply have to push the button.

“The success of the Commonwealth Bank’s covered bond issuance, followed quickly by Westpac’s, demonstrates the appetite among investors for different types of funding. We think it is likely that corporates, who would usually have used bank loans for financing, will instead consider corporate bonds. This brings corporate bonds to the fore,” Mr Dickman said.

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Ms Thomson has eighteen years experience in the financial services industry.  She was most recently with ING Investment Management, as a senior research analyst – income assets, within the fixed income department. Prior to this, she was head of risk and business strategy at ING.  She has also worked at Macquarie Bank in London in project and structured finance, and started her career at Mercantile Mutual Life Insurance as an actuarial analyst. 

Ms Thomson holds a bachelor of science, majoring in pure mathematics and mathematical statistics, from the University of Sydney, and an MBA from the Australian Graduate School of Management.  She is an associate of the Institute of Actuaries of Australia. 

Altius was established last year as a joint venture between its principals and Australian Unity Investments and launched its first fund in July this year. 

Mr Chris Dickman, senior portfolio manager at Altius, said that the Altius approach is to take advantage of both credit and thematic opportunities in the market to optimise returns for investors. 

“Ongoing market volatility and economic uncertainty, particularly in Europe and the US, can bring attractive investment opportunities and high-quality credit skills are vital in exploiting these.  

“Vanessa has a diverse range of sector experience both across investment and sub-investment grade levels, and tremendous quantitative skills, which will prove very useful to our investment activities. 

“We had a very clear idea of how the credit research role will work within the business, and the skills and experience we required to complement the rest of the team, and Vanessa fits these criteria perfectly,” he said.

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