However, the returns on fixed income have actually been superior to the returns on term deposits over the past 10 years. Given the current economic environment both globally and domestically, cash rates are likely to remain lower for longer, which should keep bond prices higher and term deposit rates lower. As a result, Australian investors may want to reassess their low exposure to fixed income. 

Q: Is Australia unusual in its preference for cash vs fixed income?

A: The simple answer is yes. Historically, Australian investors have preferred cash rather than fixed income as the default position for the defensive asset holding in their investment portfolios. Although US investors have held around the same amount of equities as an Australian investor, instead of cash they held more of their portfolios in fixed income.

Pension Fund Asset Allocation in Selected OECD Countries, 2012

 Source: OECD Global Pension Statistics

The “Other” category includes loans, land and buildings, unallocated insurance contracts, hedge funds, private equity funds, structured products, other mutual funds (i.e. not invested in cash, bills and bonds, shares or land and buildings) and other investments.

For Australia, Source: Australian Bureau of Statistics. The high value for the “Other” category is driven mainly by net equity of pension life office reserves (14% of total investment).
For Canada, the high value for the “Other” category is driven mainly by other investments of mutual funds (15% of total investment).
For Japan, Source: Bank of Japan. The high value for the “Other” category is driven mainly by accounts payable and receivable (22% of total investment) and outward investments in securities (21% of total investment).

For Germany, the high value for the “Other” category is driven mainly by loans (18% of total investment) and other investments of mutual funds (17% of total investment).

 Q: What are the reasons for this disparity?

A: It is partly due to a lack of familiarity with fixed income in the Australian market and partly because historically Australian cash rates were high, leaving very little premium between the cash rate and the yield on the 10-year bond. By contrast, US investors historically have been paid to hold 10-year bonds and so have been incentivised to hold long duration assets.

Q: What was the effect on Australian investors of holding cash rather than fixed income?

A: Given the high yields available on Australian term deposits, the decision to hold them rather than bonds may be seen as rational and appropriate in a high inflation environment. However, such  investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. This particularly came to light in the GFC when equity prices collapsed and many Australian investors had no fixed income exposure to offset the negative returns from equities. In fact, as cash rates fell to help stabilise the economy, cash holdings performed poorly compared with fixed income.

Q: What’s the difference in long-term returns between fixed income and term deposits?

A: The returns on fixed income have surpassed term deposits over the longer term despite the fact the Australian yield curve has been so flat over the past 10 years.  Although investors in cash believed they were investing in an asset class which was offering higher returns, actual returns were higher for true fixed income funds since cash and term deposit holdings missed out on the capital returns enjoyed by bonds. When choosing where to allocate funds, it seems that investors are more concerned about ex ante returns than the returns they would have got from an asset class they don’t own.

Bonds outperform term deposits over the long term

Source: Mercer Insight; RBA (data reference: FRDIRBTD10KAR)

Dividends and distributions are reinvested. Returns are gross (pre fees, pre tax) and assume reinvestment of distributions.
*Term deposit return is the average rate on $10,000 term deposits across all terms at the five largest banks, including their advertised ‘specials’ and regular rates (using the monthly effective rate)

Q: Will we see domestic investors looking more closely at fixed income for their liquid or defensive asset class holdings?

In our view, they should but the problem is that investors are still scared off by the fact that bond markets have had a 20-year rally and rates must return to their normal levels from the current historically low yields.

Bond markets have had a 20-year rally in Australia and this has been due to the fact the neutral rate for cash has fallen as inflation has fallen. The Reserve Bank of Australia (RBA) has an inflation target of 2-3%. The success of the RBA in achieving its target has resulted in the financial market viewing it as credible. Since longer-term bonds use this as a realistic inflation level, it has lowered the risk premium around future inflation levels helping to lower bond yields and raise prices.

Q: Bond yields are historically low: is this likely to continue?

A: Central banks globally have intervened to lower bond rates. They could not cut cash rates below zero and so embarked on unconventional policies, such as quantitative easing (QE) to help repair their economies. QE has depressed real rates and term premiums globally. Many of these programmes have stopped or are being tapered. In 2013, US rates rose by 100 bps on the back of the Federal Reserve’s tapering of QE. However, the Fed still holds a vast quantity of fixed income securities on its balance sheet. This is not just holding up bond prices (therefore keeping yields low) but also bolstering all risky assets, including equities.  While QE persists, bond yields will remain depressed.

As we have stated previously, Tyndall views the new neutral rate for cash as being around 4.0%, which would imply a normal rate for the 10-year bond yield of around 5.0% (100 bps above its current level of 4.0%).  With the cash rate at 2.5%, even the current low bond yields are still providing a better return than cash.

Q: What will be the impact on Australia of lower rates for longer?

Australia’s household debt to disposable income is at record highs at around 148%[1]. With the decline in the terms of trade, low wages and low returns, income growth will remain low. As a result, monetary policy will have a stronger impact on the economy and won’t require large increases in interest rates to have the desired effect on the economy as we have seen in previous cycles. With cash rates low and likely to remain low and term deposit rates falling, Australian investors may start considering increasing their exposure to fixed income.

The risk of being so underinvested is a major one that is often ignored and leaves investors exposed not only to a potential fall in the cash rate but also the current low interest rate environment.  Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of low inflation and the inability of central banks to adequately deal with it also warrants an allocation to bonds, in our opinion.

[1] Source: Reserve Bank of Australia, table E2, http://www.rba.gov.au/statistics/tables/index.html.

By Roger Bridges, Head of Fixed Income Strategy, Tyndall AM

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual.  The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

The Tyndall Australian Bond Fund (ARSN 098 736 255) is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL 229664, a related entity of Tyndall AM.  Potential investors should obtain their own independent advice and consider the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.

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Neuberger Berman’s release its latest views on equities, fixed income and alternatives.

Managers and strategists at global investment manager Neuberger Berman envision positive momentum across many asset classes in 2014, as the global economy stabilises and generates moderate growth, according to Solving for 2014, the firm’s third annual outlook across global equities, fixed income and alternative investments.

As the investable universe has grown—across borders and asset categories—Neuberger Berman’s focus has broadened as well. This year’s edition is deeper, covering more ground than previous issues, reflecting the market’s increased diversity and the firm’s broad perspective.

The outlook provides Neuberger Berman’s views on equities, fixed income and alternatives, all on a global basis, and capitalises on the fundamental research of its portfolio managers and analysts.

“From an economic perspective, things are improving across a number of major economies,” said Joseph Amato, President and Chief Investment Officer of Neuberger Berman.

“As the Fed and other central banks adjust their approaches, investors should remain alert. Inflation trends remain moderate and we do not expect a significant uptick in rates this year. These shifts in policy merits close attention as investors adjust portfolios to capitalise on the improved growth and somewhat tighter monetary conditions.”

In equities, Mr Amato anticipates continued earnings growth this year tied to modest operating leverage as developed economies pick up.

In fixed income, investors can likely expect slow and steady growth and the potential for rising rates, said Brad Tank, Chief Investment Officer, Fixed Income.

“In my view, we’re probably in the middle innings of this growth phase in the US,” Mr Tank said.

“Things are getting better, but not rapidly. For the coming year, we anticipate a relatively benign growth environment, with continued momentum in the US, a modest acceleration in Europe and an ‘Abenomics’-driven recovery in Japan, offsetting China’s slower growth trajectory.”

An improving economy should lead to more private equity buyout activity, according to Anthony Tutrone, Neuberger Berman’s Global Head of Alternatives.

“At this point, we haven’t gotten to a major acceleration in buyouts, but we believe deals will begin to pick up,” he said.

Alan Dorsey, the firm’s Head of Investment Strategy and Risk, said a key issue for 2014 is achieving incremental return—whether through capital appreciation or additional yield—mindful that return outlooks have gradually shifted downward while interest rates remain extremely low. Alternatives are one key area that has gained traction, but another particularly important one from a portfolio allocation standpoint is emerging markets, he said.

“As investors enter 2014, improving global growth combined with shifting monetary policy are creating a nuanced environment, with obstacles but also opportunities,” said Paul O’Halloran, Managing Director, NB Australia.

Download Solving for 2014 here.

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Mark Burgess

Looking forward to 2014, Threadneedle Investments believes the year will be characterised by the move towards financial markets standing on their own feet again, as the global policy support that has been providing abundant liquidity to markets starts to be withdrawn.

This will mark an important change in the drivers of investment returns:

Mark Burgess, Chief Investment Officer at Threadneedle, commented: “Following many years of liquidity provision from the world’s central banks which supported the performance of ‘risk assets’, 2014 will be about selecting the right investments as the global economic recovery will be put to the test. Financial markets will have to re-engage with reality against a backdrop of significant macro and policy challenges and investors need to be alive to the consequences of this changing environment and subsequent volatility. What happens if QE is withdrawn too quickly? What risks lie ahead if companies don’t deliver earnings growth?”

Equities

“While we remain bullish on equities overall, regional and sector performance will vary significantly. Investors are increasingly shifting their focus away from market liquidity to company fundamentals following the Fed’s announcement in September that it is preparing to start turning off the QE tap. Companies will have to step up their game and earnings will have to pick up significantly if equities are to sustain or even come close to the rally we have seen in developed markets during 2013.

“US company earnings have been at the forefront, having recovered and surpassed their previous peak. We don’t think this year’s returns of close to 30% will be repeated in 2014, but US equities remain attractive. The banking sector is well capitalised and has started lending again, providing a boost to the economy. While the debt ceiling remains a risk, a combination of low energy and labour costs should support company margins into 2014. We think the best performers will be companies in the technology and consumer discretionary sectors.

“In contrast, only half of European companies have beaten earnings expectations so far this year. The region remains beset by relatively poor growth dynamics compared with the rest of the developed world. This year’s stock market recovery could easily herald a false dawn. The banking sector still has a long way to travel to address its capital shortage, although the fundamentals are much improved. While for the first time in three years we believe Europe is likely to return to positive GDP growth in 2014, earnings growth is likely to be steady rather than dramatic. Stock pickers, however, could be handsomely rewarded when concentrating on companies with strong business models, robust finances, experienced managements and ideally dominant market positions.

“While the UK economy is still smaller than it was pre-crisis, we have seen some very encouraging data in 2013 and there could be a surprise uptick in GDP growth of around 2% next year. Unemployment has been falling and there is a likelihood that the BoE’s 7% threshold will be reached in late 2014. The problem is that the positive data has not necessarily translated into domestic profits thus far and companies are likely to end the year flat. On the upside, we have seen a pickup in IPO activity and expect the improved economic backdrop to further drive corporate confidence and activity in 2014. We think the best returns are going to come from industrials and the consumer discretionary sector, with consumption (and housing) having driven the economic recovery to date. However, relatively little economic rebalancing has taken place to date, something that has been exacerbated by the success of the ‘Help to Buy’ scheme and raises questions over the sustainability of the recovery.

“Japan has embarked on a clear and credible path, and ‘Abenomics’ has been transformative. Low interest rates support credit growth and 80% of companies are set to raise base salaries.^[1] More challenges lie ahead but we expect further gains in equities and are overweight in financials and beneficiaries of policy action.”

Fixed income

“2014 will be a year of transition for bonds. The expectation of QE tapering has already led to the end of the bond market rally, although we see no evidence for a rotation out of the asset class as demand from pension funds and banks remains. In sovereign markets, we expect yields to move gradually upwards, with the 10-year US Treasury yield at around 3.5% by the end of 2014. While we may not witness a return to the historic norms just yet, the gap between equity and bond yields should slowly start to normalise, so the “risk-on” stance that has worked well for investors during the last few years becomes less glaring in 2014. In fact, corporate credit as an asset built for a slow growth environment should perform well next year, having already delivered positive returns in 2013. High yield in particular has had a good year and we expect this to continue. Company balance sheets are robust and we see defaults as very unlikely.”

Emerging markets

“Emerging markets are a mixed bag and a wildcard in 2014. The announcement of QE tapering has caused significant headwinds in fixed income assets and concerns over currency volatility and current account deficits remain. Equity valuations are attractive, but history shows that rising US Treasury yields and a stronger US dollar can have a negative impact on EM returns. In addition, GDP growth in countries such as Brazil is unlikely to look spectacular compared to the developed world. On the upside, Mexico points to a year of solid growth linked to the US economic recovery and the country’s lower manufacturing cost base compared to China. While the latter has impressed us with the third plenum, stock picking is going to be of particular importance over the next few years. Equally, domestic markets in Latin America and those emerging market companies that are geared to an economic recovery in the developed world should not be dismissed.”

Commercial property

‘We expect the UK commercial property market to deliver good returns in 2014, as the economic recovery continues to positively impact upon occupational demand. The main beneficiaries should be the South East, as well as logistics and warehousing markets across the country. Top provincial office markets are also showing some signs of recovery. We believe investors will continue to be attracted to commercial property next year and competition for stock will place upward pressure on capital values.”

——————

^[1] Japanese Ministry of Labour and Welfare survey

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The future of fixed income.

Roger Bridges, Head of Fixed Income and Anita Daum, Head of Portfolio Management and the portfolio manager for the Tyndall Australian Bond Fund have provided their answers to AdviserVoice on fixed income and the future for bonds.

Roger has 30 years’ experience in the fixed income market, and has overall responsibility for managing and implementing the strategy for Tyndall’s fixed income portfolios. Anita has 11 years’ experience in the fixed income market and has been managing the Tyndall Australian Bond Fund for four years.

Why did bonds take such a hammering in June?

Roger:  The June reaction of bonds was due to the market’s expectation for the reversal of quantitative easing or QE in the US. Bonds prices surged to record highs in recent years, in part due to central banks such as the US Federal Reserve and Bank of England buying them under QE programmes. The intention – and the effect – was to push down bond yields, which move in the opposite direction to prices.

Low bond yields tend to cause interest rates to fall. This helps to reduce the cost of borrowing for consumers and governments and boost the prices of other assets such as shares. These effects can help pull a country out of recession and assist economic recovery.

But as the recovery gathers momentum, central banks try to curtail and then reverse QE, sending the previous trends into reverse. Announcements by the Fed in June that it planned to scale back its QE programme sparked fear among investors, sending bond prices in the US sharply lower and yields higher. Our bond market is strongly affected by the movement of US bonds, particularly longer-dated bonds such as the 10-years. As a result, we also saw a sell-off here with yields rising and bond prices falling below fair value.

Following this upset, the Fed was forced into a partial retreat and tried to calm market fears over QE tapering, which caused bond yields to fall back to more normal levels. In fact, July saw Australian bond market indices post modest positive returns as bond yields fell.

Can we expect more volatility in the short term?

Roger:  In our view, September seems to be a likely start date for the US Fed’s tapering of its bond-buying programme. The Fed indicated back in June that it may start tapering next month and recent strong economic data makes this all the more likely. In the past week or two, we’ve seen strong US employment and consumer price data.

Given the strong correlation between the movement of US government bonds and Australian government bonds, bond market volatility remains a strong possibility as the market tries to work out what the effects of tapering QE will be.

As growth improves in the US and this tapering of QE comes into effect, how likely is it that we will see another 1994 with bonds experiencing negative returns?

Roger:  It is possible, though unusual, for bonds to deliver negative returns. In general, this only occurs when either the cash rate unexpectedly increases by a large amount or the bond market tries to price in unexpectedly large rate increases and adjusts these expectations quickly. If these market expectations are slowly priced in, then the market value of bonds may fall but they don’t experience negative returns, only lower returns.

This is what happened in 1994: The Fed and its chairman Alan Greenspan were worried about inflation following the 70s and 80s and so decided to take swift action to avoid a spike in inflation. The market was surprised by the sharp rate hikes that the Fed introduced and US bonds didn’t respond until the rate hikes occurred since they were not well telegraphed in advance. The market then panicked and bond yields jumped, while prices fell. 2004-2006 also saw rate hikes in the US but because the Fed was more transparent and took action more slowly, the market had time to react to avoid bond losses.

The current situation is likely to be a repeat of 2004-2006. The Fed is telegraphing its moves in advance so the market shouldn’t be taken by surprise, although there might be brief periods of panic, like in June. But in the longer term, QE unwinding and rate hikes will be slow, measured and telegraphed in advance which shouldn’t lead to bond losses even though the trend will be for yields to rise.

Focusing back on the domestic economy, what’s the likely impact on our bond market of the upcoming Federal election?

Roger:  There is unlikely to be much of a reaction. In general, investor confidence should improve if there is a clear-cut outcome, with one party obtaining a decent majority. A hung parliament will be a negative for confidence and add to uncertainty.

Whichever party wins, if they intend to achieve a fiscal surplus, then obviously that will have an effect on bonds due to the reduction in bond issuance. If there are fewer bonds on issue, it should help to support pricing and keep yields lower.

With prices surging to record highs in recent years, is it fair to say that Australian bonds have had their day?

Roger:  Given historically high prices and low yields, investors have been questioning whether bonds have had their day. I don’t think this is the case.

Australian 10-year bonds have fallen from around 15% in 1982 to record lows below 3%.  The decline in bond yields has been largely the result of a structural decline in global inflation expectations, partly due to QE from central banks around the world and partly to slowing population growth and an aging population.

But in the shorter term, there are three main reasons why Australian bonds should remain attractive.

1)     Foreign investment. Even though this has started to drop off, it is still historically very high. Before the GFC approximately 20-30% of our bonds were held offshore, but by this year, it had jumped to just under 80%. This is largely due to other central banks wanting to diversify away from currencies such as the US dollar.

2)     QE globally. For Australia, this artificial suppression by other central banks means that there is increased demand for our higher yielding assets. Although interest rates are at record lows, our cash rate of 2.5% is still much higher than the zero or close to zero rates seen in Europe, the UK and the US.

3)     Our AAA rating. Australia is one of only 8 countries that has a AAA rating with a stable outlook from all 3 major rating agencies (Standard & Poor’s, Fitch, Moody’s).

So, in a world with a still highly volatile macroeconomic backdrop, the combination of very loose monetary policy in other countries and foreign demand for our debt due to its yield advantage should help to support the bond market in the medium term. We don’t envisage many catalysts that would suddenly push bond yields upwards for a sustained period.

Anita, why should an investor maintain a bond allocation in their portfolio?

Anita: Australians have traditionally invested in shares rather than bonds. But bonds are a valuable component in a diversified portfolio. Bonds tend to perform relatively better in market downturns and when deflation is a major risk. Diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns and reduce overall risk.

Although equities can offer the potential for greater returns more quickly, they involve considerable volatility and the potential for capital losses. Fixed income, on the other hand, offers regular, predictable income with a greater likelihood of capital protection and much more stable returns over the long term. It’s the non-correlation to equities that’s important – bonds should outperform when equities are underperforming and vice versa. So it’s important to have some of a portfolio invested in bonds.

What do you think an investor should look for when choosing a bond fund to invest in?

Anita:  If an investor wants a core bond holding to diversify their portfolio, then they should look for a traditional “true-to-label” bond fund to offset the volatility of other market sectors and provide that non-correlation to equities risk.

A fixed income fund should perform well in market downturns, providing the consistency of performance and regular income that investors expect. However, it’s important to note that not all bond funds are the same. For example, some funds are able to allocate large portions of their portfolio to credit. This gave investors in some of those funds a nasty shock during the GFC. Instead of the fixed income portion of their portfolio doing its job and being the outperformer during that time, funds that were very overweight credit actually performed badly and in some cases actually delivered negative returns during that period.

Our flagship bond fund did very well during the GFC because it is a true-to-label fund that is highly risk-aware and designed to deliver consistent performance even through serious market dislocations, when equities are doing badly.

So, it’s important to consider what an investor wants from fixed income and choose a fund accordingly. If it’s a non-core holding and the investor is looking for a higher return and is prepared to take on extra risk, then a fund that is able to invest in riskier securities could be appropriate. But if the investor is looking for a core holding, then they want a conservative true-to-label fund that won’t give them any nasty surprises at a time they can least afford them.

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Disclaimer

This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The Tyndall Australian Bond Fund ARSN 098 736 255 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”).  Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.  TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.

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In the first half of 2013, developed market equities have outperformed emerging markets, while fixed income has performed poorly, except for high yield bonds, which have benefited from their shorter duration characteristics. After a strong first quarter, risk assets rose through to mid-May before an aggressive bout of profit taking hit most financial markets. The trigger for this was the US Federal Reserve (Fed), which commented that it may ‘taper’ its bond purchase programme if economic data remains strong.

In this regard, the news is good for the US economy, but not so good for those who had expected quantitative easing (QE) to continue indefinitely. On the data front, US car sales have picked up markedly in the past two years and, importantly, housing starts have also improved – indeed, housebuilding is seeing a material uptick, having been a serious drag on the US economy over the past five years. As a result, US growth should continue to outperform the rest of the developed world. The fiscal cliff has also been less of a drag than feared, while the tax take has been better than expected.

The market now expects a US interest rate rise in 2015, about a year earlier than was forecast a few months ago and prior to the comments on ‘tapering’. It is worth emphasising that ‘tapering’ does not mean tightening (as shown in Figure 1 below), but rather making policy ‘less loose’. It is understandable that the Fed wants to begin to unwind QE, given the strength of the US economy compared to the rest of the developed world, and we expect this to happen in $20bn chunks, starting later in 2013. Further support for the ‘tapering’ argument comes from the fact that US inflation is very subdued, despite the pick up in economic growth.

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The great rotation from bonds to equities

While recent extreme volatility in global bond markets again raises the question of the role of fixed income in investor portfolios, new analysis from AXA Investment Managers (AXA IM) shows the significant impact a “great rotation” from bonds to equities could have on investor portfolios.

In The Great Rotation paper AXA IM’s leading researchers discuss and analyse investors’ capacity to take on additional risk and the potential for significant asset allocation shifts in the current market environment.

A great rotation is a big shift of strategic long term asset allocation driven by a combination of factors, including: long-term risk budgeting, the regulatory environment, monetary policy and liquidity. In 2013, AXA IM analysis shows these factors have seen a shift from cash to equities, rather than bonds to equities as investors risk appetite returns and they seek higher returning investments.

However, AXA IM’s Director of Australia & New Zealand, Craig Hurt, said any ‘great rotation’ of investor portfolios from bonds to equities could have multiple repercussions on investment decision making.

“For such a move to occur, both market and regulatory conditions would have to support greater appetite for risk. We evaluated the concept of a great rotation with regards to investors’ long-term investment objectives. The impact of a great rotation in global markets on the average Australian could be significant if their asset allocation is not given due attention,” he said.

“Similarly, if there is indeed a great rotation out of bonds and into equities at the same time Australian retirees are moving out of equities and into bonds in the search for a reliable income stream, then retirees may find themselves on the wrong end of a big global trade,” Mr Hurt added.

Focus on the fixed income landscape

According to AXA IM, while bond investors may already have come to terms with the risk that their exposure to high rated government and investment grade bonds will deliver negative real returns over the medium term, there are still a number of options for fixed income investors in an environment of asset class rotation including; reducing portfolio duration, adding inflation protection and yield pick-up.

“Investors can minimise interest rate risk by limiting the duration of their portfolios or by further replacing interest rate risk for credit risk. There is also a strong argument for seeking inflation protection,” Mr Hurt said.

AXA IM believes there are a number of important questions investors should ask to understand the risk of significant asset allocation shifts from bonds to equities.

Firstly, will other assets offer greater certainty of higher returns if bond yields are to remain very low? Secondly, are we on the verge of a bond bear market that will generate a period of negative returns in fixed income? Third, if that is the case, will it be through higher interest rates or a re-pricing of credit risk premiums? Lastly what can bond investors do in an environment of asset class rotation?

Such questions are even more important for an ageing Australian population as they move from the accumulation to decumulation phase.

“Whereas in the accumulation phase there is a focus on real-return growth assets, the investment strategy in the post-retirement world is generally centred on capital protection, inflation protection and yield generation,” Mr Hurt concluded. .

AXA IM’s Great Rotation paper provides an in depth analysis of options available to investors across the various asset classes.

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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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“In my view, as long as global uncertainty and problems in Europe and, to an extent, the US persist, the behaviour of the Australian dollar (AUD) is unlikely to change significantly.

“I also believe that the domestic economy is on a slower growth path as it continues to adjust to a high AUD and the RBA is setting monetary policy to accommodate this period of adjustment.

“In the short term we will experience lower official interest rates as the rest of the world continues to de-lever and the continuation of foreign quantitative easing (QE) programs keep the AUD strong.

“The currency will most likely continue to remain strong in the near term, which should restrain inflation, allowing the RBA to keep interest rates at these lower levels.

“However, in the longer term, as the AUD stabilises and the economy continues to adjust to accommodate it, the effect of the AUD on containing inflation will wear off (as it began to in the December quarter of 2012).

“For interest rates to remain low, inflation (and the outlook for it) needs to remain stable. This either requires domestic inflation to fall or the AUD to not depreciate. If the strength in the AUD is a direct result of overseas QE programs, we could see the official cash rate rising as these programs reverse and the upward pressure they are exerting on the AUD starts to dissipate,” Mr Bridges said.

He said that for the time being, the main drivers of the strong AUD show no sign of disappearing. These drivers include:

• Australia remains one of the few remaining countries with a stable AAA rating.  Even the US has lost its coveted AAA status, with many other major economies on a negative outlook. This creates demand for Australia’s relatively ‘safe’ assets.
• By running deficits during the GFC, the Australian government has effectively re-established a large and deep government bond market.  This extra supply may have created its own demand as more central banks look to the AUD as a currency to diversify into, while they reduce their weights in the US dollar (USD) and Euro.
• The effect of the mining capital expenditure boom is another factor in the AUD’s strength.  A recent research paper from the RBA highlights that net foreign investment into the resources sector increased from 0.5 percent of GDP in 2007 to 3 percent in 2012. This foreign direct investment in the mining sector to fund new projects has exerted upward pressure on the AUD.
• Many of the world’s central banks have used QE to stimulate their country’s weak economy, hoping to push investors into equities and riskier assets than government bonds as they search for greater yield. Essentially, this means that the bank increases the money supply by flooding financial institutions with capital, in an effort to promote increased lending and liquidity. Another objective of this policy is to weaken the home country’s currency.  For a country like Australia that has a floating currency and is not itself engaging in QE, the result is that its currency appreciates as these policies unfold.

“The easier monetary policy from the US, and now Japan, is essentially being imported into Australia’s economy, pushing up our currency.

“Although Australia has an independent monetary system, the rising currency can still result in easier monetary policy here.  Exchange rate sensitive sectors are suffering as the currency remains strong, making them less competitive than peers in countries with a weaker currency.

“In addition, the stronger dollar helps to keep top-line inflation subdued, which has allowed the RBA to cut official interest rates over the last year or so.  While domestic inflation has not fallen, international or tradeables inflation has plunged due to the strong currency, dragging down the headline inflation figure and keeping inflation within the RBA’s target band.

“In fact, domestic inflation is still very high, being above the RBA’s two to three percent inflation target. 

“Furthermore, the effect of the stronger dollar on tradeable inflation is starting to wane and there has been a marked pick up over the past six months. This may be due to improvements in domestic productivity as the economy adjusts to the ‘new normal’ rate of the AUD.

“However, domestic consumer and business confidence levels are at historical low levels and, in some cases, are worse than in countries experiencing much greater economic problems.

“Some of this can be explained by the bad news from overseas and the fact the Australian economy is going through a structural rebalancing, which is causing uncertainty.

“Much of the structural change is due to the strong AUD forcing businesses to readjust to accommodate it and improve productivity,” Mr Bridges said.

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George Vassos, Managing Director of Omega, believes the last few years have seen a fundamental economic shift to the East – and that investors have finally recognised the fact.

“Asian corporations have strong balance sheets relative to their global sector peers and often with much less risk, which makes them an attractive option for investors looking for superior risk adjusted returns,” said Mr Vassos.

“Banks are just one example. The European and US banks have certainly had their issues over the last few years and those are continuing. On the other hand, their Asian counterparts, such as ICICI Bank and OCBC Bank, have experienced strong growth, strong balance sheets and have a far more positive long-term outlook with a lower probability of downgrade or default,” said Mr Vassos.

According to Mr Vassos, Omega is one of the few investment managers that saw the potential of Asian corporate bonds prior to them becoming more widely favoured.

“Omega’s Corporate Bond fund has had a 40 per cent allocation to Asian corporate bonds, excluding Japan, since its inception in 2009. Our proprietary risk-controlled methodology uses key criteria such as profit, liquidity, gearing and solvency to assess risk and allow us to identify quality securities for our clients.  Using this methodology, we were able to identify the quality securities well ahead of the pack,” said Mr Vassos.

Mr Vassos went on to explain that the corporate bonds Omega has selected are underpinned by strong fundamentals, and therefore have a strong, long term positive outlook.

“At Omega we expect to see an increased demand for Asian corporate bonds over the coming year as growth in the region continues.  We’re particularly looking at corporations issuing bonds in countries such as Malaysia, Thailand, Taiwan, Korea and Singapore that are showing signs of maintaining that growth over the next few years,” said Mr Vassos.

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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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